The End of the Beginning
Dated: September 24, 2008
For an answer, remember Winston Churchill’s words in 1942. “This is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”
The financial crunch that began in mid-2007 has worsened so dramatically that all politicians have agreed to a government rescue. In that sense, we have reached the end of the beginning of the current drama.
But two major chapters are yet to unfold. The first relates to problems that will hamstring, and maybe doom, the rescue. The second relates to the global recession that has probably started, and will hit countries like India far harder than mere Wall Street turmoil.
Right-wing analysts sneer that the US has created the world’s biggest sovereign wealth fund. This is skewed badly towards the financial sector alone. But just wait: opportunities for diversification are at hand, since the Big Three auto giants also seek rescues. And, as the recession bites, further opportunities will arise to rescue giants in retail and technology!
Politicians are uninterested in criticism that the rescue will encourage a repetition of profligacy and excessive risk-taking in the future. Right now, they want to appear as saviours, not disciplinarians.
Many legislators resent being asked to sign a blank cheque for $ 700 b, and want to attach all sorts of conditions. But populist pressure will probably ensure rapid legislation with minimal conditions.
Yet that will not end the saga. A thousand thorny political issues will follow. Who will decide which securities are toxic and worthy of rescue? The Treasury alone? Should one authority have so much power and discretion?
Will the Treasury buy only mortgage securities? Or also derivatives such as credit default swaps? What about credit card defaults, which loom ahead? Or corporate bond defaults?
How many companies will be allowed to go bust before the Treasury saves others by declaring a new set of instruments to be toxic? What checks and balances are needed on enormous discretionary power over $ 700 billion, that can make or break fortunes, and can be manipulated by old-boy networks and lobbyists?
At what price will the government buy toxic securities? Merrill Lynch sold some mortgage-backed securities at just 22 cents in the dollar. Will Treasury offer more to others? If so why? In setting prices, the scope for fraud, collusion and suspicion is huge. Will vulture funds, which have already bought distressed securities for a song, be allowed to resell these at higher “rescue prices” to the Treasury?
Which fund managers will be appointed to manage the huge assets taken over? Why, they will be drawn from the very financial class that has just disgraced itself! The potential conflicts of interest are vast.
Maybe all these issues will be overcome. But a significant risk remains that the rescue will be hamstrung by allegations of fraud and collusion.
Much greater is the risk that the financial crisis will keep worsening. Professor Nouri-el Roubini was the first to predict massive carnage. He now estimates bad loans at $ 2 trillion, large enough to overwhelm the rescue package. Roubini correctly predicted the fall of the shadow financial sector---lightly-regulated financial entities that avoided the tight supervision imposed on banks, such as off-balance sheet SIVs (special investment vehicles), leveraged investment banks, and leveraged hedge funds. He now predicts that the carnage will spread to hedge funds, for whom the rescue package makes no provision.
Meanwhile risk is set to multiply in derivatives. Most at risk are credit default swaps (CDSs), which insure against bond and loan default. The size of the CDS market is $ 62 trillion, four times the GDP of the US! After netting out offsetting transactions, the balance CDS risk is around a trillion dollars.
The future of the CDS market depends on the real economy. A major recession is now unavoidable, and this will mean more corporate and banking defaults. Some experts think at least 4,000 US banks will go bust. Recessions typically lead to a 10% default on corporate bonds. The default rate last year was only 1.8%. So a surge in defaults in coming, and CDS markets are trembling.
Despite a credit crunch starting with the bursting of the US housing bubble 13 months ago, the US and world economy have remained remarkably resilient so far. GDP growth in the US was 3.3% in the last quarter on an annualized basis. The Indian and Chinese economies have slowed, but only modestly.
What explains this resilience? Well, US monetary and fiscal policies have flooded the country—and the world—with dollars to try and stave off recession. The Fed has given financial markets unprecedented access to liquidity, and cut interest rates to just 2%. US Congress has legislated $ 140 billion in cheques mailed to consumers, just to increase purchasing power. The trade deficit remains high, and is paid for by issuing dollars to the world. This Niagara of dollars has kept purchasing power (and GDP) rising despite the credit crunch.
But a major recession is now unavoidable. Japan and some European countries suffered negative growth in the last quarter, and the US may already be in recession this quarter. Emerging markets are all slowing down.
The credit crunch means that fresh financing of both consumers and industry is going to slow down, in the US and globally. Risk aversion in financial markets means that emerging economy companies will find face problems in rolling over $ 111 billion of debt falling due over the next year. Several companies that had banked on cheap loans and high IPO prices now find doors closed. The problem may persist through 2009-10.
So, the greatest financial crisis since the Great Depression has a long way to go yet. And the journey may be long and painful.