Staying Afloat in =
the
Great Financial Whirlpool
Little d= oubt 2008 is a year of catastrophe. In the last month, we have had a devastating flood i= n Bihar, terrorist attacks in Delhi and Islamabad; thousands of babies poisoned by b= aby-formula in China. Lehman collapsed, Merrill vanished into the maws of Bank of Ameri= ca and the insurance giant AIG was propped up by the US government with an $85 billion credit line; Goldman and Morgan Stanley ceased to be investment ban= ks. As financial markets emptied out of confidence, there was a run on the $3.3 tr= illion money market mutual funds and the US Treasury had to stall the run by exten= ding a one year guarantee. Finally, Treasury Secretary Paulson went to the US Congress with a proposal to create a $700 billion fund to resolve the impossible contagion that the sub-prime based debt securities had wreaked. =
The worl= d’s currency markets have effectively become a duopoly. You have the US Dollar = and the Anti-Dollar, namely the Euro. If one goes up, the other has nowhere to = go, but down. The lack of confidence in financial assets has driven and will contin= ue to drive investors to commodity based assets, namely, shares in oil & g= old companies and oil & gold futures. Oil and gold have become today the “Not-dollar” and the “Not-euro”. The steps taken by= the US government to stem the financial crisis imply additional actual or poten= tial debt being assumed by it. To date, these add up to $314 billion taken on by= the US government through the Federal Reserve; if this is separate from the proposed $700 billion Paulson fund, then it gets to be over a $1 trillion. = In case the support already extended is to be folded into the Fund, then it is $700 billion total.
Is that = a big sum? Yes, it is. Converted into rupees, $700 billion is Rs 32 lakh crore. Even in dollars it is big. The total outstanding debt of the US government system w= as $9.4 trillion in June 2008, of which a $4.6 trillion was marketable debt. If the $700 billion in commitments of the US government had to be fully funded= it would mean that the marketable debt would increase by 15%. In theory this c= ould happen in either of two ways: (a) the US government sells these additional bonds to investors – domestic and overseas – which would cause interest rates to rise and/or the dollar to fall; (b) the Fed monetises all= or part of the issuance which would cause the dollar to drop even faster and b= onds would fall in price, i.e., interest rates would rise. Both ways, inflation becomes a bigger danger than otherwise. The continued weakness in European = and US equity markets after the deal was announced was in part because investors reacted unfavourably to the implications for the dollar, which fell 6% sinc= e 12 September.
However,= the main reason for the uncertainty and unease after the Paulson plan was unveiled, = was of course, the fear that it would fail to pass Congress or do so in so chan= ged a manner as to make it less than workable, and the hearings on Tuesday 23 September may have strengthened these apprehensions.
Pause fo= r a moment and think. Neither the Democrat nor Republican leadership in Congress have = said that they would not pass the bill. Many have expressed disquiet, but that is natural. Who in his or her right mind would oppose the passage of such a bi= ll and assume responsibility for the subsequent collapse of the financial syst= em? But yet US and European markets doubted the outcome. That shows exactly how muc= h of a funk they have worked themselves in; how deep the loss of confidence had = gone. To the question, “does 2+2 always equal 4” they might have responded “maybe, maybe not”.
It is ce= rtain that it will be later argued, that the crisis could have been handled much bette= r, much earlier and with much less damage to the financial system in the USA a= nd abroad. And it will not simply be on account of the benefit of hindsight an= d time. For leave aside the obvious failures of policy and regulation that allowed = the subprime problem to assume the dimension and power that it did, it was clea= r to most observers that more imaginative intervention a year earlier when the crisis broke out could have greatly reduced the extent of damage.
Now to g= et back to what happens after the Paulson plan does become law. Does the US public debt zoom by $700 billion? No, it does not. Most of the obligations are potentia= l. How much will become real? Difficult to say; it all depends on how fast things settle down. If that happens, AIG will sell off parts of its $1 trillion in= assets, rather than pay 11% interest to Uncle Sam. Fannie Mae and Freddie Mac may n= ot need all of the $200 billion of government capital if the subprime assets it owns (which it should not have touched in the first place) does not all go = belly up. The Paulson Fund may function as a repurchase fund where companies pawn their sub-prime based assets and later buy it back when they find buyers. O= r it may buy outright, but then the modalities will become much trickier.
Resident= ial sub-prime and other iffy loan-based securities have a total face value of about $2.0 trillion. All of the loans are not going to go bust. There is a lot of Cred= it Default Swaps (what brought AIG low), but on a net basis it is smaller, and= the sum of the problem parts cannot exceed the problematic whole, i.e. the unde= rlying mortgages. In addition to what the Fed has put up and the Paulson Fund plan= s to do, to date, over $400 billion of write-downs have already been taken by US= and other banks and a whole lot of paper has been tossed into bankruptcy court = by the failure of Lehman.
As for t= he government guarantee to money market mutual funds – the “as-good-as-cash” business – which invests mostly in high quality commercial paper, it is entirely unlikely that the gesture will cost the US government a cent. The only reason for extending the guarantee was to prevent the cash business from freezing over and the principal avenue by wh= ich US companies raise working capital from shutting down.
The subp= rime crisis has shown the power of contagion in securities markets in a way that= no previous crisis has shown. Some $2 trillion of securities have successfully held to ransom a credit market that exceeds $50 trillion and an equities ma= rket bigger than $20 trillion, simply because it was so difficult to isolate the affected securities and even more so, because of the complex foliage of der= ivatives and counterparties that they had sprouted, completely fouling the closely intertwined lives of financial enterprises in a modern market.
For sure= , there will be some expansion of US public debt as a result of this bailout. It may lower the appetite of overseas investors in US treasuries and result in gre= ater weakness in the dollar, higher interest rates and enhanced potential for in= flation. The Euro-zone has its own problems of higher fiscal deficits and faces an economic downturn with a painfully overvalued currency. This may discourage investors to take too much of a Euro exposure. That may mean more may move = into commodities which will stoke inflationary fires. In time, some investors wi= ll return to emerging economies, which will be good for us. But for that story wait for 2009.
(The =
author is
Economic Advisor, ICRA)
Number o= f words: 1,247
Publi=
shed in
Mail Today, Wednesday, 25 September 2008
Saumitra Chaudhuri
ICRA Limited
2F, Bldg 8, Tower A
Sep 24, 2008