For the markets, global chill by Julian Delasantellis

For the markets, global chill
By Julian Delasantellis

The 1970s British Broadcasting Corp comedy show Monty Python's Flying Circus once did a skit about a new way that council flats - public housing - were being built near the town of Peterborough in England. Instead of building these 25-story towers through the conventional employment of construction workers, concrete and steel, this council was employing the services of El Mystico (Terry Jones), a magician in cape and top hat, along with his curvaceous assistant, in her sequined leotard, the Amazing Janet.

All it took for El Mystico and the Amazing Janet to put up a block of flats was a wave of his magic wand. According to a council spokesman, Ken Verybigliar, "Well, there is a considerable financial advantage in using the services of El Mystico. A block, like Mystico Point here, would normally cost in the region of 1.5 million pounds [US$3 million]. This was put up for 5 pounds, and 30 bob [shillings] for Janet."

These flats constructed with the black arts were just as reliable and sturdy as those conventionally constructed - with one exception. According to Clement Onan, identified as an architect to the council, "They are as strong, solid and as safe as any other building method in this country - provided, of course, people believe in them."

If tenants did start to doubt the actual existence of the buildings they were then living in, the building would fall down, until their faiths were restored, then the buildings would magically reassemble themselves.

Of course, unlike Monty Python's Britain, this sort of thing could not happen these days - because since the Margaret Thatcher/Ronald Reagan revolution of the late 1970s and early 1980s, neither the British nor the US government has done much investment in public housing, even with the dramatic cost advantages available with construction by El Mystico.

If you want a contemporaneous example of something held up only by the faith of its participants, take a look at the corporate debt markets of the past few years. And if you want an example of what happens when that faith evaporates, look at the world's stock markets last week.

It has been the worst two weeks for the world's equities since the corporate-scandal-ridden summer of 2002 (I wrote about the scandals of 2002 in my Asia Times Online article of May 10, The decline of US equity markets). In the US, the S&P 500 stock index has declined 6%, Britain's FTSE 100 is down more than 8%, Japan's Nikkei 225 almost 6%, Germany's XETRA-DAX almost 9%.

The financial media and, as the losses accelerated late last week, the general media (with the exception of Fox News, which is pinning the blame squarely on the proposal by US Democratic candidate for president John Edwards to repeal the 2001 cuts in capital-gains tax for those with incomes over US$250,000), have taken to blaming the selloffs on what they call "the subprimes".

This refers to the part of the market for US housing finance that specializes in lending to those with poor credit histories, what the industry calls "subprime borrowers". The media use this phrase so often it almost seems it has become a sort of tantric mantra for them; without even knowing what it means, they say it and it makes them feel better - probably because it presents the illusion that they know what they're talking about.

Four times this year [1] I've written about the subprimes; those who want background on how the subprime crisis developed can read these articles. However, it is is no longer accurate to describe the current world equity-market selloff on the suprimes as if it were the case that if only that problem would go away everything would be fine. That's like a man going to the doctor with gangrene from his toe to his hip expecting all will be fine if only the splinter he got in his toe six months ago and ignored were excised. It's too late for that; as for the markets, this problem has gone well beyond what started out in the subprime housing-finance market.

Much more so than any politician or ideology, savvy commentators on what's going on in the world economy point out that most of this decade's remarkable run of global prosperity can be traced to what has been called the tremendous "wave of liquidity" that has crashed up against the shores of most of the world's economies lately. (The wave has not yet managed to wash up against most of sub-Saharan Africa; hence that region's continuing grinding poverty.)

Liquidity is, of course, econospeak for just plain old money; "wave of liquidity", in its simplest terms, just means that there's a whole lot of money sloshing around the world. I tell my students that in a free economy it's as if the quantity of money and prices of assets are on either side of an apothecary scale; if the quantity of money goes up that platform gets weighed down, driving the value of the physical assets on the other side up. Hence the tremendous run in global equity markets over the past few years.

There are ever-changing attempts to explain how the wave of liquidity was created. Some credit or, depending on your perspective, blame the US Federal Reserve; in response to the bursting of the dot-com boom in 2000-01 it reduced its key short-term lending rate from 6.5% in 2001 to 1% in 2003-04, before raising them back to the current 5.25%.

With rates this low it meant that banks were practically giving loans away; as that money circulated through the economy, from lender to borrower, from producer to consumer, over and over again, that began the wave of money. Low Japanese interest rates also get part of the credit/blame. Interest rates in Japan have been on the decline since the pricking of Japan's Nikkei stock index bubble in the late 1980s.

Japanese interest rates have been 1% or lower since 1995; from 2001 until recently, the Bank of Japan held its official discount rate at around 0.1%, making it virtually cost-free for international currency speculators to borrow funds in yen, convert them into other, higher-yielding currencies (this is what's referred to as the "carry trade"), thus increasing these countries' money supply, their "wave of liquidity".

But both the Bank of Japan's and the US Federal Reserve's interest-rate policies are basically on hold; they don't explain what happened in world equities in the past couple of weeks.

In William Shakespeare's Hamlet, Lord Polonius advised that one should "neither a borrower nor a lender be". It follows, then, that Polonius, a chief adviser in the court of King Claudius, might be particularly piqued at a phenomenon of today's finance capitalism where many banks, brokerages and other financial institutions are simultaneously both lenders and borrowers

American economist and historian Edward Luttwak calls the new globalized economy turbo-capitalism; applied to finance, it means an essential blurring between the distinction between borrower and lender. Where once the distinction was very clear (the lender lends, the borrower pays back with interest), these days a borrower might turn around and lend the money he just borrowed from the lender to another borrower, who just might be doing the same with another borrower further down the line.

Every successive round of borrowing and lending acts to increase the global money supply; the tops of the "wave of liquidity" grow ever higher. There are a few limitations on this process, but not many. Under an agreement brokered under the auspices of the transnational banking regulatory agency the Bank for International
Settlements, the lenders must meet what are called capital reserve requirements of what are called the Basel II accords.

This means that the amount they can lend is limited by the value of whatever actual assets the bank has in its portfolio. How much the bank can lend out is dependent on what kind of asset the bank actually has, but whatever the underlying asset is, the bank can lend many times its actual value. Hence money is created.

For the borrowers, it's the same process, but in a mirror. Borrowers need collateral to borrow. If they get the loan, that loan becomes their capital reserves to lend to someone else.

When asset prices rise, it's as if El Mystico has waved his wand. Both the values of the reserves for the lenders and the collateral for the borrowers are rising; that means that commensurately more can be lent and borrowed based on these newly inflated prices. The mechanism becomes virtually self-reinforcing: higher asset prices leading to more borrowing and lending, more liquidity creation, higher asset prices, and so on.

Until, as the residents of Mystico Point were warned not to do, somebody begins to doubt whether this is all real.

Yes, this did all start with the subprimes. It was obvious to everybody (especially the realtors and mortgage brokers) but the prospective buyers that a lot these people were not going to be able to afford the monthly payments on a no-down-payment $1 million ranch house in Orange county, California. When these people started to fall behind on their mortgages, the great money engine ground to a halt and, slowly, went into reverse.

The subprime mortgages had been pooled and sold as interest-paying bonds called collateralized debt obligations (CDOs). As many of the mortgage borrowers were not paying their mortgages back, these CDOs, as measured by the ABX subprime indexes, fell in value. With their decline in value, banks and other financial institutions that had been using the CDOs as either capital reserves or collateral found that the fall in the value of the CDOs meant they could not lend or borrow as much as they could previously. Under the hot, glaring sun of reality, the global wave of liquidity starts to dry up.

Many of the banks and brokerages with a presence in the subprime/CDO market also had a presence in other aspects of the capital markets. The contractionary effects of the withdrawal of liquidity from subprimes is starting to take its toll there, as well.

Many have noted that it is the rise in corporate buybacks and private-equity buyouts (see my February 22 article The highs and lows of buyouts) that has greatly supported US, and more recently world, equity prices these past few years. This is not surprising; if one company in a particular sector gets bought out at, say, a 25% premium to current market prices, stock investors come to believe that the rest of the companies in the sector might be similarly bought out by other, greater fools - sorry, canny entrepreneurs.

The whole private equity/buyout phenomenon would not have been possible without the wave of liquidity. The supply of shares is, at least in the short term, fixed; if the supply of money keeps growing exponentially, more of it will be employed to drive stock values up. As the wave of liquidity recedes, so does the argument that you must own stocks so as to profit from the next buyout. No financing means no buyouts, and without buyouts, stocks are just not thought of as valuable as they were previously.

The news that really got the selloffs rolling last week were the reports that banks were having trouble arranging financing for the $7.4 billion buyout of Chrysler by the private-equity firm Cerberus. Across the Atlantic, similar problems were being faced in the leveraged buyout of the UK drugstore chain Alliance Boots by Kohlberg Kravis Roberts (of 1988's Nabisco/Barbarians at the Gate fame). The initial public offering of the Blackstone Group, considered a bellwether for the worldwide private-equity business in general, has sunk like a rock; it's down 17% from its offer price.
Without the belief, the faith, that there will be more forthcoming liquidity to support these deals, stock prices are reverting to what they would be based on - just the companies' fundamental prospects for further growth in earnings from these levels.

That was last week. It wasn't pretty.

Greed drives stock prices up, and fear takes them down. Here, the big fear is that of the unknown - nobody knows just how much bad and/or deteriorating debt these banks and brokerages have on their portfolios. "Transparency", financial-market jargon for information, might help the situation; the banks and brokerages could report just what they do have on their loan books. This could help through calming some nerves here.

The banks and brokerages will never do this individually, for the companies that open their trading books put themselves at a significant competitive disadvantage against those that do not. You would need some greater power, like the US secretary of the Treasury, perhaps acting in concert with financial officials from other countries, to get everyone to do this simultaneously.

That is unlikely; the administration of US President George W Bush does not want to tarnish the image of its one success, the strong economy, and thus have the public realize that the administration's failure to oversee and regulate the US debt markets properly is, just like Iraq, Afghanistan, the inability to capture Osama bin Laden and the response to Hurricane Katrina, just another among its many failures. Besides, just as then-defense secretary Donald Rumsfeld once said his Pentagon doesn't do quagmires, Hank Paulson's Treasury Department doesn't do market intervention.

Or the US Federal Reserve could intervene and supply extra reserves to the banking system, either directly through lending from its discount window or by lowering interest rates. This is the approach that has been employed in previous financial crises and panics, among them the 1982 bailout of Mexico, the 1987 stock-market crash, the 1989-90 implosion of the US savings-and-loan industry, the 1998 bailout of hedge fund LTCM, and the 2000-01 dot-com bubble burst. Here too pride goeth before the fall. This probably will happen eventually, but only once the crisis deepens and intensifies so greatly that US populist politicians, such as Ron Paul on the political right and Dennis Kucinich on the left, start to get a serious hearing in the popular media on their charges that the US political structure is way too dominated by the interests of finance capital.

That'll get the Fed moving.

In the meantime, let's look at El Mystico's assistant, the Amazing Janet (Carol Cleveland). According to the Monty Python skit, "as Napoleon has his Josephine ... so Mystico has his Janet. An honors graduate from Harvard University, American junior sprint record holder, ex-world skating champion, Nobel Prize winner, architect, novelist and surgeon. The girl who helped crack the Oppenheimer spy ring in 1947. She gave vital evidence to the Senate Narcotics Commission in 1958 ... In 1967 she became suspicious of the man at the garage, and it was her dogged perseverance and relentless inquiries that two years later finally secured his conviction for not having a license for his car radio. He was hanged at Leeds a year later despite the abolition of capital punishment and the public outcry."

Maybe a young lady this talented is what we need to tell Ben Bernanke that his phone is ringing.

Note
1. Rocking the subprime house of cards, Asia Times Online, March 6; The subprime dominoes in motion, March 16; Of termites and index mania, July 3; and Soothing words for panicky markets, July 13.

Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.

(Copyright 2007 Asia Times Online Ltd. All rights reserved. Please contact us about sales, syndication and republishing.)
http://www.atimes.com/atimes/Global_Economy/IG31Dj04.html