Below are three comments about the banking industry made by three individuals. Identify the one that is most prescient and the individual who is the least famous, if not totally unknown, among the three.
Comment 1
“I believe that the tools available to the banking agencies, including the ability to require adequate capital and an effective banking receivership process, are sufficient to allow the agencies to minimize the systemic risk associated with large banks. Moreover, the agencies have made clear that no bank is too big to fail. So that bank management, shareholders, and uninsured debt holders understand that they will not escape the consequences of excessive risk taking. In short, although vigilance is necessary, I believe the systemic risk inherent in the banking system is well managed and well controlled.”
Ben Bernanke, Federal Reserve Chairman and a former Princeton University professor
In an answer to a Senate Banking Commitee question on his first confirmation hearing in 2005
Comment 2
"[G]iven 1990 levels of capital, both Fannie Mae and Freddie Mac had sufficient capital to survive." even when tested against "the financial and economic conditions of the Great Depression." And "on the basis of historical experience, the risk to the government from a potential default on GSE debt is effectively zero."
Joseph Stiglitz, former Chief Economist of the World Bank and a Columbia University professor
In a paper written in 2002 titled "Implications of the New Fannie Mae and Freddie Mac Risk-Based Capital Standard."
Comment 3
"Running a bank is like piloting a warplane. If you alter the steering even a little bit, you end up in a completely different position."
Coskun Ulusoy, a former banker and the CEO of OYAK, Turkey's Armed Forces Pension Fund
On the rationale for selling OYAK's own bank to ING for USD2.7b in 2007
In terms of grey matter, academic credentials and widespread recognition, Bernanke and Stiglitz are far ahead of Ulusoy. But Ulusoy has one essential trait ― the ability to correctly size up the situation and then to use it to discern the key underlying patterns ― that separates those who can rise above the trivia and see the obvious from those blinded by the mass of details. In this, Ulusoy is one of the brilliant few that possess such insight. Certainly getting out of the global banking mess in the nick of time is one thing but to offload a future muck onto ING at a good price deserves acclaim.
While Bernanke and Stiglitz are muddling through one step at a time with the apparent solution at each step being overwhelmed by unintended side-effects, Ulusoy has already leaped five steps ahead knowing fully well the adverse consequences of the slow plodding. Bernanke and Stiglitz do conduct serious analyses and researches but these are all done to confirm their already firmly held beliefs, not to challenge them. This is the fundamental flaw of smart people ― a refusal to admit that they could go wrong.
The whole banking industry has a basic failing which is only evident during a depression ― its high gearing. This weakness is unique only to the banking industry. Practically all bankers except the enlightened few, such as Ulusoy still believe that it's their asset quality that matters. However, in a depression characterised by deflating prices, asset prices will definitely collapse. No amount of money printing can stave off this collapse because such money will be sucked by the black hole of loan write-offs and bank deleveraging. Money printing works only to stem a panic, not to avoid a decreasing money supply which should be allowed to take its natural course.
How does a bank's gearing choke the bank to death? Let's start with the bank's balance sheet. A bank's capital is typically about 8 to 10 percent of its total assets which comprise loans issued out to borrowers. To support the huge asset base, a bank raises the other 90 percent externally in the form of outside liabilities. These consist of money from depositors and inter-bank borrowings. Banks are classic cases of an entrepreneur's dream – use of other people's money (OPM) – that are extremely dangerous in tight liquidity situations. In a depression, asset prices can fall by more than 30 percent and at the extreme can surpass 50 percent whereas the liabilities remain fixed.
How are property prices holding up in the US? For commercial properties, prices have fallen by 44 percent from their peak in October 2007, a fate similarly shared by those in the UK. The median existing house price for the US has fallen by 25 percent from its peak in the 4th Quarter, 2005 with another 10 percent fall forecast for 2010. The Case-Shiller index covering houses in 20 cities in the US reveals a decrease of 33 percent from its peak in July 2006 to its trough in April 2009. Prices then rose for the next five months because of the Obama stimulus before stalling in October 2009. Karl Case, the eponymous co-founder of the index has predicted that prices will fall by another 15 percent. All in all, it won't be surprising if the price collapse exceeds 50 percent, posing fatal threats to the banks' existence.
Because of a bank's gearing, typically from 10:1 to 12:1, it takes only a 10 percent fall in its asset values to compeletely wipe clean the bank's capital. The bank's assets comprising mostly loans are secured against collaterals which can be real properties or other assets, such as machinery financed by those loans. In a deflation, the values of these collaterals will be dragged down with the falling economy. It doesn't take a mathematical genius to figure out that even with loans amounting to only 80 percent of the collateral values, it needs only a 30 percent fall in the collateral values to drag the bank's assets down by 10 percent. The actual situation is much worse because at the peak of the subprime mania in 2006, the loan-to-value (LTV) ratio even exceeded 95 percent. With their collaterals worth less than their loans, the borrowers will simply walk away from their obligations leaving the bank, devoid of capital, holding on to fast depreciating assets.
The severity of such a scenario can only be felt by looking at the impact of the Great Depression in the 1930s. In 1921, the number of banks in the US peaked at 30,456. Thenceforth, the number gradually diminished but the rapid decline occurred between 1929 and 1933, in the midst of the Great Depression, in which 43 percent or about 10,800 of the banks went bust. Even the relatively mild Savings and Loan crisis of the late 1980s and early 1990s led to the closure of more than 1,600 Savings and Loan institutions.
How do the current bank closures stack up against those of the Great Depression? Actually, we haven't scratched the surface. From 2000 to 2008, the US had only 53 bank closures, including two years, 2005 and 2006, the only time in the history of US banking without any closure. In 2009, the pace started picking up with 140 closures. The US now has about 8,000 odd commercial banks. The coming depression which I call the Grand Depression is definitely many orders of magnitude worse than the Great Depression. The credit expansion was many times bigger and, in a regression to the mean, the credit contraction would need to be equally huge. We can expect more than 3,000 banks to shutter for good within the next few years. These zombie banks are still walking because of the foreclosure moratorium which puts on hold the writedowns of their toxic assets to market value.
Would Islamic banking and sukuk bonds be immune to this catastrophe as bragged about by their proponents? In truth, there's no difference between Islamic and conventional banking. They share the same chink in their armour – high gearing. An economic depression doesn't differentiate between Muslims and non-Muslims. Even any other businesses with high gearing will incur the wrath of the depression. And this crisis in banking won't be restricted to the US; it is spreading globally in line with falling commodity and real estate prices. We only have to wait for the other shoe to drop in the US banking crisis to trigger a chain of falling dominoes in other countries.
Monday, December 28, 2009
Saturday, December 5, 2009
Clutching at the recovery straws
"A specialty of martial arts is to see that which is far away closely and to see that which is nearby from a distance." wrote Miyamoto Musashi in The Book of Five Rings. That statement aptly applies to fields as distant from martial arts as economics and politics. More so now that we are enmeshed in conflicting signals about the global economy so much so we can't make head or tail about which way the economy is heading. The confusion stems from the absence of a guiding pattern as reflected in our anxiety for any indicative news on the economy. There's no way to strategise when your only beacon is the unfolding news.
A typical confusion is exemplified by none other than two well known professors, both having divergent views on how the economy will turn out. In one corner is Niall Ferguson, an economic historian at Harvard whose contention is that the money printing by Bernanke will lead to rampant inflation and consequently high interest rates. In the other is Paul Krugman, an economics professor at Princeton and a Nobel Prize winner to boot. Krugman believes that Obama's deficit will lead to recovery and any rise in interest rates is an indication of funds moving to stocks and investments.
How these two icons of erudition in economics could go wrong is easy to see. They both rely on analytical inquiry; with one or two steps you can plausibly argue out your position. Instead, we should use a different approach, that is, pattern recognition. This approach takes five or more steps in one thinking cycle. For example, using the investment clock as a pattern (see Ticking towards midnight), it's safe to predict that cash will be precious in this depression because of its scarcity. The likelihood of high nominal interest rates is low but because of falling general prices, real rates will be high. We will see major debt write-offs and financial sector deleveraging (loans being called in as banks' capitals get eroded from debt write-offs). Now it appears that cash is aplenty with Bernanke furiously printing money. But don't be so sure that this can continue indefinitely.
We first need to understand the reasons for the temporary growth spurt and why this is just an aberration in a secular downsliding global economy. The refrain about the coming recovery stems from the actions of three men: Bernanke, Obama and Hu Jintao. I will tackle each in turn and debunk their claims to reversing the depression. But first, an overview of the common structural weakness of their actions.
Their failing lies in their inability to perceive the cause of the depression as more than just a liquidity crisis. If it were so, it would have been easily solved by Ben Bernanke's money printing. The fact that it hasn't proves that it's more than merely a liquidity issue.
In my earlier post, I've argued that this depression is actually a capacity crisis (see It's capacity, not liquidity, stupid). Actually, it's more than that; to find out, we need to take a step back. The real reason is the absence of a new growth driver, not only to propel growth but also to creatively destruct the present growth engine. The alternative is annihilative destruction as exemplified by Hitler's WW2 legacies in Europe. The mind can't even contemplate such a nightmare scenario.
The term 'creative destruction' was coined by Joseph Schumpeter of the Austrian school of economics. This school has been disdained by mainstream economists because of the Austrian school's eschewal of mathematical models. The Austrian school has a valid reason since human behaviours are too complex to avail themselves to modelling.
The purpose of creative destruction is to keep the wealth moving from those who have succeeded under the present growth paradigm to those who will succeed under the new growth paradigm. Without this changeover, whatever deficits and money printed will benefit only those who prosper under the existing growth paradigm. Within the context of the global economy, the higher the budget deficits of the US government, the more will be the US current account deficits as China and the oil exporting countries siphon off the surpluses. And for any national economy, the sizes and debts of almost all governments keep burgeoning to meet the demands of their populace until they collapse under their own and their debts' weights. Take Japan, while its public debt has exceeded 200 percent of GDP (second only to Zimbabwe), its household financial assets amount to US$16 trillion (second only to the US).
Ancient societies had ways of dealing with this imbalance through debt cancellation in times of crisis and famine. Our inability to recognise this unsustainable imbalance condemns us to tackling the symptoms while the real problem remains misunderstood. It seems despite our technological advances, we are way behind the ancients in the understanding of social and economic issues.
A similar ineptitude afflicts our three key decision makers. I have written an earlier post on Bernanke (see Bernanke vs The Market), so what's described here are additional comments on his perverted beliefs. Ben Bernanke has earned the nickname Helicopter Ben for his remark that he would drop dollar notes from a helicopter in order to keep the economy going. If only it were that easy. Ben is in need more of a helicopter view to overcome his myopic sight than a helicopter ride. Actually, he has to call upon Obama and Congress to drop money because only they can authorise the spending budget. What Bernanke or the Fed can do is to swap the printed money with existing debts, not willy nilly throwing away money.
Most of his swaps (or purchases, to be exact) comprise treasury bills and mortgage backed securities (MBS). There are limits to both. In the case of T-bills, his holding has exceeded US$700 billion. Any further increase depends on the US government getting deeper into deficits or the holders of existing T-bills continue selling to the Fed. The first is getting tougher as Obama has come under increasing pressure to balance the US government budget. The latter option can only be made at increasing prices as supply of T-bills gets scarcer with greater Fed purchases.
As for the MBS, for which the Fed now holds more than US$800 billion, more purchases of it exposes the Fed to higher risks as following the law of diminishing returns, incremental debts tend to carry greater risks of default, more so in times of deflating prices.
Bernanke's artificial suppressing of interest rates through his flooding of liquidity is not helping the economy either. The sloshing liquidity is sending wrong signals, such as higher commodity prices. Commodity producers are encouraged to increase capacity at a time when the commodity prices are going to collapse as they eventually will when their supplies overwhelm the shrinking demand. The only time when the money floodgate should be opened is during a panic and that moment passed in March 2009. Now is the time to allow the liquidity to gradually decline.
The next decision maker, Pres. Barack Obama is facing many critical issues: economic depression, unemployment, health care, global warming, Afghan and Iraq; all of which offer no easy solutions. To tackle them he must first acknowledge that the US is no longer a hegemon especially when the survival of the nation-state itself is precarious. His priority is to the American voters. He can thus safely ignore global warming, Afghan and Iraq.
A typical confusion is exemplified by none other than two well known professors, both having divergent views on how the economy will turn out. In one corner is Niall Ferguson, an economic historian at Harvard whose contention is that the money printing by Bernanke will lead to rampant inflation and consequently high interest rates. In the other is Paul Krugman, an economics professor at Princeton and a Nobel Prize winner to boot. Krugman believes that Obama's deficit will lead to recovery and any rise in interest rates is an indication of funds moving to stocks and investments.
How these two icons of erudition in economics could go wrong is easy to see. They both rely on analytical inquiry; with one or two steps you can plausibly argue out your position. Instead, we should use a different approach, that is, pattern recognition. This approach takes five or more steps in one thinking cycle. For example, using the investment clock as a pattern (see Ticking towards midnight), it's safe to predict that cash will be precious in this depression because of its scarcity. The likelihood of high nominal interest rates is low but because of falling general prices, real rates will be high. We will see major debt write-offs and financial sector deleveraging (loans being called in as banks' capitals get eroded from debt write-offs). Now it appears that cash is aplenty with Bernanke furiously printing money. But don't be so sure that this can continue indefinitely.
We first need to understand the reasons for the temporary growth spurt and why this is just an aberration in a secular downsliding global economy. The refrain about the coming recovery stems from the actions of three men: Bernanke, Obama and Hu Jintao. I will tackle each in turn and debunk their claims to reversing the depression. But first, an overview of the common structural weakness of their actions.
Their failing lies in their inability to perceive the cause of the depression as more than just a liquidity crisis. If it were so, it would have been easily solved by Ben Bernanke's money printing. The fact that it hasn't proves that it's more than merely a liquidity issue.
In my earlier post, I've argued that this depression is actually a capacity crisis (see It's capacity, not liquidity, stupid). Actually, it's more than that; to find out, we need to take a step back. The real reason is the absence of a new growth driver, not only to propel growth but also to creatively destruct the present growth engine. The alternative is annihilative destruction as exemplified by Hitler's WW2 legacies in Europe. The mind can't even contemplate such a nightmare scenario.
The term 'creative destruction' was coined by Joseph Schumpeter of the Austrian school of economics. This school has been disdained by mainstream economists because of the Austrian school's eschewal of mathematical models. The Austrian school has a valid reason since human behaviours are too complex to avail themselves to modelling.
The purpose of creative destruction is to keep the wealth moving from those who have succeeded under the present growth paradigm to those who will succeed under the new growth paradigm. Without this changeover, whatever deficits and money printed will benefit only those who prosper under the existing growth paradigm. Within the context of the global economy, the higher the budget deficits of the US government, the more will be the US current account deficits as China and the oil exporting countries siphon off the surpluses. And for any national economy, the sizes and debts of almost all governments keep burgeoning to meet the demands of their populace until they collapse under their own and their debts' weights. Take Japan, while its public debt has exceeded 200 percent of GDP (second only to Zimbabwe), its household financial assets amount to US$16 trillion (second only to the US).
Ancient societies had ways of dealing with this imbalance through debt cancellation in times of crisis and famine. Our inability to recognise this unsustainable imbalance condemns us to tackling the symptoms while the real problem remains misunderstood. It seems despite our technological advances, we are way behind the ancients in the understanding of social and economic issues.
A similar ineptitude afflicts our three key decision makers. I have written an earlier post on Bernanke (see Bernanke vs The Market), so what's described here are additional comments on his perverted beliefs. Ben Bernanke has earned the nickname Helicopter Ben for his remark that he would drop dollar notes from a helicopter in order to keep the economy going. If only it were that easy. Ben is in need more of a helicopter view to overcome his myopic sight than a helicopter ride. Actually, he has to call upon Obama and Congress to drop money because only they can authorise the spending budget. What Bernanke or the Fed can do is to swap the printed money with existing debts, not willy nilly throwing away money.
Most of his swaps (or purchases, to be exact) comprise treasury bills and mortgage backed securities (MBS). There are limits to both. In the case of T-bills, his holding has exceeded US$700 billion. Any further increase depends on the US government getting deeper into deficits or the holders of existing T-bills continue selling to the Fed. The first is getting tougher as Obama has come under increasing pressure to balance the US government budget. The latter option can only be made at increasing prices as supply of T-bills gets scarcer with greater Fed purchases.
As for the MBS, for which the Fed now holds more than US$800 billion, more purchases of it exposes the Fed to higher risks as following the law of diminishing returns, incremental debts tend to carry greater risks of default, more so in times of deflating prices.
Bernanke's artificial suppressing of interest rates through his flooding of liquidity is not helping the economy either. The sloshing liquidity is sending wrong signals, such as higher commodity prices. Commodity producers are encouraged to increase capacity at a time when the commodity prices are going to collapse as they eventually will when their supplies overwhelm the shrinking demand. The only time when the money floodgate should be opened is during a panic and that moment passed in March 2009. Now is the time to allow the liquidity to gradually decline.
The next decision maker, Pres. Barack Obama is facing many critical issues: economic depression, unemployment, health care, global warming, Afghan and Iraq; all of which offer no easy solutions. To tackle them he must first acknowledge that the US is no longer a hegemon especially when the survival of the nation-state itself is precarious. His priority is to the American voters. He can thus safely ignore global warming, Afghan and Iraq.
Global warming, even if it really is caused by carbon emissions, cannot be solved by government edicts and regulations. Only technology can address it. Furthermore, in a severe depression, it will eventually be relegated to the back burner. Iraq is a goner when oil prices crash. The reason the Iraq surge succeeded was because it was accompanied by cash bribes to the Sunni tribal chiefs who then rallied the Sunni tribes against Al-Qaeda. This lesson has been lost on the American generals who still believe that it was the surge alone that turned the tide. American intelligence in preventing attacks in its homeland has improved tremendously that the US doesn't need to be present in Afghanistan. It should allow Taliban to rule Afghanistan and use the threat of the missiles to get them to put on their best behaviour. Israel's experience with Hamas after Hamas's rule of Gaza is instructive. For invisible enemies, the key is to make them visible so that they can be contained.
Health care, the last pocket of inefficiencies in the private sector, is a secondary issue in a downturn. The way health care is administered now, with practitioners operating autonomously within a hospital, engenders perverse incentives and is predatory on the consumers. The US should look into certain revolutionary health care practices, especially in India where salaried doctors using factory line style procedures focusing on volumes, have improved quality and lowered costs.
The economic depression is a given as the moment Obama reduces the US deficits, if not balances its budget, the global economy will keel over once again. That leaves unemployment as the critical issue that Obama should redirect his attention to. To solve this, he must first institute trade barriers and capital controls. It's no point incurring massive deficits if the money eventually flows out. Of course, these measures are economically inefficient.
But look at the factory floor, you can only be very efficient in only one area of your choosing; it's either labour, machine or space. Similarly, if you want cheap quality goods, you must tolerate continual deficits and high unemployment. It's Linear Programming 101: you can only maximise efficiency in only one area, but subject to the constraints or minimum thresholds that you have specified for the others. In the case of the US economy, it's maximising goods production efficiency without regard to any constraints on the level of unemployment nor on the deficits.
Finally, Hu Jintao who is the President of China, a country living on borrowed time. China is probably the last in a series of countries ranging from Japan to the East Asians and South East Asians that have been or about to be humbled by the deflationary plague. The Tibetan and Uighur riots in 2008 and 2009 were just mild foretastes of worse things to come. The riots were easily quelled because they were initiated by minorities. When the turn of the Han Chinese comes, not even the biggest army in the world can subdue it. Even Suharto, politically once the strongest man in Asia had to shamefully step down in 1998 after 30 years of iron rule when the whole region was steeped in economic turmoil.
China survives for the moment because of its US$586 billion stimulus and the US$1.2 trillion in additional bank credits. These packages are being used to increase capacity when it is least needed. Soon abandoned factories and real properties will dot China's landscape. The cost in terms of massive bank failures and lost jobs will be closely followed by a social breakdown of immense proportion.
At least Japan were rich when they were hit by the crisis in 1990 while the East Asians and South East Asians were partially saved by the devaluation in 1998. China may be the world's second biggest economy but its per capita GDP is still low. The devaluation option is no longer available as, given its economic impact, all eyes are watching its actions. As the negative forces of unsustainable debts, falling asset prices, rising unemployment and shrinking exports close in on their quarry, China, we can only watch with trepidation the strangulation of a would-be superpower. How fortunes change ― from greatness to wretchedness, from prosperity to calamity, from mastery to misery, from predator to prey, all it takes is a spin of the economic wheel.
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