The Rationality of Panic by Steve Coll, The New Yorker

The Rationality of Panic

Between the industrial revolution and the nineteen-thirties, financial panics occurred regularly in America. Busted speculative bubbles usually caused them. The asset on which people speculated varied; often, it had something to do with land, but later, financiers promoted magical thinking about railroads, too. As the years passed and the financial system grew more robust, investors could borrow more money to speculate when certain assets became fashionable and rose in price, and this additional leverage amplified the booms and busts, making them more consequential to the real economy. When speculative investors using enormous amounts of borrowed money produced the stock market crash of 1929, which was then followed by the failure of policymakers to respond with needed rescue measures, we had the Great Depression.

The financial regulatory system that emerged from the New Deal was meant to protect us from the recurrence of such a catastrophe by reducing the amount of borrowed money used by major financial institutions in speculative schemes. It was also meant to create much greater transparency about the facts underlying stock and bond prices, so that investors, as a whole, would make more rational decisions and prevent asset bubbles from getting completely out of hand. That regulatory system was never designed to banish greed or eliminate asset bubbles, but it seemed for a long while to moderate the impacts of speculative fevers on the real economy. Transparency of information allows markets to work off busted bubbles fairly quickly, and it gives policymakers the confidence and direction necessary to inject relieving shots of new money. The tech-stock boom of the nineteen-nineties, for example, was demonstrably crazy while it was going on--but it was crazy in plain sight, in the sense that all of the relevant information about tech-stock prices, including the fact that many companies with high share prices had no earnings and no convincing business model, was disclosed to the public.

The tech boom and bust seemed to show that central bankers had learned how to respond quickly and effectively when bubbles burst. Alan Greenspan, for one, concluded that it was easier and better for the economy overall to clean up bubbles after they busted than to intervene heavily to prevent them from inflating in the first place. Thus he stood by passively during the housing bubble of the past few years. This bubble, too, took place in plain sight, in the sense that by 2006 or so it was clear by historical measures of housing prices, price-to-rent ratios, and so on, that a bubble had inflated. If the housing bubble had inflated entirely inside a transparent, well-regulated financial system, its end might have been painful, as the tech bust was, but it probably would not have been unusually consequential. The problem, however, was that the bubble inflated inside both the old regulatory system and, simultaneously, inside a new financing system that grew up during the Bush Administration outside of all government scrutiny.

In the current global panic, unprecedented in fifty years, it is common to say that the madness of crowds has taken over. It is certainly true that we should be fearful of fear itself, since panic has practical economic consequences. Prices, for example, speed down faster than they would otherwise, which then causes more panicked selling by leveraged investors. Fearful consumers sit on their wallets, hurting businesses that might otherwise be healthy, and so on. At the same time, it is wrong to blame crowds for this current panic. In many ways investors are reacting rationally to the fact that critical information about the financial markets--the sort of information that New Deal-originated regulatory architecture was supposed to make routinely transparent--is simply not available.

People don’t generally panic in the sunshine. They panic in the dark. And we are in the dark about what assets and liabilities are truly held in what has been properly labeled the “shadow banking system”--the global aggregation of hedge funds, privately placed debt securities, and the hedging or insurance contracts known as credit default swaps. By some accounts, the value of assets held in this shadow system is as large or larger than then value of the assets held in the formal, regulated banking system. But nobody really knows, as there is no transparent market for many of the securities of concern, and no systematic disclosure of assets and liabilities to government regulators--not here, not in Europe, and not in Asia, either.

There are many kinds of uncertainty fueling the current panic. Some of it is a normal sort of uncertainty, that which typically takes place when the economy goes from good to bad--for example, nobody knows for sure how bad the coming recession is going to be, and so it is hard to price stocks, since the earnings of many companies are headed downward at an unknown rate. Some of the current uncertainty, however, is not normal. For example, the market for short-term business-to-business loans, known as “commercial paper,” has basically ceased functioning. The Federal Reserve has intervened, but nobody knows how long it will take to restart such lending, or what damage the seizure has already done to businesses.

The scariest uncertainties of all involve the unknown liabilities lurking out there in the shadow banking system. Maybe it will turn out that these liabilities are not as great as some people fear. On Tuesday, for example, the International Monetary Fund revised upward its estimate of the total losses incurred by all global financial institutions from securities tied to American housing mortgages--the I.M.F.’s new estimate is $1.4 trillion in losses. That sounds like a lot, but in the scheme of the global economy, whose annual output is in the neighborhood of $60 trillion, it is not so bad. If the rate of mortgage defaults does not spike horribly, it might be a manageable liability.

On the other hand, this week, the New York Federal Reserve began to convene meetings to try to create transparency and liquidity in the global market for credit default swaps. These are essentially unregulated insurance contracts sold privately to financial institutions to protect them against losses in stocks or bonds. No government agency regulates credit default swaps. There is no official information available about the size of the market or the distribution of liabilities within it.

Maybe most of these contracts are sound, or balanced out in ways that don’t create huge systemic liabilities--let’s hope so. Published estimates of the nominal value of all credit-default-swap contracts in the world today are in the range of $55 trillion to $60 trillion. So here is a global private market whose products, combined, have a nominal value roughly equal to the total size of the world economy’s output in a year, and apparently no one in any government knows the full market’s shape, distribution, or true vulnerabilities. Gulp.
Posted by Steve Coll
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October 6, 2008
The Debtor’s Dilemma

How will the global financial meltdown affect the next President’s national-security policy? A typical—and true—reply is that our expeditionary armies in Iraq and Afghanistan will be harder to finance. But there are also subtler issues of potentially greater importance. Consider this episode from Britain’s post-imperial awakening:

In 1956, Egypt’s Gamal Abdel Nasser nationalized the Suez Canal, previously a British asset. Britain, France, and Israel intervened militarily and occupied the canal zone. President Dwight Eisenhower objected and sought to pressure Britain to accept a United Nations-supervised plan for withdrawal. Britain had borrowed heavily from the United States during the Second World War and was vulnerable to the demands of its creditor. To squeeze London, Eisenhower conditioned direct U.S. financial support and backing for a loan to Britain from the International Monetary Fund on Britain’s acceptance of withdrawal. The tactic worked. As the British Prime Minister Anthony Eden put it, “We were therefore faced with the alternatives, a run on sterling and the loss of gold and dollar reserves till they fell well below the safety margin…or make the best we could of U.N. takeover and salvage what we could.”

Brad W. Setser cites this example in an important new paper,”Sovereign Wealth and Sovereign Power,” published by the Center for Geoeconomic Studies, at the Council on Foreign Relations. The paper is exceptionally balanced and accessible, and it explores in depth the potential national-security consequences of American trade and financial imbalances with China, Russia, and oil-exporting states in the Persian Gulf. Setser challenges the view that economic interdependence inevitably promotes stability. He argues that such optimism “neglects the differing interests of creditors and debtors.”

The United States, of course, is a large-scale debtor in the current global system because we have voraciously consumed more than we have produced and have allowed China, among others, to finance our consumption. Many economists have argued that this pattern of indebtedness is, at least in some respects, a strategic advantage of the United States because the dollar remains the world’s dominant reserve currency and thus our creditors—even though they may not be political allies—have bound their economic prospects to our own. This is a geopolitical extension of the old Wall Street saw: If you borrow a little from a bank, the bank owns you; if you borrow a lot, you own the bank. China’s government, for example, owns a dollar portfolio worth more than a trillion dollars; it has no interest in seeing the value of that portfolio collapse by forcing a devaluation of the dollar, this argument goes. This has proven true so far, but will it always? Setser’s argument is that U.S. reliance on foreign governments for credit is an “underappreciated strategic vulnerability.” He writes:

A debtor’s ability to project military power hinges on the support of its creditors….In some ways, the United States’ current financial position is more precarious than Britain’s position in the 1950s…Britain’s main source of financing was a close political ally. The United States’ main sources of funding are not allies. Without financing from China, Russia, and the Gulf states, the dollar would fall sharply, U.S. interest rates would rise, and the U.S. government would find it far more difficult to sustain its global role at an acceptable domestic cost.

The current financial crisis is dynamic and its outcome is impossible to predict, but it does seem likely that it will extend, rather than reduce, the type of vulnerability that Setser has described. In the short term, the problem is panic and a lack of liquidity; in the longer term, those (like the United States) who took on debt to speculate on rising asset prices will suffer most. The relative winners, once the markets stabilize, should be those with large cash positions and sound fundamental economies. If you were to choose a single winner by that formula, it would be China, our largest creditor.

What interaction of creditor-debtor dynamics and hard military power might test this proposition, in a way comparable to the Suez crisis of the 1950s? Last week, the Bush Administration announced plans to sell about $6.5 billion in arms to Taiwan, a nation that China regards as its own sovereign territory. At a minimum, what Setser’s paper suggests is that the Pentagon’s traditional Taiwan war games—whose ships can maneuver fastest, whose weapons systems can perform the best, etc.—may be myopic and outdated.
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October 2, 2008
Osama’s Trust Fund

In early 1993, Osama Bin Laden was living in Sudan. At the time, he was a shareholder in both of his Saudi family’s main companies, the Mohamed Bin Laden Company and the Saudi Binladin Group. From Khartoum, however, Osama began to deeply annoy the Saudi royal family by writing and faxing into the kingdom essays and pamphlets denouncing Saudi princes by name. After the first terrorist bombing of the World Trade Center, in February 1993, Osama also attracted publicity as a possible source of finance for jihadi groups. That he ran an organization called Al Qaeda was unknown to American intelligence agencies at the time.

Because of his anti-Saudi writings, the Bin Laden family came under pressure to do something about their wayward member. They instituted proceedings to force Osama to sell his shares in the two family companies. According to affidavits later filed by the family in a New York federal court, the value of Osama’s combined shares was set at about $9.9 million. One of Osama’s half-brothers, Ghalib, purchased the shares, apparently as a trustee, according to these court documents. (I have described these Saudi legal proceedings in my book, “The Bin Ladens,” in a chapter entitled “The Construction of Exile.”) It was decided, then, to freeze this money in what court documents describe as a “trust.” The trust was not to be for Osama’s benefit, according to the Bin Laden family. The trust’s purpose has never been entirely clear, but it may have been established to protect the rights of Osama’s non-terrorist heirs under Islamic law.

For almost seven years, a group of surviving family members of victims of the September 11th attacks has been attempting to sue the Saudi Binladin Group to recover damages for their losses. One question that courts and magistrates have been considering is whether the 9/11 families might be entitled to the money held in Osama’s trust fund. The matter touches on a number of complicated questions of jurisdictional law, but it also raises questions of fact: Was there actually a trust fund with Osama’s name on it somewhere in Saudi Arabia, and, if so, was there cash in that account? What was the history of the account? Had dividends been deposited, withdrawals made?

When I completed the research for my book late last year, all I knew is what I have summarized here so far. In the intervening months, U.S. court proceedings have uncovered some new and curious facts. It turns out that although Osama was removed as a shareholder in 1993, his trust was not funded with the $9.9 million until 2000, when an account was opened in the Saudi-based National Commercial Bank, or N.C.B. During that time, Osama’s half-brother Ghalib apparently held the shares. Why? The Bin Laden family, through its American lawyers, have reported to the American courts that the formal establishment of the trust account was held up by complicated proceedings that arose from the need to obtain permission and policy direction from the Saudi government. The lawyers for the 9/11 victims, however, regard the seven-year gap between the trust’s inception and its actual funding as suspect. Was the original sale of Osama’s shares just a ruse, these lawyers wonder—perhaps a cosmetic gesture to deflect American scrutiny of Osama’s fortune? In this analysis, the Bin Laden family might have taken symbolic action against their brother, but never actually took the practical step of freezing his money until, in 2000, his terrorism had made Osama a target of U.S. intelligence and law enforcement. In 1999 and 2000, the Clinton Administration began to press the Saudi government for greater coöperation on the Osama problem, and also for greater coöperation in the area of terrorist finance. Was the trust hurriedly funded in 2000, as Osama gained global notoriety, only to ward off American questions, or to cover something up?

The court overseeing In Re Terrorist Attacks, as the omnibus case is captioned, has yet to decide whether or not the 9/11 families have the right, under American jurisdictional law, to explore these questions in a civil lawsuit against the Saudi Binladin Group. However, the court has permitted a certain degree of fact investigation, or “discovery,” in order to help determine whether S.B.G. should be subjected to U.S. jurisdiction.

Earlier this year, in May, a magistrate overseeing this discovery ruled that the new revelations about the late funding of Osama’s trust might yet have relevance. After rejecting a number of proposals for more fact-finding by the lawyers for the 9/11 families, the magistrate judge, Frank Maas, wrote:

There is nonetheless one area in which additional discovery seems warranted…The trust that holds the proceeds of OBL’s shares of SBG was not funded until 2000. In the interim, Ghaleb held the shares and presumably received any distributions attributable to them. Nonetheless, when Ghaleb turned over the proceeds of the shares to NCB, the amount placed into the trust account reflected the value of the shares in 1993, not any distributions that may have been made to Ghaleb with respect to those shares in the intervening years or any increase in share value. If the plaintiffs are able to show that this was part of an intentional plan whereby SBG diverted funds to Ghaleb, whom they characterize as an OBL sympathizer, the transfer of the shares to Ghaleb might have jurisdictional significance.

It is not clear what else has been learned since this permission to conduct further discovery was granted; many of the materials in the case are kept from public view under a protective order requested by the Bin Laden family’s lawyers. However, it does not seem likely that the 9/11 families will ever collect money from Osama’s trust fund. In August, the 2nd Circuit of the United States Courts of Appeal issued a ruling that raises a high bar for the families in their attempts to hold overseas entities accountable for support to Al Qaeda. The court ruled that lawyers for the victims must show that the activities in question were “‘intentional, and allegedly torturous actions…expressly aimed’ at residents of the United States.”

In the meanwhile, $9.9 million sits in trust in a bank account in Saudi Arabia. The full history of that portion of Osama’s fortune (his total inheritance was about twice that amount) is likely to remain mysterious. Will some of Osama’s children eventually collect the money, on the grounds that they were not participants in their father’s crimes? That would be a strange brand of justice, even by Saudi standards.
Posted by Steve Coll
http://www.newyorker.com/online/blogs/stevecoll/?xrail