'Easy money' prompts hard times


If intervening effectively in the United States housing fiasco is challenging, as we saw in my recent column, solving the multiple crises of the financial system looks equally, if not more, tough.

Although easy money has been the Greenspan-era panacea for all that ails financial markets, it has its drawbacks.

Reducing interest rates was largely what got us out of the pickle when the stock market crashed in October 1987, also when the Long-Term Capital Management hedge fund’s soured gamble threatened a systemic meltdown in 1998, and when the dot-com bubble burst in 2000 and 2001.

The obvious drawback of the easy money solution is inflation. The former Fed chairman was very lucky that his reign coincided with the great deflationary period brought about by globalisation and the introduction of low-wage Asian workers into the world labour market.

That restraint on prices seems to have run its course. As Asian economies take off, their workers can now demand slightly higher pay and their consumption is stretching natural resource supply in an inflationary way. So inflation has to be taken seriously again. 

Easy money also creates asset bubbles and risky behaviour in the credit markets.

In other words, the current crisis, comprising a house-price bubble, an over-indebted American consumer and a plethora of risky banking practices, has its very origin in cheap money. Some economists see the Federal Reserve as being much more constrained this time around by the fact that the US is heavily in debt to foreign lenders. Those lenders have already seen fairly painful currency losses with the slide in the value of the dollar over the past few years. If they lose confidence and sell their dollar assets, that slide would resume and gain speed. A plummeting dollar really would ignite inflation in the US, unless a steep downturn in output pushed prices in the opposite direction.

There are plenty of reasons, then, for prudent policy-makers to look for targeted ways to cure the ills of the financial system. The urgent problem on the agenda is the credit ratings of the bond insurers.

Unlike other threats to the economy, from derailment of credit default swaps or from failures of over-leveraged private equity deals, for example, the monolines conceivably are a candidate for some kind of rescue.

The ratings agencies, S&P and Moody’s, having totally failed the market by giving a ridiculously rosy bill of health to all those structured securities, have found religion again. (To be fair to them, many other market participants avidly desired to enter into the self-deception.) The ratings agencies are now threatening to downgrade the bond insurers, reasonably enough since those outfits are running through much of their capital cushions on the losses on mortgage-related securities that they foolishly guaranteed. This matters both because it will trigger downgrades to the ratings of assets that the big banks are holding and because it could make it harder for municipal governments to raise money to fund their infrastructure projects.

New York state regulators have pushed the solution of splitting the insurers’ books of business into safe and less safe bonds. The safe side of the house, the muni bond insurance portfolio, would need to take enough capital with it to keep its AAA rating and would then be able to go back to business as usual. Municipal governments would be able to issue debt and get on with life and personal investors who own insured munis would be able to relax that their income is assured. The problem, of course, is that there is not enough capital in these bond insurance firms to satisfy the risky side of the house.

A split that kept the muni side happy would spell more agony for the risky-asset side. The big banks would be faced with having to mark down securities that no longer had supposedly strong guarantees behind them. A lot of this is about facing (and accounting for) a reality that has already come about, namely that a lot of structured paper is worth much less than when it was issued.

One of the biggest bond insurers, Ambac, was poised at the time of this writing to do the deed, splitting up and simultaneously raising $2 billion (Dh7.3bn) or $3bn of fresh capital from big banks, including Dresdner. Perhaps Ambac hopes the capital raise might be enough of a sweetener to convince its insured parties not to sue to prevent the split. Or maybe it is an upping of the ante in a game of chicken that the insurers seem to be playing with the big banks: “Bring us capital or we’ll be downgraded and then you’ll have to write down a big bundle of your own assets.” The banks are presumably playing chicken with each other, too, since they all have something to gain from their fellow-sufferers putting capital into the insurers. This is the kind of situation where government or a senior financial statesman sometimes can give a lead, cajoling several players into sharing the pain for the collective good.

Not everyone is convinced that this is the right occasion for such state intervention. The Economist’s free-market doctrine finds it repugnant to interfere with contracts, which is what a split of the books represents. In other words, the banks bought insurance of those mortgage-backed securities on the assumption that the insurers’ rock-solid muni-related premiums would be there to cushion their riskier paper. Take away that free subsidy and bankers cry foul. (The corollary is that muni buyers were left holding the bag once their bond insurers deviated into covering toxic assets. Who’s crying foul for the muni-bond owners?) The uncertainty of interminable lawsuits over the asset split could indeed be more disabling to markets than the status quo. Other sceptics just see a bank rescue of the monolines to be postponing their inevitable collapse. The line of argument is that the monolines guaranteed a lot of risky paper, these bonds come unstuck in housing and other credit busts, the busts are occurring, and it cannot be in the banks’ interest to bail out these flimsy insurers indefinitely. Some bank executives may want to put off the evil day when they have to take charge-offs on their assets, which reminds purists of the Japanese approach, thought to prevent the market from recovering. On this view, government should not encourage more bad behaviour.

The Economist also thinks that the municipal bond market will sort itself out. New insurers like Warren Buffett’s Berkshire Hathaway will fill the vacuum left by crippled monolines, or investors may even decide to do without guarantees on what tends to be quite safe debt. However, that would mean the end of the current monolines, as they stop earning premiums on muni bond insurance and payouts on the toxic paper swamp their capital bases.

If the banks do have to take charges against structured assets that were notionally protected by MBIA and Ambac, how bad will the damage be? The two biggest monolines had between them guaranteed over a trillion dollars in debt at the end of 2007. The Economist cites estimates of the banks’ exposure that they suggest are not too scary: at the very worst not more than $70bn and quite likely only a few billion dollars. But the Financial Times’s Martin Wolf is not so sure. He finds the pessimistic outlook of Professor Roubini at New York University’s Business School to be credible. Prof Roubini sees a bank write-down of $150bn if the monolines lose their AAA rating. A few more hits like that and we’re talking real money. However, just because the outcome could be calamitous does not mean that a government-imposed solution at this stage could work or be positive.

This discussion has treated the banks as if the buck stopped with them. Unfortunately, real people get hurt as the banks take pain. Pension funds and regular investors that have bank stock have already taken a pounding to their portfolios, with more to come. If pension funds also invested with hedge fund managers that specialised in structured finance, they will probably suffer losses before this is over. Likewise, pension money that went into private-equity deals is not likely to receive a hundred cents on the dollar, let alone the alluring returns that the financiers held out. Cerberus Capital’s purchases of GMAC and Chrysler are both garnering bad press, and plenty of other, lower-profile acquisitions will probably turn out badly. The upshot is that either people are going to receive lower retirement pensions or employees and taxpayers are going to have to contribute more than before to make up for the wealth destruction from this financial debacle. Reports are beginning to trickle in of clients looking for recompense from bankers for luring them into risky assets.

The City of Springfield in Massachusetts apparently got burned on sub-prime assets and the German state-controlled HSH Nordbank is another, in the news as suing UBS. Many more “victims” are likely to join them.

With the ultimate losers among the public in mind, central bankers, regulators and Congress will want to be seen to be doing something. It’s just not evident that there is an alternative to letting the problems run their course. In the worst case, if a bank fails, Federal deposit insurance will protect families with cash at the bank. It is programmes like federal bank deposit and pension protection that should have prompted regulators to stop banks and pension funds from gambling in credit default swaps, other structured financial assets and risky private equity deals. Fresh leaders will need to come up with a framework that does a much better job of avoiding disaster next time.