谢国忠

Beyond Bear Stearns(译文在这里)

谢国忠搜狐博客　http://xieguozhong.blog.sohu.com/

The Fed has effectively removed liquidity problem for investment banks by making its discount window available to them. The flash point in the unfolding crisis has moved elsewhere. Local banks are probably next on the line. The following is in the current Caijing Magazine.

Beyond Bear Stearns

Before I departed for Fiji, my colleagues at the World Bank regaled me with cannibalism stories about the place. Fiji was historically known as 'Cannibal Isles'. One colleague gave me a book that a missionary's wife wrote one century ago. The book portrayed in vivid language the gory details of multiple ways to practice cannibalism. I don't know why a missionary's wife had such an intense interest in this subject. 'It's not for the food', one senior colleague drove the message home, 'they enjoy it'. The education had quite an effect on me. After eating steaks for years, one develops a special fear for becoming the steak. After my arrival, I was relieved to learn that Fijians had become devout Christians a long time ago. Further, they never liked thin men anyway, the locals told me. That was quite a relief.

In the book by the missionary's wife, it described in gruesome details a cannibalism ritual. A giant stone oven that fits a human inside stands in the middle of an open ground. Inside, burning woods heat up a layer of rocks. All sorts of spices and sauces are neatly lined up on a table next to the oven. A throng of tribesman in straw skirts dance around. Two large tribesmen drag an unlucky man towards the oven. The dancing heats up. Everyone's eyes light up, expecting a sumptuous stone grill.

The death of Bear Stearns reminds me of the scene. The hapless Bear Stearns was dragged by the Fed and the Treasury to the oven with JP Morgan Chase standing next, smacking its lips. The 87-year old investment bank must have had the same sensation on the way to the oven as countless cannibalism victims felt in Fiji a long time ago. If I were Bear Stearns, I would swallow plenty of poison on the way; it would feel better knowing JP Morgan Chase would get indigestion or worse. This story has sequels.

Bear Stearns was bankrupt. After going through its books, JP Morgan Chase declared that its capital was negative. Of course, JP Morgan Chase had the incentive to understate Bear's value. But, with the Fed and the Treasury on the side, it wouldn't have the guts to declare Bear bankrupt if it were solvent. Only days ago, the senior executives at Bear were confident of its $17 billion capital. The Fed had to assume risk on $30 billion of most illiquid assets (euphemism for very bad assets) on the Bear's book to convince JP Morgan Chase to take it over. JP Morgan Chase paid a notional value of $2 per share or $279 million in total. Bear's share price traded as high as $170 only one year ago. JP Morgan Chase appears to be raising the offer to palliate the infuriated shareholders of Bear Stearns. The Fed is hesitant to approve a higher offer, as it is afraid of the impression that it is using taxpayers' money to bail out the shareholders of a failed financial institution. The legal wangle over the deal could drag on for a long time. But, under the watchful eyes of the government, Bear Stearns is folding into JP Morgan Chase regardless of the development.

Many argue that Bear failed due to a bank run, i.e., its customers wanted their money back at the same time. They said the same about Enron's collapse. The argument seems to suggest that the bank run is at fault. It confuses people with a false causality. The bank run began as Bear's customers suspected it was bankrupt. The due diligence by JP Morgan Chase proved that the market was correct. When a killer is sentenced to death, don't blame the executioner for his death; blame the killer.

A more relevant implication is how many financial institutions are bankrupt like Bear. The Bear's case reveals that the capital accounting at financial institutions is not reliable at all. Banks can have assets twelve times their capital, according to the BIS rule. Investment banks have 25-30 times, as they are not regulated by the BIS. As most global banks have investment banking arms, their assets are much more than 12 times their capital. Further, with the liberal use of off-balance sheet vehicles like S.I.V., their effective asset base is harder to measure. The high leverage makes financial institutions vulnerable to bankruptcy. If an investment bank has assets 30 times its capital, if asset price drops 3%, its capital is gone. Markets can move this much in a day. Of course, most banks claim they have sophisticated risk management tools. The most common is value at risk or VAR. It claims to limit the loss within a day. Most big investment banks have VAR around $100 million. This technique has lost its credibility completely. Just look at billions of dollars that the banks have so quickly lost.

If other banks price their assets like JP Morgan Chase did to Bear's, more banks are probably bankrupt. That raises the question why Bear Stearns was singled out while others are still standing. Not every bank without capital should die. The franchise value-the ability to earn return above the cost of capital is significant for some. Financial institutions average price-book ratio of 2. Even if the physical capital is zero, the franchise value is still significant. The market is trying to decrease industry capacity by pushing weak institutions out of business to boost the franchise values of the remaining ones. Even if the remaining ones are technically bankrupt, their operating income could pay off their liability.

While folding Bear into JP Morgan Chase, the Fed made an important change to support the securities industry; it would open discount window to non-banks like investment banks and would accept mortgage securities as collaterals. This development would stabilize the securities firms. The Fed would effectively accept mortgage papers as collaterals in exchange for cash. The Fed says it would apply a haircut to the collateral value. In future, the Fed, not the market, would determine the viability of an investment bank. It could decide what haircut to apply to collateral value. This is a judgment call and could be influenced by the Fed's desire for outcome. While the Fed now has the tool to stop another collapse like Bear Stearns's, it could end up owning huge amount of bad assets. The Fed could be exchanging nationalization of bad debts for the stability of the securities industry.

The collapse of Bear Stearns marks a milestone in the unfolding credit burst. If the Fed could have allowed Bear Stearns to be liquidated, it would have marked the bottom of the current bear market; investors would know the true prices for the vast amount of illiquid papers. It may have meant the collapse of several more investment banks. But, the catharsis would have brought transparency and re-established trust in the financial system. Instead, the Fed has made it possible for the remaining investment banks to avoid a liquidity squeeze. The investment banks would write down their bad debts gradually with their income, just like Japanese banks did. Every quarterly earnings report would come with a write-off. The crisis is temporarily eased by stretching the adjustment period.

The storm may shift from the liquidity problem at investment banks to other areas. The Fed may be able to stop the liquidity problem at financial institutions. It couldn't stop property price declining and mortgage and construction loan bankruptcies. No matter how hard the Fed pumps liquidity; massive capital losses in the financial system mean credit contraction, which means a big recession. Twenty million households in the US may see their home value dropping below their mortgage debts. They are likely to default and return their properties to their funding banks. $300 bn construction loans could default en masse as the construction market collapses. The defaults would force financial institutions to write off their capital and to stop the game of writing off losses gradually. The eye of the storm is shifting to small local banks that are heavily exposed to construction lending. The failures of such banks will start another wave of panic. We may have to wait one to two months for this drama.

The Fed seems determined to bail out everyone. It prevents market from clearing. Hence, financial institutions can use 'judgment calls' to value their assets. When local banks begin to fail, even though these banks may go out of business like Bear Stearns, the Fed could prevent the liquidation of their assets from taking down the financial system. Japan's adjustment lasted for a decade because Japanese government didn't force banks to liquidate their bad assets; the banks wrote off their bad assets gradually with their operating income. The US is doing something similar. This gradualist approach kept credit and economy from expanding for a long time.

Even though the Fed commented on inflation again at its latest rate cut, I am convinced that the Fed wants to inflate debts to lessen the adjustment pain. Foreigners hold $16 trillion of the US's financial assets. Inflation and dollar devaluation are good for Americans. In particular, middle and low-income Americans are in net debt position. Inflation is good for their balance sheet. The only way to stop the Fed is for foreigners to sell the US treasuries now, which would push up bond yield and create pain for Americans to find long-term financing. So far, foreigners, mostly central banks, are watching their assets depreciating and not taking actions. Hence, the Fed has no incentive to change its policy. Gradualist approach in unwinding the credit bubble gives inflation time to decrease the real debt burden, which gives the Fed powerful incentives to bail out everyone and stop the market from clearing. Further, the resulting weak dollar boosts the US's exports, i.e., exporting the US recession around the world.

To what extent Ben Bernanke's belief rather than national interest is guiding how the Fed is handling the crisis? Most of the elite in the US support the Fed's approach to stretching the adjustment out and inflating away debts, because they believe that American people are not tough enough to pay back what they owe. Some attributes the Fed's approach to Ben Bernanke's fear of 1930-style debt deflation. Most economists blame the Fed's tight monetary policy for the depression in the 1930s. The mass bankruptcies of banks then triggered a vicious spiral of asset deflation and bankruptcy-induced liquidation. Mr. Bernanke concluded a long time ago that the Fed should flood the financial system with money after a financial crisis. The Fed's approach partly reflects Mr. Bernanke's belief.

The belief of the previous Fed Chairman, Alan Greenspan, has brought today's calamity. He is probably the most overrated man in the world. So many people believed his magic in boosting confidence by jus talking. He was just a bubble blower! Since the Asian Financial Crisis in 1998, globalization and IT revolution increased productivity and kept down wage in high income economies. Hence, the sensitivity of inflation to money growth declined. Central bank should have allowed price to fall to reflect the rising productivity. For example, the prices of electronics products always decline due to rising productivity. The world was like the electronics industry. Instead, Mr. Greenspan inflated the prices of services like haircuts or restaurant meals to offset the declining prices of shoes and electronics. He did it all in the name of price stability. To offset the natural tendency of price declining due to high productivity, he pumped a lot of money that led to the NASDAQ bubble in 1999-2000 and the property bubble afterwards. Greenspan's magic came from printing money with abandon in a low inflation environment, which caused the bubbles. History will judge him harshly.

Mr. Bernanke's belief in an inflationary solution to a property burst may generate severe costs in the future. There is no free lunch. Inflation seems like a free lunch to the US now as it lessens its debt burden at the expense of foreigners. However, the loss of the US's credibility and the risk to the US dollar's status in the global economy could outweigh the short-term benefits. The US lost its edge in manufacturing in the 1980s. Its competitiveness has depended on R&D intensive industries like defense and medicine and service industries like finance and entertainment. Finance is probably the most important sector to the US economy. It keeps the dollar the currency for global trade and finance. The benefit of the dollar's status seems to sustain 3% of GDP in current account deficit for the US economy. The dollar's status may carry $10 trillion of value to the US economy. The Fed's policy could destroy the dollar's status. The loss of long-term benefit to the US may exceed the short-term benefit from inflating away some debts.

As the Fed makes unlimited amount of liquidity to investment banks (most big commercial banks have investment banks), the battleground in the credit crisis shifts to small local banks. They are heavily exposed to the declining property sector. The construction lending alone exceeds $300 billion. The defaults from this sector could become a tidal wave soon. In the next three months, the Fed may have to decide if to bail out these banks. If these banks liquidate their assets, the declining prices would feed back to investment banks that carry similar assets on their balance sheets. Of course, the Fed could allow to use the bad assets as collaterals to borrow from it, another step down the slippery path of nationalizing bad debts.

In addition to capital losses, the financial sector faces shrinking business prospect. The financial industry accounted for 40% of earnings among all listed companies at the peak from 5% twenty years ago. Under Mr. Greenspan's loose monetary policy, the financial sector earned money from riding the asset bubbles. As the world returns to an inflationary environment, bubbles are hard to sustain. Hence, the financial sector may need to downside by half or more to fit the new business environment.

Overcapacity became a serious problem for the financial sector after the NASDAQ burst in 2000-01. The credit bubble happened afterwards as excess workforce created businesses for themselves. The delay in downsizing was a big factor in causing the bubble. The day of reckoning is finally here. JP Morgan Chase will only pick up a small part of Bear Stearns and shuts the rest down. Big commercial banks may have to exit the investment banking business that they went into ten years ago. Investment banks may have to merge. In short, the pain on Wall Street is just beginning.

The Fed's inflationary policy makes life difficult for rest of the world. Japan is already in recession. Europe may follow in the second half of 2008. The OECD economies may grow at 1-1.5% from 2.5% last year. Emerging economies are doing better. Thanks to the large foreign exchange reserves, they can continue to invest despite weakening exports to the OECD block. High commodity prices, thanks to the Fed's loose monetary policy, are a big help. They may be able to grow at 6.5-7% in 2008 from 7.9% in 2007.

As the Fed stabilizes the investment banks, financial markets may improve in April or even May. I suspect that the next storm will hit soon when the US's local banks begin to fail around the mid of the year. The attractiveness of gold is inversely correlated with stock market. When calm returns like now, gold price declines. It resumes climbing when the turmoil returns.

谢国忠搜狐博客　http://xieguozhong.blog.sohu.com/