The last 5 years in perspective

Central Banks Are Suckers
03 September, 2007
The markets are in uproar and central banks are stepping in to try to bring about calm. But should they? Or should banks get their just punishment for wreckless lending? Dick Bove, an analyst with investment bank Punk Ziegel, thinks the market should be left to seek its own solution.

(The Banker) In the past five years, the debt markets worldwide have changed dramatically. These changes can be ascribed to a number of factors.

First, there has been a shift in the control of money. After the Second World War, the only convertible currency in the world was the dollar. Now that other economies have grown and gained in strength, numerous currencies are convertible, and the dollar, which was once 100% of the world’s money supply, may now only be 24% of the total.

Second, the persistent trade deficits suffered by the older industrial economies have resulted in a skewing of the growth of world money supply to the exporting, or newer, industrialised countries. Massive cash hoards built up in these nations as a result and a place needed to be found to invest this money.

At the same time, technology was improving. Fibre optic cable was being laid all over the world. Computing power was being increased. Two important results were that unusually complex calculations could be completed in seconds, and millions of tiny transactions could be handled accurately over global distances, also in seconds.

The pools of money and the improved technology led to an explosion in product development in the financial sector. New products, from commercial mortgage-backed securities to collateralised debt obligations, were developed.

The existence of such instruments spawned a new generation of money managers. Alpha investors promised that they could show a positive return under any set of market conditions. Funds fled from beta investors who only promised to match the markets to the new alpha investors.

These money managers benefited from the low interest rates prevalent across the globe. They borrowed money in huge amounts leveraging investor funds to maximise their returns.

The new markets proved to be more facile and less costly than the older regulated bank-operated financial systems. Therefore, the protections that once existed when banks loaned the bulk of the available funds were stripped away. The new loans did not have reserves set aside; they were not backed by capital; they were not audited by third parties; and they offered no lines of credit to borrowers to provide protection in case of economic reversals.

Freed from constraints, lenders ventured aggressively into the negative amortisations arena. Payment option adjustable-rate mortgages (ARMs) were provided to households that automatically provided the borrower with the ability to borrow their debt service payments. Payment-in-kind loans were provided to corporations and private equity funds so that if necessary they also could borrow their interest payments. The system went from demanding that borrowers pay back, to ‘evergreen’ type loans, to now paying the interest for the borrower under a negative amortisation scheme.

Driven by the desire to place the funds available to them, lenders stopped underwriting loans and they no longer demanded any meaningful risk premium for providing their funds.

Inevitable fallout

For years, this new system expanded. Fed with low-quality credits, debt instruments in the US economy grew at a pace roughly three times faster than the US economy in the past five years. Then the inevitable happened: income was not growing fast enough to make the debt service payments required on the new debt instruments.

Defaults proliferated at the low end of the household markets. Lenders began to realise that they had provided monies to fund the purchase of instruments that they did not understand; had not underwritten; and had not been adequately paid to purchase. They began to lose money. They panicked. Initially, they caused disruption in the commercial paper markets by refusing to roll over their holdings. Ultimately, they shook the banking markets by forcing banks to refund the money owed on the commercial paper.

Pressure was then placed on the world monetary authorities to bail out the profligate lenders and borrowers. Seven central banks responded with what may have been an injection of $500bn to the money markets, lower interest rates in some cases for loans, and easier repayment terms based on lengthened maturities.

No steps were taken to resolve the debt crisis created by greed, inappropriate lending and borrowing, and a systemic unwillingness to adhere to even the simplest disciplines for handling funds. Old Polonius would be clapping his hands with glee saying “I told you so”. (The Shakespearian character is famous for his line in Hamlet: “Neither a borrower nor lender be.”) Lenders and borrowers failed equally in their responsibilities.

Challenging times

While monetary authorities are providing funds now to stabilise the markets, even they must realise that they are contributing to a worldwide Ponzi scheme (a scheme that offers abnormally high short-term returns to entice new investors but which requires an ever-increasing flow of new investment to keep the scheme going). They are bailing out the miscreants. It is my belief that these authorities may be beginning to realise that their actions fall in line with 19th-century American showman P T Barnum’s maxim about what is being born every minute: “a sucker”.

Ultimately, the monetary authorities will pull back. The marketplace will sort out the good loans from the bad. There will be numerous financial failures as this occurs. The economy will slow down. New regulations will be developed for lending worldwide. Times will be challenging.