Blame the financial engineers - the Sun
DURING the Soviet economy era, free market capitalists used to joke that Soviet workers pretended to work and the state pretended to pay them. Now we have financial engineers pretending that they are creating value and the state is pretending that the value still exists. We have built a Tower of Babel through financial engineering.
Through excessively low interest rates, we created a financial bubble that has to deflate back to reality. Subprime mortgages meant that we pretended that people without the income can afford high price housing.
The originators sold that dream and took away their profits. The packagers then pretended that the CDOs (collateralised debt obligation) had AAA ratings and sold that dream to investors who thought the rating agencies knew what they were branding. The CDS bought or sold pretended that the guarantees were valid. Now we are not so sure.
Civil engineers build real structures, but financial engineers build dreams. We should have seen through that dream when financial engineers, fresh out of business schools, could make four times the money than civil engineers. Why should Wall Street make up to 40% of total corporate profits, when the real sector could only make 60%? Answer: Marking future profits to today and pass the costs to the taxpayer.
What financial engineering pretended was that we can consume our future production today. This is the discounting of future cash flows using exceptionally low interest rates that did not take into consideration true risks. Through unfair use of fair value accounting, we have marked the future to the present, so that we can have it now, but the procyclicality nature of fair value accounting means that we are about to pay for what we have consumed. Correction – the taxpayer and many investors and depositors will pay for it.
Financial engineering assumed that we can pass our risks to the public through the distribution (aka socialisation) of private risks via the OTC markets that were not transparent to either regulators or themselves. They persuaded everyone that risk distribution was like spreading muck, good for the soil. Unfortunately, the soil has slowly become toxic, while some people have taken the goodness out of that soil. The Gordon Gekkos have won.
What effectively has happened is that we have socialised risks via eventual government bailout, because the private costs of unravelling gross OTC transactions are so large that it is impossible to price.
It is hard to imagine how we can hope to unravel through the courts the gains and losses of huge gross transactions in complex network OTC markets.
We should have created exchanges and centralised net clearing for all high volume OTC financial products to ensure that these transactions could be transparent, the players are solvent and credit risks are netted, controlled and supervised. We are seeing the unwinding of OTC markets in a networked system in which the contagion is spreading to the real economy.
The real nature of the crisis is that we created a financial bubble through excessively low interest rates. Interest rates are the price of money and lowering nominal interest rates beyond the natural rate of return (the real return on capital) is to create a nominal value of financial assets significantly above their true value.
When the Japanese bubble occurred, the interest rate on the yen had to be lowered to almost zero to prevent an implosion in Japanese financial assets.
If Japanese dividend yields and long-term interest rates were around global interest rate levels of say 4% instead of 1.5%, the Japanese stock market and bond market would be significantly lower than what it is today. But no one wanted to admit that loss immediately, so the loss is actually passed on to the saver in Japan through years of stagnation and political dispute as to who is to blame.
The Japanese investor is still subsidising the inefficiencies arising from the bubble deflation of 17 years ago. It is a tragedy that many frugal Japanese housewives (the frugal Mrs Watanabe) have been induced to invest in the yen-Australian dollar carry trade just to eke an income flow from the interest differential, because they get almost zero interest rates from their high savings.
That zero interest rate has subsidised many investment bankers and hedge funds so that they actually believed that their high returns on the carry trade were all due to their remarkable investment skills.
These financial engineers then were emboldened to leverage up and create new products that created more "pretend values". In essence, Wall Street replicated the Japanese bubble and now we are again lowering interest rates to bail out the mess.
Stratfor analyst George Friedman put it perfectly when he said that the nature of the crisis was because conservative investors sought to increase their return without giving up safety and liquidity. They wanted something for nothing, and the financial engineers obliged. They created financial instruments of increasing complexity that embedded leverage and sold these to professional bankers and fund managers who should have known better to pass them eventually to retail investors who thought they were buying AAA products. It was a pyramiding scheme that rested on the prayer that house prices will continue to grow because there is always the
Greenspan put – the government will lower interest rates to bail out the errors of Wall Street. That prayer was wrong about house prices, but not wholly wrong about the put.
Liquidity crises are always the manifestation of solvency crises. It is not about the shortage of liquidity, but the lack of trust in the solvency of the counterparty. What is happening is that commercial banks and investors are trying to sort out what is marked to myth and what is marked to reality. The reality will only occur once the deleveraging process is completed, namely, instead of 30+ times leverage (if we count below the line leverage), we bring the banking system back to roughly 12 times leverage.
There are two ways of deleveraging: one is to pretend that the bubble is still good for the money, by forbearance. The other way is to increase the capital of the banking system. Forbearance means telling the bubble not to deflate like King Canute telling the tide to go down.
Increasing the capital of the banking system means the virtual nationalisation of the banking system. If banks are public utilities whose failure is catastrophic, then there is a justification for their temporary nationalisation, so long as they are managed competitively and transparently. The real political economy problem of nationalisation to bail out the banks is how to allocate the losses between the existing shareholders and the state.
Main Street is justifiably angry that the financial engineers who created the mess expected the public to pay for it. Unfortunately, there is no alternative, since the economic losses have already happened, but not yet recognised in accounting terms. During all crises, there is no alternative but to recognise the economic losses as soon as possible. In this sense, mark to market is not wrong because it recognises economic losses.
Pretending that the values still exist in some of these toxic products is not the solution. Recognising one accounting standard on the way up and another standard on the way down is only confirming that socialising private greed is acceptable. Recapitalising the banking system is the way to go. We can sort out who is to blame afterwards.
Through excessively low interest rates, we created a financial bubble that has to deflate back to reality. Subprime mortgages meant that we pretended that people without the income can afford high price housing.
The originators sold that dream and took away their profits. The packagers then pretended that the CDOs (collateralised debt obligation) had AAA ratings and sold that dream to investors who thought the rating agencies knew what they were branding. The CDS bought or sold pretended that the guarantees were valid. Now we are not so sure.
Civil engineers build real structures, but financial engineers build dreams. We should have seen through that dream when financial engineers, fresh out of business schools, could make four times the money than civil engineers. Why should Wall Street make up to 40% of total corporate profits, when the real sector could only make 60%? Answer: Marking future profits to today and pass the costs to the taxpayer.
What financial engineering pretended was that we can consume our future production today. This is the discounting of future cash flows using exceptionally low interest rates that did not take into consideration true risks. Through unfair use of fair value accounting, we have marked the future to the present, so that we can have it now, but the procyclicality nature of fair value accounting means that we are about to pay for what we have consumed. Correction – the taxpayer and many investors and depositors will pay for it.
Financial engineering assumed that we can pass our risks to the public through the distribution (aka socialisation) of private risks via the OTC markets that were not transparent to either regulators or themselves. They persuaded everyone that risk distribution was like spreading muck, good for the soil. Unfortunately, the soil has slowly become toxic, while some people have taken the goodness out of that soil. The Gordon Gekkos have won.
What effectively has happened is that we have socialised risks via eventual government bailout, because the private costs of unravelling gross OTC transactions are so large that it is impossible to price.
It is hard to imagine how we can hope to unravel through the courts the gains and losses of huge gross transactions in complex network OTC markets.
We should have created exchanges and centralised net clearing for all high volume OTC financial products to ensure that these transactions could be transparent, the players are solvent and credit risks are netted, controlled and supervised. We are seeing the unwinding of OTC markets in a networked system in which the contagion is spreading to the real economy.
The real nature of the crisis is that we created a financial bubble through excessively low interest rates. Interest rates are the price of money and lowering nominal interest rates beyond the natural rate of return (the real return on capital) is to create a nominal value of financial assets significantly above their true value.
When the Japanese bubble occurred, the interest rate on the yen had to be lowered to almost zero to prevent an implosion in Japanese financial assets.
If Japanese dividend yields and long-term interest rates were around global interest rate levels of say 4% instead of 1.5%, the Japanese stock market and bond market would be significantly lower than what it is today. But no one wanted to admit that loss immediately, so the loss is actually passed on to the saver in Japan through years of stagnation and political dispute as to who is to blame.
The Japanese investor is still subsidising the inefficiencies arising from the bubble deflation of 17 years ago. It is a tragedy that many frugal Japanese housewives (the frugal Mrs Watanabe) have been induced to invest in the yen-Australian dollar carry trade just to eke an income flow from the interest differential, because they get almost zero interest rates from their high savings.
That zero interest rate has subsidised many investment bankers and hedge funds so that they actually believed that their high returns on the carry trade were all due to their remarkable investment skills.
These financial engineers then were emboldened to leverage up and create new products that created more "pretend values". In essence, Wall Street replicated the Japanese bubble and now we are again lowering interest rates to bail out the mess.
Stratfor analyst George Friedman put it perfectly when he said that the nature of the crisis was because conservative investors sought to increase their return without giving up safety and liquidity. They wanted something for nothing, and the financial engineers obliged. They created financial instruments of increasing complexity that embedded leverage and sold these to professional bankers and fund managers who should have known better to pass them eventually to retail investors who thought they were buying AAA products. It was a pyramiding scheme that rested on the prayer that house prices will continue to grow because there is always the
Greenspan put – the government will lower interest rates to bail out the errors of Wall Street. That prayer was wrong about house prices, but not wholly wrong about the put.
Liquidity crises are always the manifestation of solvency crises. It is not about the shortage of liquidity, but the lack of trust in the solvency of the counterparty. What is happening is that commercial banks and investors are trying to sort out what is marked to myth and what is marked to reality. The reality will only occur once the deleveraging process is completed, namely, instead of 30+ times leverage (if we count below the line leverage), we bring the banking system back to roughly 12 times leverage.
There are two ways of deleveraging: one is to pretend that the bubble is still good for the money, by forbearance. The other way is to increase the capital of the banking system. Forbearance means telling the bubble not to deflate like King Canute telling the tide to go down.
Increasing the capital of the banking system means the virtual nationalisation of the banking system. If banks are public utilities whose failure is catastrophic, then there is a justification for their temporary nationalisation, so long as they are managed competitively and transparently. The real political economy problem of nationalisation to bail out the banks is how to allocate the losses between the existing shareholders and the state.
Main Street is justifiably angry that the financial engineers who created the mess expected the public to pay for it. Unfortunately, there is no alternative, since the economic losses have already happened, but not yet recognised in accounting terms. During all crises, there is no alternative but to recognise the economic losses as soon as possible. In this sense, mark to market is not wrong because it recognises economic losses.
Pretending that the values still exist in some of these toxic products is not the solution. Recognising one accounting standard on the way up and another standard on the way down is only confirming that socialising private greed is acceptable. Recapitalising the banking system is the way to go. We can sort out who is to blame afterwards.
