FINANCIAL MELTDOWN :WHERE ARE WE HEADING ? Ricardo V. Lago

Florida Interna-onal University Professor JIN ZENG’s Class

INTERNATIONAL POLITICAL ECONOMY

FINANCIAL MELTDOWN : WHERE ARE WE HEADING ?

November 22 ,2008 RICARDO V. LAGO

THE SPECTER OF 1929

 They Shoot Horses, Don't They? is a 1969

American drama film directed by Sydney Pollack. It is based on the 1935 novel of the same name by Horace McCoy.

 It focuses on a group of disparate characters

desperate to win a Depression‐era dance marathon and the opportunistic emcee who urges them on to victory.

ISSUES  CAUSES OF THE CRISIS AND POLICIES TO DEAL

WITH IT  THE PROBLEM OF HIGH LEVERAGE  DO WE NEED MORE REGULATION ?  THE ATTITUDE OF THE PRESIDENTIAL CANDIDATES  ARE WE HEADING FOR A 1929‐TYPE OF DEPRESSION

Causes of the crisis: “let’s round up the usual suspects”

THE CAUSES OF THE CRISIS  WAS IT EXCESSIVE CREDIT AND MONEY GROWTH ?  WAS IT AN UNSUSTAINABLE HOUSING FINANCE

MODEL IN THE US ?

 WAS IT TOO HIGH LEVERAGE RATIOS ?  WERE THE REGULATORS ASLEEP AT THE HELM ?  THE ANSWER IS : ALL OF THE ABOVE .

ILLIQUIDITY OR INSOLVENCY ?  I CALCULATE THE SIZE OF THE WORLD BANKING SYSTEM AT

AT LEAST US$ 100 TRILLION OR 200% OF WORLD’S GDP

 FURTHER , I CALCULATE CONSOLIDATED BANKS BOOK VALUE

EQUITY AT AT LEAST US$ 5 TRILLION

 MY HUNCH IS THAT THE MARKET VALUE OF CONSOLIDATED

BANKS EQUITY IS PROBABLY NEGATIVE

 BEWARE THAT TRUE SOLVENCY IS FORWARD LOOKING ,

AND IS DEPENDENT ON MULTIPLE EQULIBRIA

 THEREFORE , THE CURRENT ILLIQUIDITY IS GROUNDED ON A

PROBLEM OF INSOLVENCY

WARREN BUFFETT’s COLORFUL ILLUSTRATON  You don't know who is swimming

naked, until the tide goes out, and “ right now, Wall Street is a nudist beach” ( Interview in CNBC , August 22,2008)

SOLUTION :BANK RECAPITALIZATON  RECAPITALIZING THE BANKS ALL OVER THE WORLD

WOULD COST NO LESS THAN US$ OR 5 TRILLION OR ABOUT 10% OF THE WORLD GDP  THE USA’s SHARE WOULD BE ABOUT US$1.5 TRILLION ( THE EXPENSE OF THE US TREASURY SO FAR IS ABOUT US$ 1 TRILLION )  BANK RECAPITALIZATION BY INJECTING EQUITY IN THE BANKS  BUYING OUT THE TOXIC ASSETS FROM BANKS ALONE MAY NOT DO THE TRICK  AND WHO PAYS FOR BANK RECAPITALIZATON ?

THE ACTIONS OF THE FED AND THE TREASURY  THE SHADOW OF 1929 and of JAPAN 1992

 IT IS IMPERATIVE TO STOP THE DE‐LEVERAGING OF FINANCIAL

INSTITUTIONS TO AVOID A 1929 ‐TYPE DEPRESSION

 THE FED IS DOING THE RIGHT THING : MASSIVE INJECTIONS

OF LIQUIDITY .IT BUYS PRECIOUS TIME BUT DOES NOT SOLVE THE PROBLEM

 THE TREASURY : THE STATE AS UNDERWRITTER OF LAST

RESORT TO AVOID LIQUIDATION (EXCEPT LEHMAN BROS)

 RUNNING AGAINST THE CLOCK :

THE 700 BILLION QUESTION IS WHETHER THE TREASURY WILL BE ABLE TO RECAPITALIZE THE BANKS FAST ENOUGH .

LET ME FOCUS NOW ON HIGH LEVERAGE

HOW DOES HIGH LEVERAGE WORK?  GOOD TIMES ‐If the economy keeps growing , you

multiply by 30 the profits you make on each dollar of capital .

 HARD TIMES ‐When the inevitable economic downswing

comes , you blow away the equity position by a wide margin .

 Key asymmetry and inequity : in good times profits are

privatized , in hard times creditors ( and sometimes shareholders) are bailed out : losses are socialized.

QQQQ

LTCM’s COLLAPSE(1998 ) : THE POSTMAN ’s FIRST RING  Leverage ratio : 26 times on balance sheet , more

than 100 times off‐balance sheet  Long Term Capital Management was a hedge‐ fund that collapsed in 1998 and had to be bailed out to prevent widespread effects on creditors .  LTCM had equity of $4.72 billion and had borrowed over $124.5 billion with assets of around $129 billion.  In addition , it had off‐balance sheet derivative positions with a notional value of approximately $1.25 trillion .

AND WHO MODELLED RISK AT LTCM ?  Two of the principals were :

Myron Scholes and Robert Merton  Two academics who shared the Nobel Price of

Economics in 1997 ( the year prior to the collapse )  Precisely for their work on the pricing of options

THE FOUR FLAWS OF LTCM  VERY HIGH LEVERAGE

 HUGE OFF BALANCE SHEET

OPERATIONS  ABUSE OF DERIVATIVES  RISK MODELLING : PARAMETERS ESTIMATED WITH HISTORICAL DATA

FIVE YEARS LATER :

WARREN BUFFET’S REMINDER Derivatives are “financial weapons of mass destruction that could harm not only sellers and buyers but the whole economic system “ (Warren Buffett’s Annual letter to shareholders , 2003 )

“History always repeats itself twice: first time as tragedy, second time as farce” Karl Marx

THE POSTMAN’s SECOND RING : Black September 2008  Abuse of “derivatives”  Leverage ratios of failed banks :

Fannie Mae and Freddie Mac 60 Lehman Bros : higher than 31 AIG : higher than 20

WHAT IS A DERIVATIVE ?

SIMPLE EXAMPLES OF  A PUT  A CALL  A CREDIT DEFAULT SWAP

 ISDA®

INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION, INC.  NEWS RELEASE  For Immediate Release, Wednesday, September 24, 2008 ISDA Mid‐Year 2008 Market Survey Shows Credit Derivatives at $54.6 Trillion

ABOUT ISDA  ISDA was chartered in 1985, and today has

approximately 850 member institutions from 56 countries on six continents.  Most of the world’s major institutions that deal in privately negotiated derivatives, as well as many of the businesses, governmental entities and other end users that rely on over‐the‐counter derivatives .

INTERNATIONAL SWAP AND DERIVATIVES ASSOCIATION ‐ ISDA ( June 2008) NOTIONAL AMOUNTS OUTSTANDING  CREDIT DERIVATIVES US$ 55 trillion  INTEREST RATE DERIVATIVES US$ 465 trillion  EQUITY DERIVATIVES US$ 12 trillion TOTAL AMOUNTS OUTSTANDING US$ 532 trillion GROSS CREDIT EXPOSURE US$ 13 trillion

HOW HIGH ARE THESE FIGURES :COMPARISON TO GDP TOTAL AMOUNTS OUTSTANDING US$ 532 trillion OR ABOUT 10 TIMES THE WORLD’s GDP OUTSTANDING IN CREDIT SWAPS US$ 55 trillion OR ABOUT EQUIVALENT TO THE WORLD’s GDP GROSS CREDIT EXPOSURE US$ 13 trillion OR EQUIVALENT TO THE USA’s GDP

DO CREDIT DEFAULT SWAPS TRADE IN AN ORGANIZED EXCHANGE ?  FORMAL EXCHANGE .No , they don’t . Today , the

Chicago Mercantile Exchange announced , it is launching an electronic trading and clearing platform .  REGULATION .How well are they regulated / supervised ?.In general , they are not .  BIS .The Bank for International Settlements (BIS) collects both notional amounts and market values in derivatives .  NEED FOR A FORMAL EXCHANGE

REGULATION

 ONE OF THE PROBLEMS IS THAT REGULATION IS

SCATTERED AMONG SEVERAL INSTITUTIONS : SECRURITIES COMMISSION , FED , COMPTROLLER OF THE CURRENCY , FDIC  DO WE NEED MORE REGULATION ?

‐THE ISSUE IS NOT NEW REGULATIONS ‐THE REGULATORS DID NOT DO THEIR JOB ‐THE FED WAS TOO LAX ON CREDIT GROWTH – ‐THE SECURITIES COMMISION AND OTHERS COULD HAVE FORCED BANK ON LEVERAGE RATIOS , INCREASED PROVISIONS , ETC ‐ UNIFY REGULATORY AGENCIES LIKE IN THE UK

THE CANDIDATES REACTION TO THE CRISIS : IN GENERAL DISAPPOINTING

 COMPLAINTS ABOUT GREED IN WALL STREET  COMPLAINTS ABOUT CORRUPTION IN WASHINGTON  A RIGHT MOVE : JOINT SUPPORT FOR THE BAIL OUT

PACKAGE  OBAMA MORE OF A STATEMAN IN : THE CORAL GABLES PRESS CONFERENCE  McCAIN :FUNDAMENTALS ARE RIGHT !  BUT CANDIDATES STICK TO THEIR GUNS :

 OBAMA ON THE MIDDLE CLASS TAX REDUCTION  McCAIN ON THE “LAFFER CURVE” :LOWER INCOME

TAXES AND CORPORATE TAXES  PROCTECTIONISM IS A SERIOUS PROBLEM : REMEMBER SMOOT‐HOWLEY TARIFF ACT OF 1930  RISK OF BEGGAR MY NEIGHBOOR ACTIONS

THE CANDIDATES SHOULD HAVE PUT ASIDE THEIR PETTY CASH GIVE‐AWAYS AND FOCUS ON THE REAL PROBLEMS : ‐ SHORT TERM :CAUSES OF THE CRISIS AND HOW TO FIX IT ‐ LONG TERM :THE UNFOLDING BUDGET TIME BOMB .

ARE WE HEADING FOR A 1929‐TYPE DEPRESSION ?

NO …UNLESS …..  THE SHORT ANSWER IS : NO  WE HAVE LEARNT FROM THE POLICY MISTAKES OF

1929

 BUT IN ANY CASE IT WILL DEPEND ON THE

LEADERSHIP AND UNDERSTANDING OF THE ISSUES OF THE NEW PRESIDENT

 WILL ALSO DEPEND ON RESPONSE BY OTHER

COUNTRIES .SO FAR SO GOOD ON THIS FRONT .

SEVEN REASONS WHY THIS IS NOT 1929  CENTRAL BANKS ‘s HANDS ARE NOT TIED BY THE

GOLD STANDARD  THERE IS DEPOSIT INSURANCE  THERE IS UNEMPLOYMENT INSURANCE  AUTHORITIES UNDERSTAND THAT THEY CAN AFFORD TO LET THE BANKING SYSTEM GO BUST  PUBLIC EXPENDITURE STIMULUS  INTERNATIONAL COORDINATION  NO RETURN TO PROTECTIONISM ( ie .No repetition of the Smoot‐Hawley Act 1930 )

AND THE RESUMPTION OF GROWTH TWO KEY DRIVERS TO PULL US OUT OF THE HOLE  SUPPLY SIDE : THE FIRST ONE IS ON CONTINUED

PRODUCTIVITY GROWTH  DEMAND SIDE :THE SECOND ON DEMAND‐PULL

FOR GROWTH

THE INTERNET

THE END