Page 4 of 5 US government throws oil on fire
By Henry C K Liu
Members of the Ukrainian parliament have filed an appeal to the country's top
court, contesting an order by President Viktor Yushchenko to disband parliament
and the cabinet and hold new elections on December 7, subsequently postponed to
December 14. Until that case is decided, it is unclear whether the current
cabinet holds power. Prime Minister Yulia Tymoshenko says it does, while the
president's office is contesting that assessment. The IMF delegation has been
meeting with both sides. The fund is offering a loan of as much as $15 billion
to shore up Ukraine's finances as foreign investors flee for safe havens. As a
condition for the loan, the IMF is asking that Ukraine run a balanced budget
in 2009, a condition that the Federal Reserve did not impose on the US
government.
The Fitch rating agency downgraded Ukraine's sovereign debt rating on October
17 and issued a negative outlook for the country. A Ukrainian shipping company,
Industrial Carriers, has collapsed. The government has frozen rail tariffs for
steel companies, and as foreign investment dries up, speculators are betting on
a decline in the national currency. In response, Ukraine plans to nationalize
some commercial banks, which are suffering liquidity problems.
In Hungary, the authorities agreed to a loan of 5 billion euros ($6.7 billion)
from the European Central Bank to allow banks to continue to loan to one
another and businesses. In Iceland, officials said they would decide within a
week whether to take out an IMF loan.
Crisis in Asian banks
In Asia, South Korea announced a $100 billion government guarantee on foreign
currency loans and a $30 billion infusion into the Korean banking system.
Malaysia and Singapore announced government guarantees of all deposits in their
nations' banks through the end of 2010, mirroring a move made earlier by Hong
Kong, Australia and others in the region.
Hong Kong's bank deposit guarantee channeled capital flows into its banks and
away from the rest of the region, as depositors shifted funds to seek out
safety. Similar moves by Australia, Indonesia and others have increased
pressure for hold-outs to make guarantees of their own. A joint statement by
Singaporean fiscal and monetary authorities acknowledged the need to respond to
other countries' deposit guarantees: "The announcement by a few jurisdictions
in the region of government guarantees for bank deposits has set off a dynamic
that puts pressure on other jurisdictions to respond or else risk
disadvantaging and potentially weakening their own financial institutions and
financial sectors," adding it would guarantee a total of 150 billion Singapore
dollars (US$102 billion).
Financial nationalism
While this wave of government intervention was billed as a positive sign of
international coordination, the fact remains that such government measures were
really driven by financial nationalism to prevent funds from leaving one
national banking system for safer havens in another national banking system
that offers better government guarantee.
Even the US Treasury dropped its earlier opposition to sovereign guarantees for
funding, as such guarantees spreading across Europe to put US banks at a
competitive disadvantage with their European rivals. Under the US plan, deposit
guarantees will be provided by the Federal Deposit Insurance Corporation at
higher limits. The US shift on sovereign guarantees makes it very likely that
Canada, and possibly Japan, will follow suit out of self interest.
Once sovereign bank loan guarantees spread across Europe, the US had no choice
but to follow suit, despite concerns among senior US policymakers that this
could put added stress on the larger non-bank financial sector that competes
with bank lenders. This development will prolong the seizure of the much larger
non-bank credit market and possibly hasten its final collapse.
Non-bank financial system out in the cold
By yielding to the need to save the banking system as a first priority, the US
has in fact abandoned its more advanced but complex and diverse non-bank
financial system and reverted back to one based on a relatively small number of
large universal banks on the traditional European model. By nationalizing the
banking system with sovereign capital at a stage earlier than in past financial
crises around the world, US policymakers hope to halt a credit market meltdown
in mid-stream and engineer a quick turnaround of the the faltering economy
before it reaches full momentum.
Unfortunately, it is a strategy similar to amputating the limbs of a patient to
relieved circulatory pressure on the heart. The fact of the matter is that the
US financial system has transformed into one in which banks get no respect from
the non-bank sector. Banks have been relegated to a supportive role rather than
their traditional prime role of intermediating of credit for the economy. The
terms of the US sovereign recapitalization plan are much more favorable to the
banks and bank shareholders than the UK proposal. The US terms favor weak banks
by establishing the same terms for all, regardless of varying capital strength.
It is directing needed medicine to the wrong organ.
To offer favorable terms to get the core group of nine top US banks to sign up
immediately for half the $250 billion nationalization program was an essential
part of US strategy. It removed uncertainty over uneven share prices of these
banks that presented "co-ordination" problems, destabilizing swings in relative
capital strength, and the "stigma" problem as a sign of weakness for
participating banks. Most importantly, it eased the risk that the $125 billion
would be too thinly spread across the vast US banking sector to make a real
difference to the core group of financial institutions.
Questions remain in the market as to whether $250 billion will be enough for
the gargantuan task. Measured against the size of capital injections in Europe
and the larger scale of the US banking system, the fund appears visibly
undersize. Also, diverting up to $250 billion to recapitalize banks, away from
the $700 billion fund created to finance the purchase of illiquid toxic assets
raises doubts of curative efficiency. The US Treasury has better ways to
transfer assets from bank balance sheets to the government balance sheet with
less cost.
The focus of the US rescue effort is now on the recapitalization and loan
guarantee in the banking system. In effect, the US has decided to build a
defensive wall around a core group of nine banks. These banks will not be
allowed to fail, and the US government will rely on them to provide the bedrock
of ongoing lending in the economy while trying to avoid any of them gaining
dominant market share, as JP Morgan did in the 1907 crash. (See
THE ROAD TO HYPERINFLATION, Part 2: A failure of central banking, Asia
Times Online, June 30, 2008).
But in taking extreme measures to ensure the core banks will survive, the
government appears to be abandoning the vast non-bank financial sector to its
fate. The Fed will try to offset the enormous competitive advantage gained by
banks by buying commercial paper from non-bank financial firms such as GE
Capital and GMAC. However, this will not come close to balancing the full
benefits of the guarantees for the banks provided by the Federal Deposit
Insurance Corporation.
Still, these radical measures to guarantee inter-bank loans and to provide
backstops for the commercial paper market do not address the structured finance
problem, which few market participants fully understand, and no one alive knows
its full extent in terms of who owns what and owes to whom and how much. Bank
of International Settlement (BIS) data show that in June 2007, two months
before the current credit crisis broke out, total over-the-counter (OTC)
derivative contracts notional value outstanding was $516 trillion, with gross
market value of $11 trillion; $347 trillion in interest rate derivative
contracts with gross market value of $6 trillion; $43 trillion in credit
default swaps (CDS) with $741 billion in gross market value. Notional value is
not the amount at risk - only market value is at risk. Still, on a notional
value of $516 trillion, a fluctuation of 1% in interest can cause market
movements of $5.16 trillion, making the government's $700 billion rescue
package look like a garden hose in a forest fire. It is true that many of the
contracts are mutually canceling in a normal market. But in a market dominated
by one sided sell off, the mutual canceling can turn into a receding tide that
lowers all boats.
By December 2007, the total notional amount of outstanding derivatives in all
categories rose to $596 trillion. Two-thirds of contracts by volume or $393
trillion were interest rate derivatives. Credit default swaps had a notional
volume of $58 trillion, up from $43 trillion a year earlier. Currency
derivatives reached a volume of $56 trillion. Unallocated derivatives had a
notional amount of $71 trillion.
The non-bank financial sector in the US is already under even more severe
stress than its banking system. US sovereign aid for banks could intensify the
non-bank collapse, unless more steps are taken to aid non-bank institutions in
coming days. Contraction of the non-bank sector and failure of non-bank
institutions could lead to more distressed sales of assets and firms, frenzied
scrambles by non-banks for bank licenses and an accelerated shift of both
assets and liabilities into the banking sector. The recent movement of
investment banks, such as Morgan Stanley and Goldman Sachs, to transform
themselves as regulated banks, is a direct response to new government policy.
The problem is that if the core banks have not only to fill the "capital hole"
left by their trading losses and to fund de-leverage moves but also must absorb
a wave of illiquid toxic assets liabilities coming into the banking system from
the wider non-bank financial sector, banks will need a lot more than their
half-share of the $250 billion in government capital, perhaps in multiples of
trillions of dollars. No one knows exactly how much.
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