In the early hours of Thursday, Bare Talk felt, as he trudged his way to the boarding gate to catch a flight to Jakarta, that the financial tsunami was already upon us and that it was too late to save the world. He was only unsure of the extent of damage. He was in good company.
On Thursday evening, US Fed chairman Ben Bernanke essentially said the same to Congressmen to their utter disbelief. He told them the global financial system was just days away from a complete breakdown or meltdown with unspecified consequences. Some measures have been taken since then. Whether they will work is not a big question for the short term. Financial markets want to believe that they will. In the near term, return of risk appetite is likely. That question matters for the medium term and Bare Talk remains sceptical of positive claims.
The Securities and Exchange Commission (SEC) in the US and regulatory authorities in the UK and in Canada have imposed some form of restriction on short-selling. Hedge funds have to swear under oath their short positions. Forgotten in this persecution is a matter of tiny detail that, in 2004, SEC made two important changes to its rules on the amount of leverage that broker-dealers could take on (Bigpicture.typepad.com). The changes increased the leverage ratio limit for five broker-dealers, reduced haircut margins on assets, thus allowing net capital to be inflated, further increasing the eventual leverage. Those five were Merrill, Lehman, Bear Stearns, Goldman and Morgan Stanley. Three of them are not around any more. It appears that the retribution for the authorities’ deregulatory zeal is to be paid by short-sellers.
Nonetheless, the short-selling ban has worked. Risky assets leapt on Thursday and Friday. Sooner or later, expectations for the return of normal economic and corporate earnings growth in 2009 would prove to be too big a burden on stocks to allow them to soar higher next year. Reality will begin to bite early next year but stock markets could party hard into its arrival.
Laws of both intended and unintended consequences would be at work soon. The bailout announced on Saturday is too short on details. It proposes a solution to provide liquidity to the institutions and not recapitalize them. The mechanism for determining the prices at which the impaired mortgage assets of institutions would be bought is unspecified. If the price paid for impaired assets is too high to enable institutions to remain capitalized, then the burden on taxpayers would be very high. If the price paid is low, many institutions would be short of capital and that would need to be shored up, too. Further, there is nothing in it for homeowners and mortgage borrowers. At the current announced size, the cost in terms of GDP should be 5-6%. By the time it is passed by Congress, the price tag could be a lot higher. With the US fiscal deficit likely to hit double digits, it would be a stretch for the rating agencies to maintain America’s AAA credit rating.
As an aside, Moody’s on Friday threatened to downgrade the financial strength rating of Ambac, the bond insurance company. The Ambac stock plunged on a day when even a speck of dust rose in value. It is clear it is being taken to the abattoir, now that keeping it alive is no longer needed. It doesn’t really inspire confidence that a new beginning is being made.
lt was one thing for Asian nations to buy treasurys and mortgage agency debt and accumulate reserves when they were deemed AAA credits. Can they do so even now, and how would their public react? Of course, it is a stretch to think that most East Asian nations respect popular wish, but it is not a stretch to state that they would fear the inflationary consequences of going back to reserves accumulation and thus entrench currency weakness.
Further, successful reliquefaction or recapitalization (omitted for now) would require American households to play their part in resuming their borrowing habits again despite their zero savings rate and recent harrowing experience with borrowing and reliance on asset price gains to finance their spending habits. If American households, defying expected rational behaviour, resume borrowing and the world returns to strong growth, we should expect inflationary pressures to return, as global spare capacity for growth is sparse.
It was never the case that the US would plunge headlong into a deflationary bust and stay there. It was expected to counter the deflationary bust with reflation attempts. Questions are whether it would succeed and, if so, at what cost to America and the rest of the world. My guess has been that the deflationary bust would arrive later but via the inflationary route. That sequence is playing out correctly. There is no case yet to change the script’s climax.
V. Anantha Nageswaran is head,investment research, Bank Julius Baer & Co. Ltd in Singapore. These are his personal views and do not represent those of his employer. Your comments are welcome at firstname.lastname@example.org