Tuesday, October 14, 2008

The engine of mayhem: Deleveraging

Oct 14, 2008

By Robert J. Samuelson

IT'S easy to explain the continuing financial chaos - and the failure of governments to control it - as the triumph of psychology. Fear reigns, and panic follows. Everyone dumps stocks, because everyone believes that everyone else will sell. Only rapidly falling prices attract sufficient buyers. All this is true. But it ignores the real engine of mayhem: 'deleveraging'. That's economic shorthand for purging the financial system of too much debt.

Just how this 'deleveraging' proceeds will largely determine the fate, for good or ill, of the present crisis. The turmoil has already moved beyond sub-prime mortgages, which (it now seems) merely exposed widespread financial failings. These were global, not just American, and their pervasiveness explains why leaders of the major economies have struggled to fashion a common response.

Alone, American sub-prime mortgages should not have triggered a global crisis. Losses are smaller than they seem. Mr Mark Zandi of Moody's Economy.com estimates that all US mortgage losses will ultimately reach US$650 billion (S$955 billion). But that hefty amount pales against the value of all financial assets - stocks, bonds, bank loans. For the United States, these totalled almost US$60 trillion at year-end 2007; for the world, the comparable figure exceeded US$250 trillion.

Such a vast financial system should have routinely absorbed the sub-prime losses. By way of contrast, the stock market's drop since its peak in October 2007 to last Friday was US$8.4 trillion, or 42 per cent, reports Wilshire Associates. The official response to the sub-prime losses also seems larger than the problem. The government has taken over mortgage giants Fannie Mae and Freddie Mac; the Federal Reserve is pumping out short-term loans of US$1 trillion or more; and Congress' US$700 billion rescue allows the Treasury Department to buy sub-prime securities and to make direct investments in banks.

Still, the situation has not stabilised; the crisis continues. It's as if the firefighters had arrived at the burning home and turned more hoses on the flames, but the conflagration raged anyway. What's going on?

What we've discovered is that the real problem is bigger. Large parts of the financial system are too thinly capitalised and too dependent on unreliable short-term debt. Leverage ratios often reached 30-1 for investment banks and hedge funds (US$30 of debt for every US$1 of capital).

The presumption was that the MBA types had learnt how to 'manage risk.' That false conceit backfired. Low capital didn't adequately protect against losses. Confidence and trust evaporated, because no one knew which institutions held suspect securities, how much the losses were and who was ultimately safe.

'Deleveraging' - a shift from excessive debt towards more capital - is inevitable and desirable in the long run. The trouble is that, in the short run, it may destabilise the economy if it proceeds too rapidly.

Consider stocks. Their plunge has been driven in part by hedge fund selling. Hedge funds often buy stocks by borrowing from their 'prime dealers' - firms like Goldman Sachs and Morgan Stanley, which in turn borrow from commercial banks. If banks 'deleverage' by reducing loans to prime dealers, then prime dealers tighten up on hedge funds, which react by selling stocks. 'It's a big piece of why the stock market is down,' says MrMichael Decker, co-head of the Regional Bond Dealers Association.

All around the world, we see variants of this cycle. The yen 'carry trade' - borrowing at low interest rates in Japan and lending at higher rates in other countries - is reportedly contracting. Iceland's main banks have been nationalised because they could not renew their short-term borrowings.

But if credit is withdrawn too abruptly, the prices of stocks, bonds and other assets that it propped up - and also the real economy of production and jobs - will fall. And the effects feed on themselves. Hedge funds, for example, have been hit with high redemptions from investors: about 5 per cent in September, 21/2 times normal. These compound selling pressures.

The present challenge is far more complicated than merely quarantining dubious mortgage-related securities. What's involved is a fundamental remaking of the global financial system, from one that was inherently fragile to one that rests on firmer foundations. But if the change proceeds too quickly and haphazardly, it risks a hugely destructive credit implosion.

All the policies undertaken so far will ultimately be judged by whether they succeed in managing the transition and restoring confidence in financial markets that self-correct naturally - as opposed to submitting to the continuing mayhem of uncontrolled 'deleveraging'.


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