The world is witnessing the end of American financial capitalism as we have known for a long time. Just consider the dramatic events this month:
*In the biggest nationalisation of modern American history, the US government took control of Freddie Mac and Fannie Mae, the two mortgage lenders who own or guarantee about half of the American $12 trillion mortgage market. Initial cost of the bailout: $200 billon but it could turn out to be much bigger. Over the past year the two giants increased their lending by about $600 billion, or 12 per cent, and this year they have financed four out of five mortgages.
*American International Group, America’s biggest insurance company and the world’s largest insurance supermarket with a balance sheet of $1 trillion, was bailed out and taken over by the US federal government for $85 billion.
*America’s fourth largest investment bank, Lehman Brothers, collapsed and filed for bankruptcy. It has more than $613 billion of debt.
*Merrill Lynch, one of the top three investment banks, was the victim of a distressed sale to Bank of America, a commercial bank. On September 17th, shares in the two largest independent US investment banks left standing – Morgan Stanley and Goldman Sachs – fell 24 per cent and 14 per cent, respectively, as the cost of insuring their debt soared, threatening their ability to finance themselves.
*The panic in world credit markets reached historic intensity last Wednesday, prompting a flight to safety of the kind not seen since the second world war, and forcing the central banks in the US, Europe and Asia to pump $180 billon into money markets.
President Bush canceled all his domestic travel last week to focus on the worst financial crisis since the great depression and said he will take any actions necessary to stabilise markets in the face of a crisis that has shattered the confidence in America’s financial system.
Senator John McCain, who said on September 15 that he believed the fundamentals of the economy were strong had to eat his words only a day later as he was calling the economic situation “a total crisis” and denouncing “greed” on Wall Street and in Washington.
The crisis is far from over and is likely to deepen and unfold over the course of at least next twelve months. Why? The roots of the crisis are to be found in defaults in the over $2.3 trillion subprime and Alt-A mortgages markets. Up to September, 14th, commercial banks have recognised losses of $510 billion while the non-banking financial institutions, including investment banks, have admitted losses of only $250 billion. But the house prices continue to fall (they fell by 15 per cent last year) and some analysts are forecasting a further drop of 10 per cent.
However, subprime lending is just one of the problems. The collapse of America’s financial giants was brought about by excessive greed, mindless deregulation, lax supervision, and a false belief represented by bipartisan Washington consensus that financial markets knew best. But the financial market shot themselves in their feet. One of the weapons they used was derivatives.
Warren Buffet – one of the world’s richest men and the best investors – had warned in 2003 that derivatives were “financial weapons of mass destruction” and that, while the Federal Reserve system was created in part to prevent financial contagion, “there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives”.
In simple terms, derivatives are financial instruments whose value changes in response to the changes in underlying variable such as bonds, stocks, commodities, interest rates, credit risk, etc. The US regulators historically focused on banking companies and actually encouraged them to transfer their risky assets to their less-regulated affiliates or third parties such as investment firms and hedge funds. The result was the growth of what’s now often termed as the shadow banking system of securitisation and derivatives.
The over-the-counter (OTC) derivatives are not traded on any exchange. The OTC derivatives market is (or rather was) dominated by the investment banks. By the end of 2007, the total notional amount of all the derivatives had risen to $596 trillion from $220 trillion in June 2004.
One type of derivatives is a credit default swap (CDS). It resembles an insurance policy, as it can be used by a debt holder to hedge, or insure against a default under the debt instrument. According to the International Swaps and Derivatives Association, the notional value of CDS totaled $62.2 trillion at the end of last year. Since there is no clearinghouse to administer these transactions, in effect it is impossible to know who could be hurt the worst.
AIG has a credit default swap portfolio of $400 billion notional value, but it cannot be fairly valued because there is literally no real market for many of these contracts. The collapse of Lehman Brothers has triggered an enormous crisis in derivative markets. Prior to the firm’s dramatic demise, no major player in the world’s biggest financial market had ever gone under. A major counterparty failure threatens the delicate web of trading in securities that are gargantuan in dollar amounts but totally lacking in transparency. The sheer magnitude of challenges, questions and uncertainties facing investors of all types — from those engaged in commodities to corporate credit to commercial real estate — is more daunting than most people at the Wall Street have experienced in their entire careers.
Given a troubled housing sector, fears of a contagion from derivatives exposures, jittery money markets, and swooning stock markets, it is extremely unlikely that the financial crisis would end any time soon. The markets rallied only for a day upon the nationalisation of the biggest mortgage lenders but sank deeper as the AIG disaster unfolded and added fuel to the fears that the worst is yet to come.
Kenneth Rogoff, a professor of economics at Harvard University, says that US government may have to spend five to 10 times more than it has already to save the collapsing firms, that is, an amount closer to $1 to $2 trillion.
The crisis though is still manageable as the privately-held US government debt of $44 trillion at the end of 2007 represented less than 32 per cent of the GDP and the bailouts this year had added a little over $300 billion to its net debt.
Though manageable, the crisis has both short and longer term implications for the global financial system. So far, the dollar has held up rather well but may be in for a slippery ride south in the next few months as the US economy continues to slow down and the financial crisis deepens.
From the viewpoint of the developing countries, the crisis may herald an era where the world’s financial system may still be dominated by Western (particularly US) commercial banks but their Arab, Chinese, and other Asian investors would wield a lot more clout they did in the past.
In the context of global politics, it marks the beginning of a major shift in the world’s balance of economic power from the West to the East, brought about by a self-destructing financial system and an unprecedented boom in the commodity prices, most notably that of oil.
The crisis is likely to have a serious impact in terms of the ability of the rich Western nations to give aid to the poor countries. The United Nations Secretary-General Ban Ki-moon has expressed deep concern and pointed to a recent UN report which said rich donor nations have failed to deliver on promises to help the world’s poorest countries, saying they must increase aid by $18 billion a year to keep their pledge to provide $50 billion by 2010.
The collapse of America’s financial giants is ironic in that it was the state that came to the rescue of the private enterprise and was forced to admit that nationalisation sometimes becomes inevitable especially when the conduct of the private enterprise turns into a reckless and greedy pursuit of money at the cost of the stability of the whole system. Pakistan’s squabbling politicians, tax-evading businessmen, and self-serving elites should take notice!
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