We never learn

Andy Xie

One year ago, Lehman Brothers collapsed. The US government refused to bail out Lehman to limit government bailouts. It warned other financial institutions to be careful about Lehman for six weeks. When it let Lehman go, it felt that other financial institutions had already severed their dealings with Lehman and its collapse could be walled in. Little did it know that the whole financial system was one giant Lehman. It borrowed short-term money to punt in risky and illiquid assets. The debt market supported the financial sector because it believed the government would bail everyone out in a crisis. When Lehman was allowed to collapse, that faith was shaken. The debt market refused to roll over financing for financial institutions. Of course,financial institutions couldn’t unload their assets to pay off their debts. The whole financial system was collapsing. Governments and central banks were forced to bail out everyone with direct lending or guarantees.

The Lehman collapse backfired. Governments were forced to make their implicit guarantees explicit. From now on no one will dare argue to let a major financial institution go bankrupt. Debt market is supporting financial institutions again only because they are confident of the government guarantee. In the Lehman saga governments lost, Wall Street won. And, and Lehman died in vain.

Today governments and central banks are celebrating their victory in stabilizing the global financial system. To achieve the same they could have saved Lehman with $50 billion. Instead, they have spent trillions of dollars, probably more than $10 trillion when the final tally comes in, to achieve the same. On the other hand, the broad objective of reforming the financial system has not made progress at all.

First, let’s look at the most basic objective of deleveraging the financial sector. Top executives on Wall Street talk about having cut leverage by half. That is actually due to expanding equity capital base rather than shrinking asset size. According to the Federal Reserve, the total debt for the financial sector was $16.5 trillion in the second quarter of 2009, about the same as $16.6 trillion one year before. After the Lehman collapse the financial sector leverage increased due to the Fed support. It has come down as the Fed has pulled back some of its support, creating the perception of deleveraging. The basic conclusion is that the financial sector debt is the same as one year ago and the reduction in leverage is due to equity base expansion, partly due to government funding.

Second, how financial institutions operate remain the same as before. Financial institutions led in reporting profit gains in the first half of 2009 during a period of global economic contraction. When corporate earnings expand in a shrinking economy, they must be due to redistribution. The strong earnings came mostly from trading income, which is really getting in and out of financial markets at the right time. With assets backed up by $16.5 trillion in debt 1% asset appreciation would lead to $16.5 billion in profits. Considering how much financial markets rose in the first half, the strong profits were easy to imagine.

Trading gains are a form of income redistribution. In the best scenario, smart traders buy assets ahead of others because they see stronger economy ahead. Such redistribution comes from giving a bigger share of the future growth to those who are willing to take risk ahead of others. Past experience, however, demonstrates that most trading profits are redistribution from many to a few in zero-sum bubbles. The trick is to get the credulous masses to join the bubble game at high price. When the bubble bursts, even though the asset price may be the same as at the beginning, most people have lost money to the few. What’s occurring now is another bubble that is again redistributing income from the masses to the few.

Third, financial supervision has not changed. After the Lehman crash most governments were talking about strengthening financial regulations and regulatory agencies and possibly establishing an international regulatory body. The developments in the past year have actually made financial supervision worse. To support financial institutions the US government suspended ‘mark-to-market’ accounting rule for the assets on the books of the financial institutions, which has allowed them to report profits.

Revamping the financial system has been reduced to a political movement to regulate banker’s pay. Indeed, if this is possible, it would remove the incentives for financial institutions to manufacture bubbles. The problem is that it is not possible. Financial professionals can be based anywhere. There are always some countries that would host them. Because of such competitive concerns a global consensus on regulating pay for financial professionals is unlikely.

I believe that the ultimate objective of the financial reforms is to make leverage transparent. There are many reasons that a bubble forms. Debt leverage, however, is always at the center of a property bubble, the most damaging kind. The leverage within a financial system-asset to equity capital ratio is a driving force for an asset bubble. Complex accounting rules and the varying treatment of different financial institutions make it difficult to measure leverage. The international standard for bank’s capital is 8% that allows twelve times leverage. How assets off balance sheet are treated can make a huge difference. A lot of big banks had leverage of 30 times at the beginning of the crisis due to their off-balance sheet assets.

Other financial institutions like finance companies are harder to regulate. Some industrial companies General Electric and General Motors took advantage of the loophole and created finance companies that are essentially banks. Hedge funds, mutual funds, private equity firms, etc., are even more lightly regulated. When they purchase securitized debt securities and engage in lending, they are like banks. One interesting phenomenon is how the money market funds caused havoc after Lehman crashed. These funds are supposed to be ultra safe for buying triple A and short-term liquid debt instruments. The problem was that their demand was the liquidity and the self-manufactured liquidity provided a false of security despite the risks of the underlying securities like the short-term papers issued by investment banks. When their false sense of security was jolted by the Lehman collapse, they all rushed for exit at the same time. Without government support they wouldn’t have been able to get their money back.

The problem with financial regulation is not the banking system per se, but the shadow banking system. It provides leverage with much less capital than the banking system. When the leverage in the economy is rising, asset prices rise too. Rising asset prices boosts collateral value and, hence, more borrowing. Surging earnings of financial institutions usually accompany such a spiral of rising leverage and rising asset price.

It is extremely difficult to stop such a spiral with an established regulatory regime. Usually some new financial institutions or products come to the scene for a new leverage game to begin. It would be impossible for an existing regime to be so comprehensive to anticipate future institutions or products. Governments may need to install principle, not just rule-based regulatory agencies that could act again new financial creatures.

The US government is proposing a consumer protection agency for financial products. Such an agency could at least respond to new financial products that are sold to consumers and, therefore, could be an effective mechanism in stopping some future bubbles. The proposal has met vehement opposition from the financial industry. It may not get through at all.

What can we speak for after spending trillions of dollars? Not much. Not even many major players have gone to jail. The US government sent many more to jail in the 1980s after the junk bond bubble burst. This bubble is ten times bigger. Yet, apart from the most obvious criminals like Bernie Madoff and Allen Stanford who ran multi-billion ponzi games, no big shots have gone to jail. Indeed, many big shots who brought the world down are still out there running things. The lesson from the Lehman collapse seems ‘take whatever you can and, when it crashes, you get to keep it’. How governments and central banks have dealt with this bubble will encourage more people to join bubble making in the future.

Since governments have failed in taking advantage of the crisis to build a better financial system, it will become very difficult to push it forward now. The sense of urgency is gone. One may argue that, as markets are stable now, there is no need for radical reforms. This is exactly the wrong conclusions. Trillions of dollars have been spent to buy today’s stability. If the money isn’t spent in vain, serious reforms should take place to decrease the possibility of a catastrophe like this in the future.

The big change that has happened is the rapid increase in the US household savings rate. It has happened much quicker than I expected and has the potential for the global economy to change with it. The economic explanation is the negative wealth effect. The US household net wealth has declined by 20% or nearly 100% of GDP. The rule of the thumb is that it would lead 5% reduction in spending. The US household savings rate has increased more than that and continues to rise. It could rise above 10% next year. Because of the rising savings the US trade deficit has already halved from the peak. It could halve again next year. This is why I have turned positive on the dollar.

Financial markets are still maximum bearish on the dollar. Liquidity is being channeled out of dollar into all other assets. This is why there is such a high correlation between the dollar and other assets. I think this is the most crowded trade in the world. When the dollar reverses, the short squeeze could cause a global crisis.

Because no meaningful financial reforms have occurred, bubble-making is rapidly back in fashion. The drivers are the faith in ever-depreciating dollar and later inflation. Stocks, commodities, and even property in some cities have skyrocketed this year. It is happening amidst a synchronous global recession. Of course, bulls would argue that the market recovery is forecasting a strong global economy ahead. I seriously doubt it. With savings and unemployment rising, the OECD block is unlikely to stage a strong recovery from the recession. This view is not the market’s consensus that assumes that all the stimulus would lead to a strong and sustained recovery. As I argued in this page before that, during a big bubble, demand and supply become misaligned. When it bursts, the economy must restructure demand and supply for the economy to be fully employed. Stimulus couldn’t solve this problem. The realignment will take time.

Because policymakers mistakenly believe that stimulus would bring growth back, they are pushing it too hard. The consequence is inflation eventually and bubbles along the way. These bubbles will be short-lived. The current booming market, for example, is a good example. At the beginning of the year I predicted such a bubble from March to September. I still hold onto this belief. China’s stock market peaked in August and the US’s is peaking in September. The reason for the shortness of the bubble is its limited impact on real demand.

How long a bubble lasts depends on how large its multiplier effect on the economy is. When the multiplier effect is large, it results in an economic boom that boosts asset returns. Market can make a plausible case that high asset prices are revaluation rather than bubble. Strong fundamentals and rising asset prices could sustain each other for a period. The dotcom bubble began in 1996 and lasted for five years. The global property bubble began in 2002 and lasted for five years too.

A technology bubble lasts by cutting costs and boosting profits. A property stimulates demand in many parts of the demand and can boost corporate earnings from financial institutions, retailers, construction companies, and material producers. Its large multiplier effect is why the property bubble usually lasts many years.

The only multiplier effect from the current bubble is stopping financial institutions from going under. However, weighed down by trillions of dollars of non-performing assets, they couldn’t lend with abandon again, which makes it impossible to revive property bubbles. Besides, American households wouldn’t go with the ‘borrow-and-spend’ game again. Essentially, the main short-term impact of the current bubble is preventing the financial system from collapsing. It wouldn’t lead to substantial demand creation.

Many investors today think that bubble is inevitable and, when one bursts, another can be created quickly to keep life going on as usual. What has occurred in the past six months seems to validate this view. History, however, is not kind to this view. Serial bubble making leads to bigger economic crisis late. What occurred in the US in the 1930s and Japan in the past two decades are good examples in that regard. There is no free lunch. If there is always another bubble to bail us out, it would be the ultimate free lunch.

Our serial bubble making began ten years ago with the Asian Financial Crisis. It led to loose monetary policy in the developed economies, especially in the US, and undervalued exchange rates in the developing economies. The inflationary force from the loose monetary policy was kept down by excess capacity or capacity creation in developing economies. The environment for tolerating such loose monetary environment ends when inflation surges in emerging economies first and developed economies second.

When inflation becomes a political problem and policymakers must respond, money supplies will cut. No more bubbles afterwards.