The so-called subprime loan crisis has led to a crisis of confidence among financial institutions. Some investors have confessed to being unable to value their portfolios, which in turn has frozen trade of some securities. This has stopped lending operations by banks. As of Friday, August 10, the Federal Reserve and foreign central banks had injected $260 billion of additional liquidity into financial markets -- a massive sum equal to 2% of U.S. GDP -- in a single step and all prior to forthcoming aftershocks. As such, this concerted effort ranks among jumbo IMF rescues of emerging markets.
Some say that it is a small or a manageable “deflation” of the 13.5 trillion dollar economy of the United States. However, it is an unmistakable end to a boom cycle and it serves as the first alarm in an unregulated market. The aftershocks are sure to unravel other details.
As an investment banker put it, it is “the tip of the iceberg and that iceberg is called Drexel, Mark II”. He referred to the largest bankruptcy on Wall Street in 1990 of the investment bank Drexel Bernham Lambert. That firm and its star director, Michael Milken, was a high-flying investment banking house in 1980s, the decade of greed. Mr. Milken created the high yield (or junk) bond market and DBL set up a massive trading system for risky instruments. Speculative trades diverted attention from basic credit worthiness and fundamental risks, hype was heaped on the fast buck.
The present crisis is essentially a repeat of the DBL story: pools of high-risk mortgages are repackaged and sold as Mortgage Backed Securities (MBS). Financiers then blended these “junk-rated” MBS with other, less risky, securities and created a fresh pool of Collateralised Debt Obligations (CDOs) to “upgrade” the investment rating and sell these instruments to a wider range of investors. Derivatives and synthetic instruments were crafted on the back of these hyped piles of paper. While the intention of pooling these assets was to spread risk, the downstream effect makes it difficult for an investor to quantify the actual risk of loss in these CDOs or separate high risk items. Thus the good and the bad burn together. Investors typically purchase these instruments in leveraged transactions. In a crunch, holders often scramble to sell their worthy assets to raise cash and reduce their debt. This kind of market tailspin traditionally goes through at least two further devaluation jolts before it finds a new comfort level.
However, this time is different. The ripple effects will be felt beyond American shores. Unlike the 1980s, world markets are globalized. Large finance houses market their instruments in all parts of the world and foreigners hold more American debt, MBS and CDOs. The DBL operation was a large financing vehicle for takeover of American companies in leveraged buyouts. Nowadays, very large American buyout funds tend to invest in European or Asian companies and finance their takeovers with CDOs. Moreover, America was not stuck in an expensive and unpopular war in 1990. As a percentage of GDP, the Reagan era arms race against the USSR was a cheaper endeavour than current budgets for military and security spending.
Accounting problems might prove to be another worry. Subjective accounting interpretations burst the tech bubble and drove Enron, Worldcom and Global Crossing (a company formed by a former DBL executive) into bankruptcy and subsequent scandals. DBL, Enron and Worldcom executives were convicted of fraud and misstatement of financial reports. Freddie Mac and Fannie Mae, two relatively conservative and government-backed institutions, are in the process of making an $11 billion revision to their books.
My assessment is that a net loss of $400-500 billion, or 3-4% of U.S. GDP, will come out of American market valuations. China is likely to enter the market as a bargain hunter dressed as a source of rescue cash, if it does not run into political opposition during this election period. And the FED has a few other tricks up its sleeve, such as lowering interest rates. A lowering of interest rates will stabilize the markets but let inflation rip.
It is most interesting to observe that one of most-watched clips on YouTube is a video of a top financial reporter on CNBC. He has branded this crisis as the “Armageddon” of financial markets. This might well be an exaggeration, as markets tend to stabilize and clear out. Nevertheless, the inevitable ripple effect will be felt in other markets. It will stop the flow of relatively small investments to emerging markets, and some investors may liquidate them to cover large losses in “developed markets.”
The next 12 months will be a fragile and testy period. It is only the tip of the iceberg that some might wrongly spin it as deflationary.
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