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A fairy-tale end to the finance crisis?
Satyajit Das
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October 23, 2008

In Arabian Nights, the beautiful princess Scheherazade buys one day of life at a time by recounting fantastic fables that entrance the King who has condemned her to die. Investors and traders are currently telling each other fairy tales to buy one day at a time to stave off the inevitable.

The drama and tumult of recent events are not symptoms of the disease but the cure. The 'disease' is the excessive debt and leverage in the financial system. The 'cure' is the reduction of the level of debt (the great 'de-leveraging').

The initial phase of the cure is the reduction in debt within the financial system. The second phase of the cure is the higher cost and lower availability of debt to the real economy. This forces corporations to reduce leverage by selling assets, reducing investment and raising equity (for example, as GE has done). This also forces consumers to reduce debt by selling assets (where available) and reducing consumption.

Feedback loops mean reduction in investment and consumption lowers economic activity, placing stresses on corporations and individuals, setting off defaults that trigger losses for the financial system that further reduces lending capacity. De-leveraging continues through these iterations until overall levels of debt reach a sustainable level determined by lower asset prices and cash flows available to service the debt.

Within the financial sector, de-leveraging is well advanced. In the real economy it is in the early stages.

Fairy tales in financial markets focus on the 'superhuman' abilities of regulators and governments to avoid the de-leveraging under way. Central banks and governments have taken progressively more aggressive actions in order to influence events.

Central banks have aggressively supplied liquidity to the money markets accepting an increasing range of collateral. Central banks may soon accept football cards and Lehman, Bear Stearns and Washington Mutual, Fortis and Dexia memorabilia (mugs, stress balls, desk decoration cubes that open up to reveal Lehman Brothers' key operating principles -- 'demonstrating smart risk management').

Governments and central banks have also 'bailed out' a number of financial institutions using a variety of strategies to limit contagion. Most recently, governments have resorted to injecting equity into selected banks and providing extensive guarantees supporting bank borrowings.

The actions have been increasingly directed at three areas. Banks are being forced to write off bad loans without delay. Bank capital needs are being addressed by forced mergers and restructuring, new equity issues and, in the absence of other options, nationalisation or liquidation.

Central bank guarantees of all major borrowings and other transactions to reduce solvency risk for banks are designed to enable normal transactions between parties in the financial markets to resume. The necessary co-ordinated global action appears at last to be under way.

Lower interest rates and increased government spending have also been used to try to reduce the effects of the financial crisis on economic activity in the 'real' economy.

The initiatives are sensible short-term measures to stabilise markets. In the longer run, they transfer the problem onto the government and taxpayer balance sheet. For example, the US government's support for financial institutions in this financial crisis is already approaching 6 per cent of GDP (compared to less than 4 per cent for the savings and loans crisis). The bailout of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) has almost doubled the US national debt. This will ultimately place increasing pressure on the US sovereign debt rating and vitally, the ability of the US to finance its requirements from foreign creditors.

It remains to be seen whether these global initiatives achieve the required re-capitalisation of banks, improve the normal supply of credit to sound borrowers, and also reduce the fear of default, allowing normal activity between institutions to resume.

The key issues remain the availability of capital and liquidity. The perceived abundance of liquidity was, in reality, merely an illusion created by high levels of debt and leverage. As the system de-leverages, it is becoming clear, unsurprisingly, that available capital is more limited than previously estimated.

Central bank reserves and sovereign wealth funds are often cited as evidence of the amount of available capital. These reserves are invested in dollar-denominated US Treasury bonds, GSE paper and highly-rated securities. It will be difficult to mobilise the funds and convert them into the home currencies of the investors without large losses.

The risk of a severe dislocation in global capital flows remains a real risk in the present environment. Some have called for a global conference (along the lines of Bretton Woods) under a respected chairman (Paul Volcker is the obvious choice) bringing together all the major players to address key structural issues within the global financial system. Any such conference would focus on economic reforms (capital flows, currency policies, fiscal disciplines, trade barriers) necessary to find a resolution to the crisis.

A principal objective of this conference would be ensuring the supply of funding for the US in the transition period. Recent comments by China about US responsibility for the crisis and its resolution miss the point. As China's Premier Wen Jiabao observed, the US financial crisis may 'affect the whole world.' As Wen noted: 'If anything goes wrong in the US financial sector, we are anxious about the safety and security of Chinese capital...' All creditors have much to lose if the de-leveraging process becomes disorderly.

Ultimately, 'all the king's horses and all the king's men' cannot prevent the de-leveraging of the financial system under way. The extent of de-leveraging is substantial and likely to take time. In recent years, money was cheap and other assets were expensive. As each of the global economy's credit creation engines breaks down and systemic leverage reduces, money becomes scarce and more expensive, triggering substantial adjustments in asset prices in a reversal of the process.

At best, the government and central bank actions can smooth the transition and reduce the disruption to economic activity in the transition to a lower-debt world. The risk is that well-intentioned steps prevent the required adjustments from taking place, delay recognition of problems and discourage action that must be taken by financial institutions, corporations and consumers.

Like a giant forest fire, the de-leveraging process cannot be extinguished. Thoughtful actions can create fire breaks that limit preventable damage to the economy and the international financial system until the fire burns itself out.

Arabian Nights had a happy ending. The King after 1,001 night of enchantment and three sons pardons the beautiful Princess Scheherazade who becomes his queen. Despite the fairy tales that investors are putting their faith in currently, the de-leveraging that is at the heart of the current financial crisis may not have such a happy ending.

The author is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives. At the time of publication, the author or his firm did not own any direct investments in securities mentioned in this article, although he may be an owner indirectly as an investor in a fund.
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