Sovereigns that bailed out banks are saddled with much greater government debt than before the crisis. In the spring of 2007, the Fed and the U.K.’s FSA reported that the degree of leverage in the global financial system was less than at the time of Long Term Capital Management, but in reality it was much greater. Global regulators are now repeating their mistakes. The risks in the interconnected global banking system have moved to currency trading and currency derivatives (remember the contribution of knock-in options to the 1995 currency crisis), leveraged loans, credit derivatives, market-linked derivatives, speculation in commodities, and both foreign and domestic government debt. Winston Churchill said we must alert somnolent authority to novel dangers; but our regulators are complacent, and the dangers are not novel.
With respect to the recent crisis, highly leveraged fixed income assets posed perils to the global banking system. When excessive leverage is combined with fixed income assets acquired at par, there is extreme risk. If the assets decline in value and liquidity becomes tight, it can cause a vicious cycle of selling that feeds on itself. If one combines that with foreign currency risk, one adds to the potential pain. If that is further accompanied by a price reduction that is due to a permanent or at least sustained price decline in underlying assets, it is virtually impossible for an undercapitalized overleveraged entity to recover from even a temporary liquidity shock. If a country cannot quickly refinance (roll financing), the collapse is quick and brutal. This isn’t a new discovery, this is simply a fact.
The structured component of international finance is so influential that the failure of the rating “agencies” — which aren’t agencies at all; they’re private companies — to competently rate structured financial products — and their overall incompetence with derivatives — means that their sovereign ratings are largely meaningless. The various issues with Portugal, Ireland, Italy, Greece and Spain (the PIIGS) are beyond the scope of this report, but the rating agencies, already at sea, seem to be somewhat influenced by politics as downgrades lagged and in some cases continue to lag reality. The result is that ratings adjustments come long after the need for a downgrade is obvious. To be clear, this has nothing to do with the theory of efficient markets. The rating agencies seem to flounder and arrive late to the party.
Banks that engaged in leveraged borrowing and that trade derivatives including currency derivatives, credit derivatives, commodity derivatives, and interest rate derivatives are not within the ability of the rating agencies to competently rate. Since governments’ and central banks’ finances are intimately tied with the global banking system, the rating agencies do not competently rate sovereign debt.
Sovereign Rating Example: Iceland’s “Aaa”
Moody’s misguided “Aaa” ratings (unlike S&P Moody’s uses “Aaa” to denote “AAA”) were not limited to securitizations. In 2007, financial professionals derided Iceland’s inflated “Aaa” rating due to the risk posed by excessive leverage and excessive borrowing in foreign currencies. A cult YouTube video, apparently out of Bombay, India in 2007 mocked Moody’s and its “Aaa” Iceland rating. It was widely circulated among financial professionals.
Moody’s tried to temper its decision in a January 2008 report: “Iceland’s Aaa Ratings at a Crossroads.” It wrote: “Iceland enjoys high per capita incomes, well-developed political, economic and social institutions, favourable demographics and a fully-funded public pension system… Its government debt ratio is less than half the average of the Eurozone member countries.” Moody’s did all it could to rationalize its decision to maintain the “Aaa” rating.
As was true of many of Moody’s “Aaa” ratings, it was forced to give up the game. In October 2008, Iceland temporarily suspended stock trading and seized Kaupthing, the country’s largest bank, as its banking system collapsed and plunged the country into bankruptcy. Iceland’s external debt was around $70 billion at current exchange rates (then â¬50 billion) or around $218,000 for each of its 320,000 citizens.
United States: “AAA” in Label Only
The financial debacle was enabled by a classic control fraud within our largest banks. Wall Street’s huge bonus payments were based on suspect accounting, and bankers continue to seek those rewards by ramping up risk within the banks. Many banks’ current illusion of profitability is currently only made possible by taxpayers’ enormous subsidies including low cost borrowing, higher interest payments on bank capital deposits, a credit line for the FDIC (to be repaid with banks’ subsidized profits), and continued government debt guarantees on bank debt. A large share of certain banks’ tax-subsidized profits is due as reparation to unsophisticated investors, the U.S. taxpayers. While the Fed prints money, it seeks to keep short-term interest rates artificially low, essentially robbing investors who earn such low interest rates on “safe” investments, that after inflation, they are earning negative real returns.
The Fed uses tax dollars to keep some of our largest banks — weakened by reverse-Glass-Steagall mergers with troubled entities — from collapsing under heavy loan losses. U.S. taxpayers became unwilling unsophisticated investors funding Wall Street’s bailout.
In the wake of the global financial crisis, Bloomberg estimated that by March 21, 2009, pledges by the Federal Reserve, Treasury Department, Federal Deposit Insurance Corporation topped $12.8 trillion. The U.S. GDP was $14.2 trillion. At the time the pledges represented more than $42,000 for every man, woman and child in the U.S.
Massive hiding-in-plain-sight fraud damaged the U.S. economy. Housing prices didn’t just fall; they plummeted as the fraud unravelled. By the end of 2010, four million home loans were more than 50% underwater with an average of $107,000 negative equity; this alone is around $428 billion in negative equity. 7.8 million loans were 25% or more underwater. Most of these damaged borrowers were paying higher interest rates than the national average, couldn’t refinance, and were ineligible for HAMP, a government initiated refinancing program.
Securitized assets were dumped on the balance sheets of the Fed (and the Fed supplied near zero cost funding to plug holes in bank balance sheets and special government guarantees on bank debt), special purpose entities set up by the Fed, Fannie Mae, Freddie Mac, and the FHA (through government guarantees). Government guarantees allowed for new issuance of securitized mortgage loans that otherwise would have no buyers, since the rating agencies are widely mistrusted.
The effect of existing government entitlements and obligations combined with expanding bank debt, flawed loans, flawed securitizations, and leverage significantly weakened the U.S. economy stunting growth as money was diverted to the banks and away from capital spending, the biggest driver of any economy.
The damage of financial malfeasance was so extensive and the protocol of the bailout so profligate that the “AAA” rating of the United States has been rendered an incorrect but politically expedient label. The U.S. issues its debt in dollars, and if necessary can engage in a silent default by devaluing the U.S. dollar. To some extent, that has already happened.
The U.S. dollar is still the world’s reserve currency. It is also an “intervention” currency, and an “invoice” currency for much international trade. Central banks hold dollars as a reserve, and private agents hold dollar denominated investments. So far, the U.S. has the most well developed short-term financial markets, so when there is a “flight to quality,” which these days means the lessor of other evils, foreigners rush to liquid financial instruments like T-Bills.
Unlike the Yuan, the U.S. dollar is freely exchangeable in most of the world. The U.S. buys its major imports such as oil in dollars. But change is already in process. Iran has said it will accept Yuan for oil. There is talk of oil prices being expressed in a basket of currencies that will include gold. Gold is already being accepted as collateral on derivatives exchanges, and in this sense, gold is now recognised again as money for trading purposes.
The problem for the U.S. is that despite the temporary advantages, the world is diversifying into other currencies, including gold. The Yen and Deutsche Mark (before the Euro) were the former candidates for diversification. Future candidates may be the Yuan and perhaps a new Euro (if Germany prevails in getting its way). That will push up the value of those currencies and push down the value of the dollar.
Even if this doesn’t happen right away, the U.S. is in a weakened state and it is not immune to shocks. Recall the 1973 oil embargo, for example. Oil prices quadrupled overnight and the dollar fell from 350 yen to 250 and from 3.25 Swiss francs to 1.80. Two hour moves eclipsed the previous two decades. Then there was the 1995 U.S. dollar crisis brought about by the “tequila effect” when one of our debtors, Mexico, neared default and had to be bailed out.
When foreigners lose confidence in the United States, they don’t suddenly sell all of their assets or pull out all of their money (although some of that does happen), the immediate effect is a fast fall in the dollar. The Fed has compensated for the explosion in new debt by purchasing government bonds, but this strategy may not be sustainable, and if not, there may be a swift rise in interest rates.
The current “AAA” rating of the United States is not on merit, but it is a convenient fiction for the global financial markets, because no one yet has an alternative. It would be more accurate to say that the United States remains investment grade, because of our current role in the infrastructure of the global economy. Whether or not the rating agencies put an explicit downgrade on the United States is largely irrelevant. The United States has seen huge U.S. dollar fluctuations and higher interest rates in the past, and on its current course will see them again. The fundamentals of the U.S.’s increasing debt load, massive future entitlements, high unemployment rate, and weak economy with no meaningful growth plan speak for themselves.
This commentary has been excerpted from, “Tavakoli Structured Finance Revokes the Credit Rating Agencies’ NRSRO Designation: Issues and Solutions for Restoring Credibility to the Credit Rating Agencies and Rehabilitating the Alternative Banking System,” July 26, 2011.
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