The financial crisis taught crucial lessons about the dangers of bubbles, loose regulation and debt. It’s a pity we didn’t learn.
By Andy Xie 28 September 2009
(Caijing Magazine) Lehman Brothers collapsed one year ago. The U.S. government refused a bailout and warned other financial institutions to be careful. The government felt other institutions had already severed their dealings with Lehman’s investment network, and that a collapse could be walled in.
Little did the government realize that the whole financial system was one giant Lehman. The securities firm borrowed short-term money to punt in risky and illiquid assets. The debt market supported the financial sector, believing the government would bail out everyone in a crisis. But when Lehman was allowed to collapse, the market’s faith was shaken.
The debt market refused to roll over financing for financial institutions. Of course, financial institutions couldn’t unload assets to pay off debts. The whole financial system started teetering. Eventually, governments and central banks were forced to bail out everyone with direct lending or guarantees.
The Lehman collapse strategy backfired. Governments were forced to make implicit guarantees explicit. Ever since, no one has dared argue about letting a major financial institution go bankrupt. The debt market is supporting financial institutions again only because they are confident in government guarantees. The government lost in the Lehman saga, and Wall Street won.
So Lehman died in vain. Today, governments and central banks are celebrating their victorious stabilizing of the global financial system. To achieve the same, they could have saved Lehman with US$ 50 billion. Instead, they have spent trillions of dollars -- probably more than US$ 10 trillion when we get the final tally -- to reach the same objective. Meanwhile, a broader goal to reform the financial system has seen absolutely no progress.
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 an expanding equity capital base rather than shrinking assets. According to the Federal Reserve, total debt for the financial sector was US$ 16.5 trillion in the second quarter 2009 -- about the same as the US$ 16.6 trillion reported one year earlier. After the Lehman collapse, financial sector leverage increased due to Fed support. It has come down as the Fed pulled back some support, creating the perception of deleveraging. The basic conclusion is that financial sector debt is the same as it was a year ago, and the reduction in leverage is due to equity base expansion, partly due to government funding.
Second, financial institutions are operating as before. Institutions led in reporting profit gains in the first half 2009 during a period of global economic contraction. When corporate earnings expand in a shrinking economy, redistribution plays a role. Most of these strong earnings came from trading income, which is really all about getting in and out of financial markets at the right time. With assets backed up by US$ 16.5 trillion in debt, a 1 percent asset appreciation would lead to US$ 16.5 billion in profits. Considering how much financial markets rose in the first half, 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 a 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 involve redistributions from many to a few in zero-sum bubbles. The trick is to get the credulous masses to join the bubble game at high prices. When the bubble bursts, even though asset prices may be the same as they were at the beginning, most people lose 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 U.S. government suspended mark-to-market accounting rules for assets on the books of financial institutions, which has allowed them to report profits.
Revamping the financial system has been reduced to political moves over regulating banker salaries. If this could be done, incentives for financial institutions to manufacture bubbles would be removed. But it can’t be done. Financial professionals can be based anywhere in the world, and there will always be some countries willing to host them. Because of such competitive concerns, a global consensus on regulating pay for financial professionals is unlikely.
I think the ultimate objective for 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. Leverage within a financial system’s assets-to-equity capital ratio is a driving force for an asset bubble. Complex accounting rules and varying treatment of different financial institutions make it difficult to measure leverage. The international standard for a bank’s capital is 8 percent, which allows 12 times leverage. How off-balance sheet assets are treated can make a huge difference. A lot of big banks had 30 times leverage at the beginning of the crisis due to off-balance assets.
Other institutions such as finance companies are harder to regulate. Some industrial companies such as General Electric and General Motors took advantage of loopholes 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 money market funds wreaked havoc after Lehman crashed. These funds are supposed to be ultra safe for buying triple-A, short-term, liquid debt instruments. The problem was their demand for liquidity. Self-manufactured liquidity provided a false sense of security despite the risks of underlying securities, such as short-term paper issued by investment banks. When that false sense of security was jolted by the Lehman collapse, all rushed to 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 leverage in the economy is rising, asset prices rise, too. Rising asset prices boost collateral value and, hence, more borrowing. A surge in earnings among financial institutions usually accompanies such a spiral of rising leverage and rising asset prices.
It is extremely difficult for an established regulatory regime to stop such a spiral. Usually new financial institutions or products come on the scene, and then a new leverage game begins. It would be impossible for an existing regime to be comprehensive enough to anticipate future institutions and products. Governments may need to install principle-based, not just rule-based, regulatory agencies that could take action to control new financial creations.
The U.S. government is proposing a consumer protection agency for financial products. Such an agency could at least respond to new financial products sold to consumers and, therefore, could be an effective mechanism for stopping some future bubbles. The proposal has met vehement opposition from the financial industry. It may not get through.
What can we speak for after spending trillions of dollars? Not much. Few major players went to jail. The U.S. government sent many more to prison in the 1980s after the junk bond bubble burst. This bubble is 10 times bigger. Yet, apart from the most obvious criminals such as Bernie Madoff and Allen Stanford, who ran multibillion-dollar Ponzi schemes, none of the big shots have landed behind bars. Indeed, a lot of the big shots who brought down the world are still out there running things. The lesson from the Lehman collapse seems to be, “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 to take advantage of the crisis and 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, since markets are stable now, there is no need for radical reforms. This is exactly the wrong conclusion. 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 happened is a rapid increase in the U.S. household savings rate. It happened much more quickly than I expected and has the potential to change the global economy. The economic explanation is negative wealth effect. U.S. household net wealth declined 20 percent, or nearly 100 percent of GDP. The rule of the thumb is that it would lead to a 5 percent reduction in spending. The U.S. household savings rate has increased more than that -- and continues to rise. It could rise above 10 percent next year. Because of rising savings, the U.S. 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 rapidly came back in fashion. The drivers are faith in an ever-depreciating dollar and, later, inflation. Stocks, commodities, and even property values in some cities have skyrocketed this year. It is happening amid a synchronous global recession.
Of course, bulls would argue the market recovery is forecasting a strong global economy ahead. I seriously doubt it. With savings and unemployment rising, the OECD bloc is unlikely to stage a strong recovery from the recession. This view is not the market’s consensus, which assumes all stimuli will lead to a strong and sustained recovery. As I have argued before, supply and demand become misaligned during a big bubble. When it bursts, the economy must restructure supply and demand before the economy can be fully employed. Government stimulus can’t solve the problem. Realignment will take time.
Because policymakers mistakenly think stimulus spending can bring back growth, they are pushing too hard. The eventual consequences are inflation and bubbles along the way. These bubbles will be short-lived. The current boom market is a good example. At the beginning of the year, I predicted such a bubble from March to September. I still hold to this belief. China’s stock market peaked in August and the U.S. market 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 the size of its multiplier effect on the economy. A large multiplier effect leads to an economic boom that boosts asset returns. Market watchers can make a plausible case that high asset prices reflect a revaluation rather than a bubble. Strong fundamentals and rising asset prices could sustain each other for a period. The dotcom bubble began in 1996 and lasted five years. The global property bubble began in 2002 and lasted five years, too.
A technology bubble can be extended by cutting costs and boosting profits. A property bubble stimulates demand in many parts of demand and can boost corporate earnings, benefiting financial institutions, retailers, construction companies and material suppliers. This large multiplier effect is why a property bubble usually lasts many years.
Only a multiplier effect from the current bubble is stopping financial institutions from going under. However, weighed down by trillions of dollars in non-performing assets, they cannot lend with abandon again, which makes it impossible to revive property bubbles. Besides, American households won’t join the “borrow-and-spend” game again. Essentially, the main short-term impact of the current bubble is preventing the financial system from collapsing. It won’t lead to substantial demand creation.
Many investors today think a bubble is inevitable and, when it bursts, another can be created quickly to keep on going with life as usual. What has occurred over the past six months seems to validate this viewpoint. History, however, is not kind to this view. Serial bubble making leads to a bigger economic crisis later. What occurred in the United States in the 1930s and Japan over the past two decades are good examples in that regard. If a new bubble were always available for bailouts, we’d have the ultimate free lunch. But there is no free lunch.
Our serial bubble making began 10 years ago with the Asian Financial Crisis. It led to loose monetary policy in developed economies, especially in the United States, and undervalued exchange rates in developing economies. The inflationary force from this loose monetary policy was kept down by excess capacity or capacity creation in developing economies. The environment for tolerating such a loose monetary environment ends when inflation surges in emerging economies first and developed economies second.
When inflation becomes a political problem and policymakers are forced to respond, money supplies will be cut. After that, no more bubbles.
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Why One Bubble Burst Deserves Another
The financial crisis taught crucial lessons about the dangers of bubbles, loose regulation and debt. It’s a pity we didn’t learn.
By Andy Xie
28 September 2009
(Caijing Magazine) Lehman Brothers collapsed one year ago. The U.S. government refused a bailout and warned other financial institutions to be careful. The government felt other institutions had already severed their dealings with Lehman’s investment network, and that a collapse could be walled in.
Little did the government realize that the whole financial system was one giant Lehman. The securities firm borrowed short-term money to punt in risky and illiquid assets. The debt market supported the financial sector, believing the government would bail out everyone in a crisis. But when Lehman was allowed to collapse, the market’s faith was shaken.
The debt market refused to roll over financing for financial institutions. Of course, financial institutions couldn’t unload assets to pay off debts. The whole financial system started teetering. Eventually, governments and central banks were forced to bail out everyone with direct lending or guarantees.
The Lehman collapse strategy backfired. Governments were forced to make implicit guarantees explicit. Ever since, no one has dared argue about letting a major financial institution go bankrupt. The debt market is supporting financial institutions again only because they are confident in government guarantees. The government lost in the Lehman saga, and Wall Street won.
So Lehman died in vain. Today, governments and central banks are celebrating their victorious stabilizing of the global financial system. To achieve the same, they could have saved Lehman with US$ 50 billion. Instead, they have spent trillions of dollars -- probably more than US$ 10 trillion when we get the final tally -- to reach the same objective. Meanwhile, a broader goal to reform the financial system has seen absolutely no progress.
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 an expanding equity capital base rather than shrinking assets. According to the Federal Reserve, total debt for the financial sector was US$ 16.5 trillion in the second quarter 2009 -- about the same as the US$ 16.6 trillion reported one year earlier. After the Lehman collapse, financial sector leverage increased due to Fed support. It has come down as the Fed pulled back some support, creating the perception of deleveraging. The basic conclusion is that financial sector debt is the same as it was a year ago, and the reduction in leverage is due to equity base expansion, partly due to government funding.
Second, financial institutions are operating as before. Institutions led in reporting profit gains in the first half 2009 during a period of global economic contraction. When corporate earnings expand in a shrinking economy, redistribution plays a role. Most of these strong earnings came from trading income, which is really all about getting in and out of financial markets at the right time. With assets backed up by US$ 16.5 trillion in debt, a 1 percent asset appreciation would lead to US$ 16.5 billion in profits. Considering how much financial markets rose in the first half, 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 a 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 involve redistributions from many to a few in zero-sum bubbles. The trick is to get the credulous masses to join the bubble game at high prices. When the bubble bursts, even though asset prices may be the same as they were at the beginning, most people lose 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 U.S. government suspended mark-to-market accounting rules for assets on the books of financial institutions, which has allowed them to report profits.
Revamping the financial system has been reduced to political moves over regulating banker salaries. If this could be done, incentives for financial institutions to manufacture bubbles would be removed. But it can’t be done. Financial professionals can be based anywhere in the world, and there will always be some countries willing to host them. Because of such competitive concerns, a global consensus on regulating pay for financial professionals is unlikely.
I think the ultimate objective for 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. Leverage within a financial system’s assets-to-equity capital ratio is a driving force for an asset bubble. Complex accounting rules and varying treatment of different financial institutions make it difficult to measure leverage. The international standard for a bank’s capital is 8 percent, which allows 12 times leverage. How off-balance sheet assets are treated can make a huge difference. A lot of big banks had 30 times leverage at the beginning of the crisis due to off-balance assets.
Other institutions such as finance companies are harder to regulate. Some industrial companies such as General Electric and General Motors took advantage of loopholes 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 money market funds wreaked havoc after Lehman crashed. These funds are supposed to be ultra safe for buying triple-A, short-term, liquid debt instruments. The problem was their demand for liquidity. Self-manufactured liquidity provided a false sense of security despite the risks of underlying securities, such as short-term paper issued by investment banks. When that false sense of security was jolted by the Lehman collapse, all rushed to 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 leverage in the economy is rising, asset prices rise, too. Rising asset prices boost collateral value and, hence, more borrowing. A surge in earnings among financial institutions usually accompanies such a spiral of rising leverage and rising asset prices.
It is extremely difficult for an established regulatory regime to stop such a spiral. Usually new financial institutions or products come on the scene, and then a new leverage game begins. It would be impossible for an existing regime to be comprehensive enough to anticipate future institutions and products. Governments may need to install principle-based, not just rule-based, regulatory agencies that could take action to control new financial creations.
The U.S. government is proposing a consumer protection agency for financial products. Such an agency could at least respond to new financial products sold to consumers and, therefore, could be an effective mechanism for stopping some future bubbles. The proposal has met vehement opposition from the financial industry. It may not get through.
What can we speak for after spending trillions of dollars? Not much. Few major players went to jail. The U.S. government sent many more to prison in the 1980s after the junk bond bubble burst. This bubble is 10 times bigger. Yet, apart from the most obvious criminals such as Bernie Madoff and Allen Stanford, who ran multibillion-dollar Ponzi schemes, none of the big shots have landed behind bars. Indeed, a lot of the big shots who brought down the world are still out there running things. The lesson from the Lehman collapse seems to be, “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 to take advantage of the crisis and 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, since markets are stable now, there is no need for radical reforms. This is exactly the wrong conclusion. 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 happened is a rapid increase in the U.S. household savings rate. It happened much more quickly than I expected and has the potential to change the global economy. The economic explanation is negative wealth effect. U.S. household net wealth declined 20 percent, or nearly 100 percent of GDP. The rule of the thumb is that it would lead to a 5 percent reduction in spending. The U.S. household savings rate has increased more than that -- and continues to rise. It could rise above 10 percent next year. Because of rising savings, the U.S. 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 rapidly came back in fashion. The drivers are faith in an ever-depreciating dollar and, later, inflation. Stocks, commodities, and even property values in some cities have skyrocketed this year. It is happening amid a synchronous global recession.
Of course, bulls would argue the market recovery is forecasting a strong global economy ahead. I seriously doubt it. With savings and unemployment rising, the OECD bloc is unlikely to stage a strong recovery from the recession. This view is not the market’s consensus, which assumes all stimuli will lead to a strong and sustained recovery. As I have argued before, supply and demand become misaligned during a big bubble. When it bursts, the economy must restructure supply and demand before the economy can be fully employed. Government stimulus can’t solve the problem. Realignment will take time.
Because policymakers mistakenly think stimulus spending can bring back growth, they are pushing too hard. The eventual consequences are inflation and bubbles along the way. These bubbles will be short-lived. The current boom market is a good example. At the beginning of the year, I predicted such a bubble from March to September. I still hold to this belief. China’s stock market peaked in August and the U.S. market 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 the size of its multiplier effect on the economy. A large multiplier effect leads to an economic boom that boosts asset returns. Market watchers can make a plausible case that high asset prices reflect a revaluation rather than a bubble. Strong fundamentals and rising asset prices could sustain each other for a period. The dotcom bubble began in 1996 and lasted five years. The global property bubble began in 2002 and lasted five years, too.
A technology bubble can be extended by cutting costs and boosting profits. A property bubble stimulates demand in many parts of demand and can boost corporate earnings, benefiting financial institutions, retailers, construction companies and material suppliers. This large multiplier effect is why a property bubble usually lasts many years.
Only a multiplier effect from the current bubble is stopping financial institutions from going under. However, weighed down by trillions of dollars in non-performing assets, they cannot lend with abandon again, which makes it impossible to revive property bubbles. Besides, American households won’t join the “borrow-and-spend” game again. Essentially, the main short-term impact of the current bubble is preventing the financial system from collapsing. It won’t lead to substantial demand creation.
Many investors today think a bubble is inevitable and, when it bursts, another can be created quickly to keep on going with life as usual. What has occurred over the past six months seems to validate this viewpoint. History, however, is not kind to this view. Serial bubble making leads to a bigger economic crisis later. What occurred in the United States in the 1930s and Japan over the past two decades are good examples in that regard. If a new bubble were always available for bailouts, we’d have the ultimate free lunch. But there is no free lunch.
Our serial bubble making began 10 years ago with the Asian Financial Crisis. It led to loose monetary policy in developed economies, especially in the United States, and undervalued exchange rates in developing economies. The inflationary force from this loose monetary policy was kept down by excess capacity or capacity creation in developing economies. The environment for tolerating such a loose monetary environment ends when inflation surges in emerging economies first and developed economies second.
When inflation becomes a political problem and policymakers are forced to respond, money supplies will be cut. After that, no more bubbles.
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