Page 4 of 5 Too big to fail versus moral hazard
By Henry C K Liu
from the value of another instrument. Among other effects, derivatives tend to
lower the systemic credit standard of the markets by manipulating the
assignment of risk to commensurate return. Highly rated corporations can now
arbitrage their high credit standing to further lower their cost of funds by
issuing long-term fixed-rate debt and then swapping the proceeds against the
obligation to pay a floating rate. In other words, they monetize their high
rating by taking on more risk.
Simultaneously, lower-rated corporations that otherwise would be frozen out of
the credit markets as the credit cycles mature can use derivatives to lock in
long-term yields by borrowing short and swapping into long-term maturity
obligations. In other words, they pay more interest to buy higher credit
ratings, not withstanding
the fact that high interest cost would actually further lower their credit
ratings.
The intermediaries, banks and other financial institutions that make credit
markets and trade these obligations enjoy the illusion of being relatively risk
free by linking their risks system wide. The credit ratings of these banks
appear relatively strong, but in fact they appear strong only because the
overall credit rating of the system has declined.
When individual risks are passed on to systemic risk, individual creditors are
comforted by the safety of the "too big to fail" syndrome because they become
part of the big system.
Socialization of capital formation
The growth of pension and retirement funds can be viewed as a process in the
socialization of capital formation. This process has brought about a
corresponding growth in professional asset management based on competitive
performance measured by short term market value, placing distorted emphasis on
technical trends investing rather than fundamentals investing. The quest to
socialize risk has led to indexation, which works better in a rising market to
capture optimal systemic returns, but can also cause the categorical downgrade
of entire families of debt instruments and their issuers without regard for
individual strength.
This can cause unnecessary and violent systemic damage, as it did in Asia in
1997 and now in the US since 2007. This socialization of risk associated with
the socialization of capital formation means that a financial collapse will
affect not merely the rich investors who may be able to afford the loss, but
the entire population who can ill afford to lose their pension.
The "too big to fail" notion then comes directly into play and government is
forced to step in, putting an end to the myth of the free market. Moral hazard
will be in full bloom as the nature of the beast. The Fed has been repeatedly
held hostage to the "too big to fail" syndrome since 1930 and will again and
again until it becomes the main agent to herald socialism to the US, as
Schumpeter predicted. Creative destruction, of which Greenspan is so fond, will
eventually destroy capitalism with creativity.
Leverage is another development that not only magnifies volatility; the
abnormally high rates of leveraged returns distort market judgment, making
normally respectable returns look unattractive. Greed becomes standardized.
Derivatives and hedging techniques have created the illusion of safety by risk
management, while they merely reshuffle risks system wide and heighten
exponentially the penalty of misjudgment.
Litigiousness is a byword of the US notion of the rule of law. Innovative
contracts and financial and business relationship are often inadequately
defined to meet rapidly changing conditions, and disputes are settled in courts
whose judgments can have drastic consequences to the litigating parties as well
as the system. Major bankruptcies have been routinely caused by court
decisions. The tobacco legal time bomb is a good example. It is a matter of
time until a court decision drives a major tobacco company into bankruptcy.
Texaco was forced into bankruptcy when faced with a judgment that exceeded its
entire market cap value, based on the legal definition of what constituted a
valid offer in a merger.
The list of potential bankrupts is long. The stabilizing value of legal
precedents is greatly discounted in a world of constant unprecedented judicial
developments. Courts are frequently confronted with controversies that the
judges and their law clerks are grossly unqualified to comprehend. Court
decisions often hark back to symbolic posturing based on dated concepts. The
anti-trust cases against Microsoft are a classic example: the issues raised in
the case have become operationally obsolete as the legal process drags on, yet
the courts are asked to make determinations based on them that will affect the
future of software monopoly.
The most fundamental flaw in US financial market system is its inherent drive
towards excess. A market boom will only end with a market crash unless
government intervenes in mid course. The quest for the short term maximization
of returns leads inevitably a speculative bubble. The traditional demand/supply
business cycle has been genetically modified into a debt-propelled cycle that
requires more debt to prolong. And the speed of the expansion dictates that
more debt can only be added by lowering credit quality. The end result is
always systemic implosion.
This is what Greenspan means when he refers to unbalances in the system, that
physical expansion of productivity cannot possibly keep pace with credit
expansion associated with the sudden wealth effect. In the Greenspan era,
stocks were valued at 181% of GDP at their peak in March 2000, while at the
beginning of the decade they were 60% of GDP. One of the characteristics of a
bubble economy is the de-coupling of the equity markets from the actual
performance of the economy.
Non-reflection of economy
There is clear evidence that the wealth effect does not reflect the performance
of the economy. One of the few valid points made by Greenspan was that the
wealth effect created imbalances that were more than conventional time lag. The
Clinton budget surplus resulting from a credit-induced extended long boom was
merely a false signal of the illusionary soundness of the US economy. GDP was
measuring the size of the debt bubble rather than the size of the real economy.
Some economists had been vocal that the Clinton budget surplus was in fact an
indicator of economic trouble ahead. Those who proudly pointed to the budget
surplus as the Clinton administration's greatest achievement have come to look
extremely foolish in 2008. Private debt, both consumer and corporate, has been
growing at record pace in the US for the past two decades, drawing funds from
lenders all over the globe. Much of this debt was taken on by telecom companies
whose revenues fell as much as 90% through deregulation. A second wave of debt
went into the housing bubble.
As the equity markets collapse from earnings shortfalls caused by an expanding
market capitalization outpacing slower earnings growth, the political pressure
for the Fed to inject more debt into the system by lower interest rates always
becomes irresistible.
The emergence of an unregulated open credit market diminishes significantly,
though not totally, the ability of central banks to manage the economy through
conventional monetary policy measures, because of the banks' shrinking
intermediary role in the credit market. A credit binge in which loose lending
to borrowers of dubious credit worthiness is always followed by a credit
crunch, as surely as gluttony leads to obesity that will outgrow the wardrobe.
Bad loans are made in good times, as Greenspan is fond of quoting. A credit
crunch is an interruption in the supply of credit, which can be caused by
destruction of the lenders' incentive through a decline in regulatory
protection, or massive defaults by borrowers on loans taken out during a credit
binge. When that happens, the central bank's only option is to alter the
financial structure to reconnect credit supply in a timely manner. And in the
current markets of electronic trading, timeliness is a matter of hours, not
weeks. The futility of the Fed's traditional time lag response is exacerbated
by the speed of oncoming danger.
Yet Greenspan told Congress in his July 1999 Humphrey-Hawkins testimony: "But
identifying a bubble in the process of inflating may be among the most
formidable challenges confronting a central bank, putting its own assessment of
fundamentals against the combined judgment of millions of investors." Investor
judgments are now mostly based on technical analysis while the Fed is still
looking at fundamentals.
This explains why the record of the Fed's recognition of market trends has been
consistently six months late. Yet the Fed cannot afford to wait for market
discipline to correct a credit crunch. And because of the recognition time lag,
coupled with the diminished ability of the Fed to affect market decisions, and
the compressed chain reaction time of collapse, each subsequent intervention
would need to be escalated or overshot to achieve a comparable effect, which in
turn increases moral hazard to fuel the next abuse. It is intervention
inflation, similar to the narcotic syndrome of pushing towards the edge to
reach new highs, which always leads to fatal overdosing.
The global financial upheavals since 1997 have damaged not only financial
markets, but national economies along their paths. The Mexican crisis of 1994,
the South Korean crisis of 1997-98 (the only one in Asian the US intervened
because Brazilian investors were holding Korean bonds), and the Brazilian
crisis of 1998, the Russian bond crisis of 1998, Argentina and Turkey in 2000,
are all victims who have become permanent patients in the critical care unit of
the IMF.
Yet the US economy has been immune mostly because the Fed, taking advantage of
dollar hegemony, which is the unique position of the dollar as the anchor
currency in the existing international finance architecture, and its ability to
print dollars unimpeded, applied a bailout standard on the US economy much less
demanding than what the US required of the IMF for other economies. In recent
decades, the Treasury and the White House have effectively usurped much of the
Fed's alleged independence through the back door of foreign exchange-rate
policy which narrows domestic interest rates options. A strong dollar policy is
part of US financial hegemony. It is a national security position of the White
House that the Fed must support. Now the Treasury is again ordering the Fed
around in the cause of national economic security.
The credit bubble has been largely responsible for the spectacular growth of
the financial infrastructure. The narrow focus on rising market capitalization
value has obscured the high leverage in the US economy and to a lesser degree
in the global economy. Global equity markets rebound within months out of the
debris of sequential financial crises while the local economies stay depressed
for years. Recovery is proclaimed all over Asia while people remain jobless and
desperately poor.
Stock options became currency not only for management compensation and
corporate mergers, but for the general working population in the so-called New
Economy and for seeding new enterprises. Loans collateralized by inflated
market capitalization are preferred to liquidation as a devise to skirt capital
gain taxes. These loans magnify growth in a rising market and they magnify
contraction in a falling market.
The Fed eased in 1998 after the Russian default. History would decide whether
the Fed did the right thing by allowing Russia to default. But there is now
clear evidence that the Fed panicked and eased excessively after the Russian
default and after the LTCM bailout, thus exacerbating the post-1998 bubble,
foreclosing the prospect of a soft landing.
A bubble is formed when there is aggregate overstating of financial value. Its
existence saps real growth because profit can then be
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