Anatomy of a Financial Crisis
It was a morning like any other. I was reviewing overnight cash transactions in the commodity markets for their influence on the Chicago Board of Trade grain opening. But this morning a cash broker told me a parcel of soymeal had been defaulted on. Then another allowed that a Central American client had his credit line cut in half. Others just reported that nothing was happening. No bids.
Asia and Russia were taking their toll. The banks had bet big and lost bigger. Maybe $200 billion, maybe more, no one is in a rush to detail exactly how much. But it's enough that even in these small and seemingly obscure commercial transactions the pattern of a larger picture begins to emerge. We are witness to the beginnings of the fallout of US Banks' retrenchment. Suddenly the word has come down that exposure must be cut.
Never mind that the credit worthiness of these individual companies was not in question. Banks were scared and retrenching.
Just how scared became apparent on Thursday September 24th at that late evening meeting at the Federal Reserve when Yankee Crony Capitalism was established as a counterpoint to everything the financial Establishment has criticized in Asia.
Oh, they put a brave face on it. In an internal memo to employees, Merrill Lynch & Co.'s chairman David Komansky noted that even if the Long-Term Capital portfolio had been liquidated in a distressed environment, any loss would be "fully manageable". However the memo continued, the company's responsibility was "first and foremost to prevent disruption of global financial markets." The company's participation was not motivated by concern over potential losses it would itself have suffered. (Bridge News Sept 25, 1998)
Right.
No, the banks and brokers that comprise the power elite of Wall St. were trying to save themselves and $3.5 billion seemed a small price to pay. Especially if one considers, as Kathryn Welling put it in the Sept 28th edition of Barron's, "the $1 trillion or so in collateral damage that the urgent unwinding of the hedge fund's positions might have done to the banks' and brokers' own immense derivatives position."
The U.S. has repeatedly criticized Asian countries for the close cooperation between government and industry. Treasury officials have argued against crony capitalism and the use of the "the convoy system" to protect companies from bankruptcy. Yet the Federal Reserve in using strong-arm tactics to muscle the banks and brokers into bailing out LTCM have resorted to exactly the same tactics. In doing so the US has lost whatever moral high ground it still occupied. This has proved to be a classic example of the pot calling the kettle black.
Unexpectedly Treasury Secretary Robert Rubin sees things differently. Speaking Thursday October 1st he said that the rescue of Long-Term Capital Management by a group of New York banks bears little comparison to Japan's "convoy system" of averting financial failures. "I think the LTCM thing is really a very…different situation, without going into all the specifics."
Rubin continued, "LTCM was a single isolated instance in which the judgement was made by the Federal Reserve Bank of New York that there were possible systemic implications of a failure, and what they did was to organize or bring together a group of private sector institutions which then made a judgement of what was in their economic self interest". He added, "This is totally not analogous when we talk about the convoy system in Japan."
Japan's "convoy system" refers to stronger financial institutions lending to support weaker institutions to prevent them from failing.
LTCM was bailed out last week by a group of international banks to prevent them from failing. Merrill Lynch, Bankers Trust, Barclays, Chase Manhattan, Deutsche Bank, UBS, JP Morgan, Goldman Sachs, Credit Suisse, First Boston, Morgan Stanley Dean Witter and Salomon Smith Barney each put in $300 million. Societe Generale put in $125 million and Credit Agricole, Bank Paribas and Lehman Brothers put in $100 million.
And if there's another pop warns Morgan Stanley's Barton Biggs "all they've done is make the credit crunch that Greenspan is worrying about worse, as $3.5 billion of additional bank equity goes down the drain as well." (Barron's Sept.28,1998)
President Clinton, in an uncharacteristic turn as economic seer, describes the current situation as "the worst financial crisis in half a century". The most essential feature of a financial crisis is the inability to obtain credit.
Such situations occur after an unexpected but well publicized bankruptcy. In this case the lightning rod may well prove to be not a bankruptcy but rather the threat of one.
The spectacle of Wall St.'s power brokers coughing up $3.4 bln to protect one of their own underscores the fact that the notional amount of derivatives in the portfolios of US based banks is $28.2 billion (Comptroller of the Currency). The Fed understands this and has switched gears. No longer is inflation the enemy. Rather it is the specter of a credit crunch that merits their attention.
This was behind the ¼ point rate cut earlier this week. But it was not enough? How much must one cut? For a credit bubble must expand or true to its name the air will go out of it.
On Mr. Greenspan's watch the credit bubble has expanded to hitherto unimaginable limits. Starting with the lowering of interest rates in the early nineties to save such moneycenter banks as Citibank from the consequences of their own lending, it has worked in spectacular fashion. Citibank from a negative net worth and a stock price of $10 rose to its present, or recently, exalted position. But at the end of the day it is a far better thing to let a bank suffer the consequence of its own mismanagement than to create an asset inflation that must inevitably put an entire system at risk.
The financial press does not acknowledge or understand that the root cause of this financial crisis is monetary. What we today call a financial system is based on fiat paper, which has destroyed the means of economic calculation. If you asked a economics professor for a definition of money fifty years ago he would have answered "a store of value". Today's dictionary defines money as "a medium of exchange".
Today's dollar may fulfill this function but what it does not do and is incapable of doing is to transmit a value judgement from consumers to producers. In addition the propensity of central and commercial banks to create "money" and keep interest rates at below natural rates creates the fuel for speculation. This ever rising volume of credit sends out false value signals. Consumers, flush with easy credit, are prone to what the Austrian school terms "malinvestment". This is the essence of capital dissipation. To use a farming analogy, capital dissipation can be compared to eating seed corn. Seed corn is what is saved to plant next year's crop. If you consume it in the short term you are fat but in the long term you starve. The long run, it would appear, has arrived. The inescapable fact is that decades of capital dissipation has succeeded in providing a fine façade of prosperity with a hollow shell. The U.S. has eaten its seed corn and the population now faces a steady decline in income.
The only thing that can cure this situation is the restoration of money to its role as a store of value.
The fact that there is something seriously wrong with the global financial system is obvious:
French President Jacques Chirac has called for a special G7 summit to discuss reforming the global monetary system.
British Prime minister Tony Blair last week issued a five-point plan, calling for reform of the IMF and World Bank to strengthen these institutions and increase their ability to respond to financial crisis.
In Germany Finance Minister designate Oskar Lafontaine said last week that the SPD (Social Democrats) would immediately seek to form a joint market reform initiative with Britain and France.
However we can be sure that all of these meetings will fail to address the root cause of the problem. Increasing the IMF's funding, issuing more SDRs (Special Drawing Rights), placing trading bands around major currencies are all ideas that have been tried. The idea of flooding markets with more liquidity will perhaps sustain the current charade. But it is no cure and will, in the end, only intensify the current problems. The excessive speculation so rampant in today's markets is the direct result of activity by the banks. More of the same is not a cure.
For twenty years since the ascent of Paul Volcker paper has been in a bull market and gold has been in a bear market. This has no doubt pleased central bankers as they view gold as a barometer of the market's faith in their ability.
In times of prosperity gold is seen increasingly as a relic of the past, something associated with a time when markets were less sophisticated. The problem with approaching gold from a supply/demand view is that no matter how great the ongoing supply deficit the vast majority of gold ever produced is still above ground. After all, the argument goes, we have masters of the universe now who know how to hedge against risk. To this end central bankers have sought to utilize their gold reserves lending it forward or selling it outright. (The Central Bank of Italy astutely invested $300 million in LTCM.) The mining industry paralyzed at the thought of falling prices has hedged forward future production. Indeed in the late 90's it took a clear and rational mind to remember why gold became money in the first place.
But here is a simple illustration. A study of the currencies of nations that have sold gold is instructive. Seven major currencies in recent years sold an average of 48% of their reserves. Their currencies subsequently lost an average 26% during the next 9-19 months (Vronsky Feb 7, 1998). This may prove that the French peasant is not as sophisticated as a central banker but has more finely honed survival skills.
We would add that this story is not yet played out as according to Veneroso Associates, there is more than 8000 tons of gold sold forward. We know which countries have admitted to selling gold. We don't know which ones have sold reserves via derivatives. Those of you with long memories will remember that when the IMF sought to do an audit of their members' gold reserves in the late 80s the US would only allow them to see the stack of bars in Fort Knox.
But as the masters of the universe insist we can hedge our risk. The extent of the vast morass of derivatives that this belief has spawned is unknown even to the participants. They are off balance sheet and therefore there is no way to account for them. A rough guess as to their outstanding value is $50 trillion.
But any attempt to regulate derivatives, even after the collapse--and rescue--of LTCM have not met with success. On September 29th Reuters reported: "The CFTC was barred from expanding its regulation of derivatives under language approved late on Monday by the U.S. House and Senate negotiators," and "Earlier this month the Republican chairmen of the House and Senate Agriculture Committees asked for the language to limit the CFTC's regulatory authority over over-the-counter derivatives echoing industry concerns."
When the initial subject of regulation was broached by the CFTC both Fed chairman Alan Greenspan and Treasury Secretary Rubin leapt to the defense of the industry claiming that the industry did not need regulation and that to do so would drive business overseas. Similar attempts by the Financial Accounting Board to have derivatives included in corporate Annual Reports have met with stiff resistance.
Is it not that the extent of derivatives so dwarfs the capital of the issuing corporations that the masters of the universe have decided there is no problem if we don't acknowledge it?
What we have behind all the hype is the premise that elegant mathematical formulas can hedge any financial transaction. However it is also assumed that an untoward systemic risk has almost no chance of occurring.
In the case of LTCM it was not so much systemic risk as hubris that caused their downfall. These masters of the universe trade spread relationships. They bought corporate and junk debt and sold T bill and T bonds against them. When the spread went against them they doubled up. As in pit parlance "they bought the first break, they bought the second break, they were the third break."
Now with $3.5 Bln of other people's money they hope to unwind the situation. Ever added to a losing position and waited for it to get better? You know the feeling. Good luck.
But what of systemic risk? Andrew Smithers in a Barron's Article of Nov. 24th 1997 concluded that based on a study by the BIS (Bank for International Settlements) that $1.4-2 trillion of insurance against market risk is currently being provided in global option markets.
His argument deals with the question of specific risk as opposed to systemic risk. His analogy is that stock option insurance unlike a specific insurance, as for example, housing is much more prone to a crash in the system. It's unimaginable that 89% of the U.S. housing stock would suddenly be wiped out, the equivalent disaster happened in the US stock market between 1929–1932.
If as he postulated the US equity markets are 10% insured that would translate to a market risk of $280-$400 Bln. By way of comparison, the combined equity of Merrill Lynch, Morgan Stanley, J.P. Morgan , Bankers Trust and Goldman Sachs is about $33 Bln.
The only way to that money can return to being a store of value is to make it redeemable in gold. And to this end Central Bankers must stop manipulating interest rates. That statement must make many readers laugh. It gets the same response as saying the Fed would organize the bailing out of a hedge fund last year, or the Asian Tigers will go bust the year before that.
It is true that the dollar has had a global franchise for so long that it is impossible for many to envision another system. But this was also true of former currencies. In the late Twenties it was hard for many to see that Sterling would no long be the world's reserve currency.
And let us not forget that Sterling, within the context of an international gold standard endured as the World Reserve Currency far longer than the dollar. And that "it was the only protracted period in which the credit facilities provided by a single country met the credit needs of a lively and expanding world commerce" (historian Judd Polk in Grant's May 12th 1995).
History has repeatedly indicated that money is not a creation of government. Rather real money is something that has proven to be a store of value and has been proven as such by eons of trading experience. Because it has proven to be a store of value gold became a standard of value. Because of this standard it became a medium of exchange. A store of value such as gold, coupled with a true bills policy on the part of the banking system keeps credit expansion within the legitimate bounds of commercial activity. In this manner consumers are able to send accurate value indications up the chain of supply. Gross capital dissipation and an ensuing depression are thereby avoided.
The growth of a commercial economy depends on trade. Trade depends on a system where value delivered is offset by value received. In the long run nothing else will work. Promises to pay cannot forever be deferred. Value delivered must be met by value received and not by depreciating paper.
Until then we will live in interesting times. As banks cut back on their lending the only winners will be the traders who through extensive contacts in individual countries can actually assess the risk involved. As Karen Valken finance director of privately held Nidera Nandelscanpagnie put it: "We love inflation, chaos and volatility." For those of a similar persuasion we could not ask for a better environment.
Greg Pickup
5 October 1998
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