Last Friday, the action in the US financial markets was far more riveting than what any movie could have offered. By 1pm in New York, the Dow Jones Industrial Average had dropped 222 basis points as rumours of the nationalization of the national housing mortgage guarantee and securitization companies Freddie Mac and Fannie Mae swirled. The US government said there was no need to nationalize. In the subsequent one hour, all the losses were wiped out. Then came the announcement that a mortgage bank, IndyMac, had been taken over by the regulator because it could not meet its cash obligations. The Dow Jones index again lost around 128 points. The US dollar weakened to nearly 1.60 against the euro. Gold rallied to around $964 per ounce.
The ground beneath the global financial markets is shifting. Most don’t feel it yet. In fact, short-term oversold assets possibly rally because the failure of IndyMac creates as much a sense of finality as the failure and takeover of Bear Stearns did. Of course, it would turn out to be as ephemeral as the earlier feeling of relief.
The distress faced by Fannie Mae and Freddie Mac is global. The US cannot extend the federal safety net without asking current bond and shareholders to accept losses. But the big holders of the debt of the two mortgage agencies are China and Russia. According to economist Brad Setser, China holds nearly a trillion dollars of treasury and agency debt, and Russia holds around $156 billion of agency debt. These are significant proportions of their national GDP. Asking them to accept some losses would be a foreign policy challenge.
But, extending a federal guarantee without any sacrifice on their part would be a huge drain on the US’ fragile fiscal balance and burden on the enfeebled dollar. Of course, the euro’s strength would also be an enormous strain on the peripheral European economies such as Portugal, Italy, Greece and Spain even as the French and German economies are beginning to slow. Industrial production has declined in both countries in recent months. The case for gold must be becoming clearer to many now.
When and where would the crisis end? To attempt to answer these questions, it is useful to trace its origins. Some would trace it to 1999 when the Glass-Steagall Act was repealed in the US, allowing financial firms to offer all services under one roof and, in the process, expand their balance sheet aggressively. Some would trace it to the Greenspan policy of putting a floor under the stock market with intra-meeting rate cuts that came into sharp focus in September and October 1998. Some would start from the rate cuts in the US earlier this decade that saw the monetary policy rate reach 1% in 2003.
Bare Talk would date it to 27 December 1993, when the Chinese renminbi was devalued by nearly 50%. That sowed the seeds of the Asian crisis, the subsequent emphasis on exports, undervalued currencies, international reserve accumulation and lending to the US that kept interest rates low, the mortgage boom and bust, and has now left Fannie Mae and Freddie Mac poised for collapse. This is not the end of the saga. The real climax is awaited. Just as it started with the 1993 devaluation in China, it may end with a bang with an equally massive revaluation in 2009 there.
Would that end it? Not necessarily, unless important lessons are absorbed. First, we must accept the limitations of financial innovation. We must start by admitting there is no “innovation” in finance — only ignorance. Financial innovation is credited with moderating economic cycles in the 1980s and 1990s. But that is an unsubstantiated claim. Rather, its contribution to the “great moderation” has been to end it. More than for controlling inflation, the Reserve Bank of India deserves credit for safeguarding financial system stability in the face of the onslaught of financial ponzi schemes masquerading as innovation.
Second, as the latest annual report of the Bank for International Settlements notes correctly, more than the difference, the similarities with previous episodes of long periods of strong credit growth, asset price boom, bust and inflationary upturn are important. In each of the previous episodes, there were always new-fangled financial products that promised the impossible to investors.
Finally, as the concluding chapter of the report brilliantly observes, “If asset prices are unrealistically high, they must eventually fall. If savings rates are unrealistically low, they must rise. And if debt cannot be serviced, (it) must be written off. Trying to deny this through the use of gimmicks and palliatives will only make things worse in the end.”
When more governments and individuals accept the inevitability of these prescriptions, the crisis will end. The dawn of that wisdom is not in sight yet.
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 email@example.com