The Great Financial Squeeze: An Economic Policy Perspective
What are some of the underlying economic policies that have resulted in the current global financial crisis? ______________________________________________________________________
Monday, September 15, 2008: Lehman Brothers files for the largest bankruptcy protection in US history. The US government refrains to intervene from saving the failing investment bank.
Tuesday, September 16, 2008: U.S. Federal Reserve presents $85 billion rescue package to the insurance behemoth: AIG. The move is made in order to avert larger, systemic shocks to the global financial system. The same day, Merrill Lynch, the third largest investment bank in the world is sold to Bank of America in a fire sale.
Sunday, September 21, 2008: In order to shore up their toxic balance sheets, two of the most venerable names in the investment banking world: Goldman Sachs and Morgan Stanley dropped their much vaunted investment banking status to become bank holding companies.
October 6-10, 2008: The Dow Jones Industrial Index falls 1874 points (18%) to record the steepest weekly fall in its history of 120 years.
Friday, October 31, 2008: UK’s second largest bank: Barclays announces a £7.3 billion investment from Middle East sovereign fund investors for roughly a third of its ownership.
Monday, November 24, 2008: US government and Citigroup together identify $306 billion in distressed assets on Citigroup’s balance sheet. Citigroup would absorb the first $29 billion in losses and various US government agencies would pick up most of the remaining tab.
Thursday, December 11, 2008: Former Chairman of NASDAQ, Bernard Madoff is arrested on a securities fraud charge that is estimated to be worth a historic $50 billion.
There’s plenty of other bad news to recount. But you get the picture.
So, what is happening to the world?
Globalization of Capital
“Globalization is a fact of life. But I believe we have underestimated its fragility.”
– Kofi Annan
Today, more than ever before, global capital markets are exactly that: global. They have ever greater access to information. They are ever more inter-connected and inter-dependent. And with the ubiquity and integration of financial data and transactional platforms, they have the ability to act across the globe on a real-time basis.
Furthermore, while some may argue that there has been a certain degree of “de-coupling” in trade flows between the West and the rest of the world, it is undeniable that there is an ever greater integration and fluidity in capital flows across the world. Globalization of capital across sovereign borders and economic blocs has broken down structural barriers that foster capital formation imbalances within economies. It is logical that when capital is given a free rein, then it will flow to fill up those gaps, i.e. geographies and industries which provide for the best risk-adjusted return on investment. However, one of the few unintended downsides to globalized unfettered capital flows is that such an environment precipitates the “hot money” phenomenon. In a world of liberalized national capital controls, a sophisticated and globalized financial system can swiftly spread a financial contagion. Today’s inter-connected financial markets can trigger higher and faster “wildfires” within and across discrete financial capitals of the world. As we have seen, from New York to London to Paris to Frankfurt to Dubai to Mumbai to Hong Kong to Shanghai to Singapore to Tokyo and to Sydney – the current contagion has spared no one.
The synchronized behavior of capital markets around the world also points to another theme: As emerging economies become more and more akin to “producer economies,” and mature economies transform themselves into “consumer economies,” there is rising affluence in the emerging, producer economies. Wealth that is being created in the emerging economies is still largely being deployed into seemingly safer and broader array of investable assets within mature, i.e. developed economies. For example, the “investor class” of the emerging economies has much more confidence in the stability and liquidity of US treasuries than the bonds issued by their respective emerging markets’ sovereign governments. To use New York Times columnist Thomas Friedman’s oft-cited notion, the “world is flat”…hot and crowded. To our collective chagrin – regardless of where we are on the planet: we are experiencing the transitional “growing pains” of a fundamental and systemic re-adjustment within the sphere of international finance. For now, a “flat” commercial world is giving rise to a “flattened” financial world.
Add to that, as the financial markets have become ever more global, inter-dependent, transparent, and in some ways, democratic, their ability to arbitrage information has declined. Therefore, the other actors within the financial markets have developed ever more inscrutable and esoteric financial instruments to generate profits.
Rising Market Volatility
“Nothing travels faster than light, with the possible exception of bad news…”
– Douglas Adams (British Author and Comic)
In today’s global markets, traditional “herd-like” emotional responses to market gyrations are magnified by the ever greater and quicker availability of information (fact, sentiment and rumor). This phenomenon acts as a self-fulfilling “feedback loop” that gathers momentum embroiling ever greater numbers of investors and amounts of capital as it builds up like a wave sweeping across the globe. In the past, it took longer to grow a short-term or a long-term bubble from one asset class, economic zone or geographic context before it spread to the next. Today, it is virtually instant, across different asset classes, and around the world.
One can hypothesize that there is a direct correlation between the rising numbers of market participants (with access to real-time market information) within an asset class across the globe to the rising price volatility of that asset class.
The recent months’ intra-day capital markets volatility may provide further evidence to suggest that faster and greater exchange of financial and economic data offers up a double-edged sword: on the one hand, faster and greater access to information (fact or fiction) reduces information asymmetries for market participants across the globe. On the other hand, this free flow of instantaneous market data affords market participants to act in real-time on both positive and negative market sentiments. The upside: quicker and bigger market corrections due to quicker and greater exchange of factual data. The downside: quicker and bigger market distortions due to quicker and greater exchange of speculative sentiment.
Furthermore, one can assert that there is also a strong correlation between the velocity and volume of capital outflows in one asset class impacting the velocity and volume of capital inflows in another asset class and vice versa. The correlation, of course, can be direct or inverse depending on which two asset classes are being considered. For example, let us imagine that there is a closed financial system where no new capital inflows into, or outflows occur out of, the system as a whole. In such a system, the velocity and volume of capital inflows in one asset class (say, real estate) may have a negative correlation with the velocity and volume of capital inflows in another asset class, say, commodities.
The steep descent of oil from a peak of over $147 in July, 2008 to $47 in December, 2008, further reinforces the notion of dramatically greater volatility originating from the same “wildfire phenomenon.” It is a phenomenon where the velocity and volume of information and fund flows is directly impacting the price volatility of a particular commodity or asset class, in this case – oil. Of course, to state the obvious, the past eighteen months’ escalation of oil prices in particular, and commodity prices in general, have a distinct marker of significant governmental, institutional and trader speculation on futures contracts.
While such volatility in the markets ushers in interesting times for students of economics and finance, such uncertainty is profoundly de-stabilizing for the smooth functioning of economies across the mature and emerging economies alike.
After all, a certain degree of economic uncertainty generates a healthy band of risk-adjusted economic opportunity. It fuels somewhat prudent and efficient capital allocation – which results in value creation and a resultant healthy pace of growth in an economy. The current levels of financial markets volatility, on the other hand, are having insidious effects on the investment climate.
The reason is, in an environment of abnormal levels of volatility like the one right now, the band of possible economic outcomes widens to the point where the option of inaction becomes ever more attractive than the option of taking virtually any investment position. Of course, in such times, being on the right side of speculative positions would generate a lot of wealth for a few investors. For the markets as a whole, however, this level of volatility is harmful.
De-regulation – The panacea that never was
“The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists.” – Ernest Hemingway
With the collapse of the communistic model of Soviet Union and the Eastern Bloc countries in late 80’s, a dramatic unraveling of decades old power structures, bureaucracies, and regulations created massive vacuums in the social, political, and economic lives of these societies. One after another, these economies eagerly, and often all too impatiently, embraced various forms of free market capitalism with all its transformational opportunities and inherent dangers. Meanwhile, the West – particularly America – became triumphant and ever more assured that free market capitalism was the panacea for all social, political and economic evils. The question raised by the Western governments and intelligentsia was: How can we not de-regulate in a time when those diametrically opposed to our ideologies are in the midst of a de-regulation frenzy?
Hence, all throughout the 1990’s, financial de-regulation continued its slow and steady march – regardless of whether the Democrats were in the White House, or Republicans held the majority in the Congress, or whether it was the Conservative Party or the Labour Party that enjoyed a majority in the House of Commons. The 1999 repealing of the US Glass-Steagall Act – that had been first brought into law in the wake of The Great Depression of 1929 – became a watershed moment for the financial services sector. In essence, this change meant that the separation between commercial banks and investment banks was no longer necessary. In addition, what it also meant was that banks could not only sell insurance products but now could also underwrite insurance. The result: a spate of merger activity and industry consolidation that resulted in today’s massive, monolithic institutions such as Citigroup, Bank of America, JPMorgan Chase, Wells Fargo (Wachovia) – that sold everything from checking and savings accounts to individual and corporate loans to mortgages to credit cards to insurance to bonds to underwriting, and so on.
They became too complex, too unwieldy, and too big to fail.
“Money is not the most important thing in the world. Love is. Fortunately, I love money.”
– Jackie Mason (American Stand-up Comedian)
The 1990’s also saw former Chairman of US Federal Reserve, Alan Greenspan’s peaking of influence on the world economy. Thanks to Greenspan’s monetary policies, this period was marked by cheap and abundant liquidity that kept building up silently in the US and across the globe for years to come. This period is fondly remembered as the “long-run, secular bull market.” As time went by, Greenspan’s prophecies became the stuff of legend. Policy-makers, economists and bankers alike hung by every word he said as gospel. They tried to decipher every assertion Greenspan made as a prized clue or a signal for something deeper, more meaningful and more valuable than it often was. Meanwhile, all of the cheap liquidity began to show up as perverse spending and investment binges involving an ever-growing number of unsophisticated investors. This, in turn, directly gave rise to a burgeoning investor appetite for equities (particularly the “dot bomb” stocks) in the late 1990’s, real estate in the early 2000’s, commodities and securitized debt instruments in the second half of 2000’s. Unfortunately, because of the outrageously high stakes involved, the most recent “financial innovations,” i.e. derivatives were put together like a string of obfuscations by some of the brightest minds coming out of Harvard, Wharton, MIT, Stanford, Princeton, London School of Economics, and other hallowed academic institutions.
According to Prof. Robert Shiller of the Case-Shiller Home Price Index fame, in the current crisis, the derivatives themselves were not so much of the problem as was the application of these instruments (meaning the enormous leverage the banks and hedge funds used to wager on these derivatives). Whether you agree with him or not, these instruments turned out to be built on untenable promises made by mortgage lenders to unsuspecting or over-optimistic homebuyers. Not-so-secure loans were sold by retail lenders as secured loans to merchant and investment bankers. Collateralized securities were rated much higher by ratings agencies than was prudent or responsible. Short sellers spread rumors of doom and gloom to line their pockets. And of course, high-risk, highly-leveraged derivatives often backed by sub-prime debt were sold by greedy investment bankers as low-to-medium risk investments to less-than-sophisticated or plain lazy buy-side investment community.
In fact, as of mid-November 2008, the asset-backed commercial paper market was valued at $845 billion. This value is post the 30% decline in their value since August, 2008.
An estimated $150 trillion (that’s right, trillion) of loans and derivative contracts are indexed to Libor across the world. Markets are now trying hard to asphyxiate the toxic monsters of sub-prime mortgages, Mortgage-backed Securities (MBS’), Collateralized Debt Obligations (CDO’s), Structured Investment Vehicles (SIV’s), Credit Default Swaps (CDS’) and other on and off-balance sheet instruments that in hindsight created little –if any – real value. And as part of this market exorcism, the global economy is being inflicted with wrenching pain and suffering.
Safety in Numbers
“We go by the major vote, and if the majority are insane, the sane must go to the hospital.”
– Horace Mann
The word on the street was: if a sufficiently high number of people would be on the wrong side of the issue, the rule of safety in numbers applied. Well, the numbers part did apply, and the safety part did not.
During the boom times, “free markets” were given as much a free rein to benefit from the growing “investor class” of wealthy high net worth individuals, investment bankers, hedge fund managers, asset managers, and private equity firms, among others. Millions of less than sophisticated investors got caught in the current financial crisis through one product or another – whether through an unrealistic home mortgage, or spiraling credit card debt, or a derivative investment, or a home equity line, or one of the other cheap credit-fuelled products. Now, tens of millions of average Joes and Janes through their savings, 401-K’s, IRA accounts, and mutual fund and common stock holdings are bleeding hundreds of billions of dollars. Somewhere along the way, the financial services sector (purveyors of easy credit-fuelled products) got too smart and too greedy for everyone’s good.
Ultimately, bad karma had to catch up.
And how has bad karma caught up?
Seemingly sophisticated financial market participants (investment banks, insurance companies, hedge funds, asset management firms, etc.) have suffered, and in certain instances, succumbed to what Warren Buffet calls, “weapons of mass financial destruction.” And now, expectedly, everyone – the perpetrators and the victims – are in that clichéd state of: fear, uncertainty and doubt.
Doesn’t history have a way of repeating itself?
In fact, there are several parallels between now and The Great Depression. On the back of years of easy credit, speculation was rampant across several asset classes such as equities, commodities and real estate then, just the way it was on this go around. There was a “trust” (investment firms that were publicly traded) securities bubble then just the way there was a derivatives (fixed income securities, commodities futures, etc.) bubble this time around. The role of investment banks in creating and selling new, arcane, and insidious financial instruments, was central then just as it has been in this crisis. And an unfettered financial markets regulatory environment and a damagingly loose monetary policy regime that spawned the market distortions then are strikingly similar to the “market fundamentalist” economic policy framework that has given rise to the current financial meltdown today.
Whether folks are aware of the parallels between now and the Great Depression or not, markets are spooked by the inability of the financial services sector to self-correct the excesses of its own offspring, i.e. products of financial engineering.
And therefore, markets find themselves underneath a cascade of events from housing price collapse, to home foreclosures, to personal and corporate bankruptcies, to the ever-growing sub-prime crisis, to millions of job losses, to an unrelenting colossal liquidity crunch, to historic stock market crashes, and to a potential US financial markets failure, and a global economic meltdown…and possibly the invocation of The D word?
About the Author: Sahil Alvi is a management consultant and a writer. He presently works with KPMG in Dubai. Previously, he has held management consulting roles with Ernst & Young and PricewaterhouseCoopers in the US. He can be reached at: email@example.com
The Blame Game
Who is most accountable for this mess? Who is primarily to blame?
“It’s not whether you win or lose, it’s how you place the blame.” – Oscar Wilde
Wasn’t it too long ago (circa 2002) that the Enron and WorldCom accounting scandals broke out? Didn’t the venerable auditing firm: Andersen go down as a casualty of the Enron fiasco? In the aftermath, didn’t Sarbanes-Oxley Act come along to transform governance and accountability in corporate America and had ripple effects across the global business community? Wasn’t the multi-billion dollar, global industry spawned by “Sarbox” or “SOX” compliance developed to protect the shareholders from reckless management practices and to provide early warning signals for financial malfeasance? And by the way, didn’t the regulatory burden of SOX compliance squelch the listing of high-growth entrepreneurial companies on Wall Street and greatly benefit London to supplant New York as the new worldwide leader in public equity listings?
Defenders of SOX would argue that it prevented many more accounting scandals, it made CEO’s and CFO’s more accountable for their companies’ financial statements, it provided greater oversight powers to Audit Committees of publicly and privately held companies, and in any case, SOX had little to do with the amount of leverage an institution could carry on or off its balance sheet. It is posited that the Basel II regulations were supposed to take care of issues like banks’ risk management, capital adequacy, and leverage ratio issues.
Auditors, rightly, would point out that the odds are stacked against them because the complexity to which accounting standards have evolved – and the disparate, distributed and fragmented nature of their clients’ global operations – makes for a breathtaking challenge to uncover financial irregularities. It is like finding the proverbial needle in a haystack.
In the ra-ra years of easy credit and even easier profits from the toxic derivatives that have been lately uncovered as the poison that ate away our collective trust in the markets and in each other, surely there must have been voices of reason within risk management departments of financial institutions and corporations across the world. But since this train-wreck was ultimately not averted, one can safely hypothesize that those voices were drowned out by aggressive and greedy bankers, corporate lenders, fund managers, among others. Even if the bankers were scrupulous or discerning enough to understand what was going on, they did not want to disrupt the gravy train of multi-million dollar bonuses coming their way.
Then, there were Wall Street’s research analysts who track company performance for a living. They were expected to scour the financial statements of the companies they cover for issues that could be material to the ongoing profitability and viability of these companies. Prior to the financial crisis, there were few analysts who forewarned investors in stark enough terms to provoke a response toward the stocks of publicly-held investment banks indulging in this high-stakes gamble. The ratings agencies fell spectacularly short of assessing the risk profiles of various companies and the securities floated by these companies for the public capital markets. There were brokerages – which make a living ostensibly by advising clients on helping pick investments that would yield them an appropriate risk-adjusted return on their investments. Then there was the not-so-elegant dance that investment banks, insurance companies, and bond issuers were doing together around Credit Default Swaps (CDS’) – exposure to which was not being reported to the investing public with the appropriate level of transparency. These constituencies were not even in a position to price CDS’ on a “fair market value” basis – especially as markets got ever more illiquid.
There were auditors, accountants, and consultants who were supposed to ensure that companies’ strategy, operations, and finances are up-to-snuff in the face of an ever-changing business landscape. And of course, there were journalists, reporters, and commentators who were supposed to report back on the anomalies they had to uncover in the first place. Were they sleeping at the switch – or more aptly at their computers while the derivatives bubble was enveloping us from all sides? Were they entranced into reporting on nothing but America’s perpetual “war on terror” to the point that everything else happening right under their noses was just a distraction?
Then there were financial and economic policy experts. There were academics who study the performance and behaviors of individuals, companies, industries, markets, economies, and societies in new, involved, and esoteric ways. Prof. Nouriel Roubini at New York University is one of those in sliver thin minority who continually and vocally predicted the collapse of the financial markets thanks to the bubble that the markets were blithely perpetuating.
Of course, there was the government: regulators and bureaucrats and politicians – all there to protect and serve.
All of them together still fell short for this enormous bubble to be allowed to form and then for it to explode in such a disastrous way.
Indeed, the current financial morass has worn thin the collective and individual legitimacy (to varying degrees, of course) of all these constituencies to protect the shareholders on Wall Street – let alone the larger set of stakeholders on Main Street.
Is it that among all of these constituencies, it was only a handful of feeble voices that, ultimately, were not heard well enough by those in power to prevent this crisis?
Blame it on the GOP
“Democracy is the process by which people choose the man who’ll get the blame.”
– Bertrand Russell
Politically, much blame has been directed at the current US administration that allowed the US financial services industry to spread this global contagion through the tattered nets of a lax, out-of-date and imprudent regulatory regime. A regulatory framework – with SEC in the center – that was ill-equipped to track, monitor, let alone regulate, these new types of derivative instruments. After all, the current crisis was largely triggered by the unraveling of the US real estate market bubble and the underlying collateralized securities backed by debts such as mortgages taken out on US real estate assets, personal loans, credit card debt, among others. Add to that, the traditional small government, fiscally conservative Republican Party’s GOP (government in power) became the torch-bearers of running massive fiscal deficits on ill-conceived wars and a “pro-business” agenda (read little regulatory oversight originating from corrupt lobbying practices across industries from oil to healthcare to automakers to real estate and, to our very own, lead actors: financial services sector).
It almost seems like the economic policy of the Bush administration was the dog being wagged by a tail of narrow, special interest lobbies of the military-industrial complex, oil companies, and automakers, among other big businesses. Alan Greenspan, of course, shoulders some of the blame for his relaxed monetary policies that created years of cheap liquidity – which in turn fostered imprudent lending practices – which in turn gave consumers a distorted view of their purchasing power, and so it goes. In the name of being an “ameliorative government,” the current Bush administration is to blame for concocting the lethal combination of a distorted interpretation of Keynesian deficit spending policies on a doctrine-driven “war economy” – and a perverted and extreme interpretation of Milton Friedman’s Monetarist agenda. Of course, there is a whole different discussion about the burgeoning US current account deficit and US national debt, the sinking US Social Security program, the ravaging “war on terror,” and other spectacularly large and potentially de-stabilizing crises that could have just as easily contributed to a US economic meltdown – and afflicted the rest of the world in its aftermath.
To paraphrase former US Secretary of Treasury and ex-Harvard University President, Lawrence Summers: For the first time in the history of civilization, the greatest super-power in the world is also the biggest debtor in the world.
In effect, there is plenty of blame to go around.
Life Without Consequences
“Too many people spend money they haven’t earned, to buy things they don’t want, to impress people they don’t like” – Will Smith
It seems there were a lot of characters in this fairy tale where life was lived without thought given to the consequences of our actions. We, the Main Street (consumers and investors) cannot absolve ourselves of the imprudence that we have exercised to help create the morass that we find ourselves in. There was little individual responsibility for actions. We could buy and consume ourselves out of anything. Anxiety, depression, insecurity, loneliness, inadequacy, frustration, anger, and so it went. You name it and the local mall down the road could solve it. Positive experiences were on sale too: love, happiness, comfort, warmth, friendship, wisdom, and so forth. Credit was cheap, home equity lines were flowing, and having our cards swiped at the counter was our endorphin “quick fix.”
About the Author: Sahil Alvi is a management consultant and a writer. He presently works with KPMG in Dubai. Previously, he has held management consulting roles with Ernst & Young and PricewaterhouseCoopers in the US. He can be reached at: firstname.lastname@example.org