Beyond Bear Stearns(译文在这里)
谢国忠搜狐博客 http://xieguozhong.blog.sohu.com/
The Fed has effectively removed liquidity problem for investment
banks by making its discount window available to them. The flash point
in the unfolding crisis has moved elsewhere. Local banks are probably
next on the line. The following is in the current Caijing Magazine.
Beyond Bear Stearns
Before
I departed for Fiji, my colleagues at the World Bank regaled me with
cannibalism stories about the place. Fiji was historically known as
'Cannibal Isles'. One colleague gave me a book that a missionary's wife
wrote one century ago. The book portrayed in vivid language the gory
details of multiple ways to practice cannibalism. I don't know why a
missionary's wife had such an intense interest in this subject. 'It's
not for the food', one senior colleague drove the message home, 'they
enjoy it'. The education had quite an effect on me. After eating steaks
for years, one develops a special fear for becoming the steak. After my
arrival, I was relieved to learn that Fijians had become devout
Christians a long time ago. Further, they never liked thin men anyway,
the locals told me. That was quite a relief.
In
the book by the missionary's wife, it described in gruesome details a
cannibalism ritual. A giant stone oven that fits a human inside stands
in the middle of an open ground. Inside, burning woods heat up a layer
of rocks. All sorts of spices and sauces are neatly lined up on a table
next to the oven. A throng of tribesman in straw skirts dance around.
Two large tribesmen drag an unlucky man towards the oven. The dancing
heats up. Everyone's eyes light up, expecting a sumptuous stone grill.
The
death of Bear Stearns reminds me of the scene. The hapless Bear Stearns
was dragged by the Fed and the Treasury to the oven with JP Morgan
Chase standing next, smacking its lips. The 87-year old investment bank
must have had the same sensation on the way to the oven as countless
cannibalism victims felt in Fiji a long time ago. If I were Bear
Stearns, I would swallow plenty of poison on the way; it would feel
better knowing JP Morgan Chase would get indigestion or worse. This
story has sequels.
Bear Stearns was
bankrupt. After going through its books, JP Morgan Chase declared that
its capital was negative. Of course, JP Morgan Chase had the incentive
to understate Bear's value. But, with the Fed and the Treasury on the
side, it wouldn't have the guts to declare Bear bankrupt if it were
solvent. Only days ago, the senior executives at Bear were confident of
its $17 billion capital. The Fed had to assume risk on $30 billion of
most illiquid assets (euphemism for very bad assets) on the Bear's book
to convince JP Morgan Chase to take it over. JP Morgan Chase paid a
notional value of $2 per share or $279 million in total. Bear's share
price traded as high as $170 only one year ago. JP Morgan Chase appears
to be raising the offer to palliate the infuriated shareholders of Bear
Stearns. The Fed is hesitant to approve a higher offer, as it is afraid
of the impression that it is using taxpayers' money to bail out the
shareholders of a failed financial institution. The legal wangle over
the deal could drag on for a long time. But, under the watchful eyes of
the government, Bear Stearns is folding into JP Morgan Chase regardless
of the development.
Many argue that Bear
failed due to a bank run, i.e., its customers wanted their money back
at the same time. They said the same about Enron's collapse. The
argument seems to suggest that the bank run is at fault. It confuses
people with a false causality. The bank run began as Bear's customers
suspected it was bankrupt. The due diligence by JP Morgan Chase proved
that the market was correct. When a killer is sentenced to death, don't
blame the executioner for his death; blame the killer.
A
more relevant implication is how many financial institutions are
bankrupt like Bear. The Bear's case reveals that the capital accounting
at financial institutions is not reliable at all. Banks can have assets
twelve times their capital, according to the BIS rule. Investment banks
have 25-30 times, as they are not regulated by the BIS. As most global
banks have investment banking arms, their assets are much more than 12
times their capital. Further, with the liberal use of off-balance sheet
vehicles like S.I.V., their effective asset base is harder to measure.
The high leverage makes financial institutions vulnerable to
bankruptcy. If an investment bank has assets 30 times its capital, if
asset price drops 3%, its capital is gone. Markets can move this much
in a day. Of course, most banks claim they have sophisticated risk
management tools. The most common is value at risk or VAR. It claims to
limit the loss within a day. Most big investment banks have VAR around
$100 million. This technique has lost its credibility completely. Just
look at billions of dollars that the banks have so quickly lost.
If
other banks price their assets like JP Morgan Chase did to Bear's, more
banks are probably bankrupt. That raises the question why Bear Stearns
was singled out while others are still standing. Not every bank without
capital should die. The franchise value-the ability to earn return
above the cost of capital is significant for some. Financial
institutions average price-book ratio of 2. Even if the physical
capital is zero, the franchise value is still significant. The market
is trying to decrease industry capacity by pushing weak institutions
out of business to boost the franchise values of the remaining ones.
Even if the remaining ones are technically bankrupt, their operating
income could pay off their liability.
While
folding Bear into JP Morgan Chase, the Fed made an important change to
support the securities industry; it would open discount window to
non-banks like investment banks and would accept mortgage securities as
collaterals. This development would stabilize the securities firms. The
Fed would effectively accept mortgage papers as collaterals in exchange
for cash. The Fed says it would apply a haircut to the collateral
value. In future, the Fed, not the market, would determine the
viability of an investment bank. It could decide what haircut to apply
to collateral value. This is a judgment call and could be influenced by
the Fed's desire for outcome. While the Fed now has the tool to stop
another collapse like Bear Stearns's, it could end up owning huge
amount of bad assets. The Fed could be exchanging nationalization of
bad debts for the stability of the securities industry.
The
collapse of Bear Stearns marks a milestone in the unfolding credit
burst. If the Fed could have allowed Bear Stearns to be liquidated, it
would have marked the bottom of the current bear market; investors
would know the true prices for the vast amount of illiquid papers. It
may have meant the collapse of several more investment banks. But, the
catharsis would have brought transparency and re-established trust in
the financial system. Instead, the Fed has made it possible for the
remaining investment banks to avoid a liquidity squeeze. The investment
banks would write down their bad debts gradually with their income,
just like Japanese banks did. Every quarterly earnings report would
come with a write-off. The crisis is temporarily eased by stretching
the adjustment period.
The storm may shift
from the liquidity problem at investment banks to other areas. The Fed
may be able to stop the liquidity problem at financial institutions. It
couldn't stop property price declining and mortgage and construction
loan bankruptcies. No matter how hard the Fed pumps liquidity; massive
capital losses in the financial system mean credit contraction, which
means a big recession. Twenty million households in the US may see
their home value dropping below their mortgage debts. They are likely
to default and return their properties to their funding banks. $300 bn
construction loans could default en masse as the construction market
collapses. The defaults would force financial institutions to write off
their capital and to stop the game of writing off losses gradually. The
eye of the storm is shifting to small local banks that are heavily
exposed to construction lending. The failures of such banks will start
another wave of panic. We may have to wait one to two months for this
drama.
The Fed seems determined to bail out
everyone. It prevents market from clearing. Hence, financial
institutions can use 'judgment calls' to value their assets. When local
banks begin to fail, even though these banks may go out of business
like Bear Stearns, the Fed could prevent the liquidation of their
assets from taking down the financial system. Japan's adjustment lasted
for a decade because Japanese government didn't force banks to
liquidate their bad assets; the banks wrote off their bad assets
gradually with their operating income. The US is doing something
similar. This gradualist approach kept credit and economy from
expanding for a long time.
Even though the
Fed commented on inflation again at its latest rate cut, I am convinced
that the Fed wants to inflate debts to lessen the adjustment pain.
Foreigners hold $16 trillion of the US's financial assets. Inflation
and dollar devaluation are good for Americans. In particular, middle
and low-income Americans are in net debt position. Inflation is good
for their balance sheet. The only way to stop the Fed is for foreigners
to sell the US treasuries now, which would push up bond yield and
create pain for Americans to find long-term financing. So far,
foreigners, mostly central banks, are watching their assets
depreciating and not taking actions. Hence, the Fed has no incentive to
change its policy. Gradualist approach in unwinding the credit bubble
gives inflation time to decrease the real debt burden, which gives the
Fed powerful incentives to bail out everyone and stop the market from
clearing. Further, the resulting weak dollar boosts the US's exports,
i.e., exporting the US recession around the world.
To
what extent Ben Bernanke's belief rather than national interest is
guiding how the Fed is handling the crisis? Most of the elite in the US
support the Fed's approach to stretching the adjustment out and
inflating away debts, because they believe that American people are not
tough enough to pay back what they owe. Some attributes the Fed's
approach to Ben Bernanke's fear of 1930-style debt deflation. Most
economists blame the Fed's tight monetary policy for the depression in
the 1930s. The mass bankruptcies of banks then triggered a vicious
spiral of asset deflation and bankruptcy-induced liquidation. Mr.
Bernanke concluded a long time ago that the Fed should flood the
financial system with money after a financial crisis. The Fed's
approach partly reflects Mr. Bernanke's belief.
The
belief of the previous Fed Chairman, Alan Greenspan, has brought
today's calamity. He is probably the most overrated man in the world.
So many people believed his magic in boosting confidence by jus
talking. He was just a bubble blower! Since the Asian Financial Crisis
in 1998, globalization and IT revolution increased productivity and
kept down wage in high income economies. Hence, the sensitivity of
inflation to money growth declined. Central bank should have allowed
price to fall to reflect the rising productivity. For example, the
prices of electronics products always decline due to rising
productivity. The world was like the electronics industry. Instead, Mr.
Greenspan inflated the prices of services like haircuts or restaurant
meals to offset the declining prices of shoes and electronics. He did
it all in the name of price stability. To offset the natural tendency
of price declining due to high productivity, he pumped a lot of money
that led to the NASDAQ bubble in 1999-2000 and the property bubble
afterwards. Greenspan's magic came from printing money with abandon in
a low inflation environment, which caused the bubbles. History will
judge him harshly.
Mr. Bernanke's belief in
an inflationary solution to a property burst may generate severe costs
in the future. There is no free lunch. Inflation seems like a free
lunch to the US now as it lessens its debt burden at the expense of
foreigners. However, the loss of the US's credibility and the risk to
the US dollar's status in the global economy could outweigh the
short-term benefits. The US lost its edge in manufacturing in the
1980s. Its competitiveness has depended on R&D intensive industries
like defense and medicine and service industries like finance and
entertainment. Finance is probably the most important sector to the US
economy. It keeps the dollar the currency for global trade and finance.
The benefit of the dollar's status seems to sustain 3% of GDP in
current account deficit for the US economy. The dollar's status may
carry $10 trillion of value to the US economy. The Fed's policy could
destroy the dollar's status. The loss of long-term benefit to the US
may exceed the short-term benefit from inflating away some debts.
As
the Fed makes unlimited amount of liquidity to investment banks (most
big commercial banks have investment banks), the battleground in the
credit crisis shifts to small local banks. They are heavily exposed to
the declining property sector. The construction lending alone exceeds
$300 billion. The defaults from this sector could become a tidal wave
soon. In the next three months, the Fed may have to decide if to bail
out these banks. If these banks liquidate their assets, the declining
prices would feed back to investment banks that carry similar assets on
their balance sheets. Of course, the Fed could allow to use the bad
assets as collaterals to borrow from it, another step down the slippery
path of nationalizing bad debts.
In
addition to capital losses, the financial sector faces shrinking
business prospect. The financial industry accounted for 40% of earnings
among all listed companies at the peak from 5% twenty years ago. Under
Mr. Greenspan's loose monetary policy, the financial sector earned
money from riding the asset bubbles. As the world returns to an
inflationary environment, bubbles are hard to sustain. Hence, the
financial sector may need to downside by half or more to fit the new
business environment.
Overcapacity became
a serious problem for the financial sector after the NASDAQ burst in
2000-01. The credit bubble happened afterwards as excess workforce
created businesses for themselves. The delay in downsizing was a big
factor in causing the bubble. The day of reckoning is finally here. JP
Morgan Chase will only pick up a small part of Bear Stearns and shuts
the rest down. Big commercial banks may have to exit the investment
banking business that they went into ten years ago. Investment banks
may have to merge. In short, the pain on Wall Street is just beginning.
The
Fed's inflationary policy makes life difficult for rest of the world.
Japan is already in recession. Europe may follow in the second half of
2008. The OECD economies may grow at 1-1.5% from 2.5% last year.
Emerging economies are doing better. Thanks to the large foreign
exchange reserves, they can continue to invest despite weakening
exports to the OECD block. High commodity prices, thanks to the Fed's
loose monetary policy, are a big help. They may be able to grow at
6.5-7% in 2008 from 7.9% in 2007.
As the
Fed stabilizes the investment banks, financial markets may improve in
April or even May. I suspect that the next storm will hit soon when the
US's local banks begin to fail around the mid of the year. The
attractiveness of gold is inversely correlated with stock market. When
calm returns like now, gold price declines. It resumes climbing when
the turmoil returns.
谢国忠搜狐博客 http://xieguozhong.blog.sohu.com/