- In the past few weeks we have watched frantic movement
of the Federal Reserve and the US Treasury to stanch the financial bleeding
of major American financial institutions that gambled quite freely on
a gigantic pyramid. If asked, any official of one of those institutions
might look you in the eye and say "there is no pyramid," then
explain that what they did was produce securities that were based on reasonable
risks backed by collateral of the most reliable form: mortgages on identified
parcels of developed American real estate." Indeed, the real estate,
per se, was not the problem.
-
- However, their paper was not land titles or mortgage
documents themselves; it was a security backed by bundles of so-called
"sub- prime" mortgages, but the bundles-based securities had
received AAA, that's triple A ratings by the country's leading rating
agencies. Those ratings were based on the apparent notion that bundling
the underlying mortgages would spread the risks of loans to "subprime"
borrowers, and in any case it would take a bundle of defaults for the
risks to be significant. The ratings, as it emerged after the fact, were
also made by organizations that had a vested interest in the outcome.
-
- After that balloon burst, in a late March 2008 interview
with Deborah Solomon for the New York Times, former Treasury Secretary
Paul O'Neill blew the raters' assertions out of the water by saying:
"If you have 10 bottles of water, and one bottle had poison in it,
and you didn't know which one, you probably wouldn't drink out of any
of the 10 bottles." By this measure, the ratings themselves were
a sham. Bundling would be risk enhancing, not risk mitigating, and that
is the way markets for those securities have responded to defaults.
-
- From the beginning the high risk mortgages in the bundles,
many written
- for a favorable "come on" rate to the borrower,
were scheduled to move upward to higher interest rates. Over time, average
returns on these mortgages would be greater than that of fixed rate mortgages;
that represented good business for the lenders, and of course for their
hedge fund collaborators. It was an incredible pyramid built not on the
Giza stone that would make it last for millennia, but on the sands of
economic vulnerability and risk that would bring us to where we are. Through
an incredible permutation, high risk loans at the lender-borrower level
were transformed into allegedly risk-free and highly profitable CDOs (collateralized
debt obligations) at the top.
-
- To be sure, the probability that one of a bundle of ten
mortgages might go belly up was materially higher than the risk that all
ten would fail, so bundling appeared to be a risk mitigation strategy.
However, that risk mitigation potential was intrinsically low because
all ten were in a high risk, sub-prime category for which a default could
be triggered by an economic slowdown, worst case a recession, or significant
increases in mortgage interest rates. Those higher rates began to kick
in at about the same time an economic slowdown caused real estate values
to falter. Facing higher interest rates and disappearing equity, borrowers
began to default in large numbers. At that point, at least in market
perception, the AAA-rated bundles were suddenly worthless. The problem
was compounded by a surge in defaults on fixed rate mortgages that also
was triggered by sharp declines in the market value of the properties
involved.
-
- As real estate values-the heart of most personal asset
pools-went galley west, it was time for everybody to register shock and
for affected financial institutions to run for cover. However, the immediate
official concern was not about homeowners but about the builders of the
sub-prime pyramid. As IMF analysts put it in their March 2008 World Economic
Outlook, the United States was "plagued by profound errors in risk
management among its leading financial institutions."
-
- While we taxpayers were never asked, the Fed and Treasury
moved briskly to bail out one of the major gamblers, Bear Stearns, to
the tune of $19 billion that we are unlikely ever to see again. In the
above-cited New York Times interview, Paul O'Neill also shot down that
maneuver, saying: "They saved the financial system from a panic collapse.
I reject the notion that they helped Bear Stearns. Bear Stearns was destroyed."
He may be right in the sense that Bear Stearns may never recover from
the loss of market confidence in its judgment, but if the bailout actually
staved off a financial collapse, our money may have been well spent.
-
- However, Bear Stearns was not alone. Too many people
had put too many eggs in one speculative basket. Even the peaks of the
pyramid builders, Citibank, Morgan-Stanley and others, wrote off multi-
billion dollar exposure strings that would boggle the mind, while a stock
market built on the unrealistic profitability of such gambling, threatened
to collapse if its wanton expectations were not assuaged. As reported
in Timesonline, the Wachovia bank suddenly had to raise $8 billion to
cover losses, heavily in the California sub-prime market. According to
a Wachovia official, "the propensity to default rises dramatically
once equity in a borrower's property falls to zero". That propensity
appears to have applied with equal rigor to more affluent fixed rate mortgage
borrowers.
-
- The damages were not confined to the United States. The
sub-prime based securities were attractive to foreign investors as well.
In truth the crisis is a vivid demonstration of how easily both risks
and opportunities move in today's international markets. British, German,
French, Japanese and other banks had bitten into this sweetbread, and
they were now carrying bundles of this paper that marketwise were worthless
and asset wise represented a mess of bad investment judgment calls that
had to be explained to shareholders. In a report on the global implications
of this crisis, the Global Financial Stability Report (GFSR) of the International
Monetary Fund, IMF analysts estimated that the global losses associated
with or otherwise contributing to the crisis approached a trillion dollars,
the great bulk but not all of it in the United States.
-
- Assessment of this crisis and what to do about it dominated
discussions in meetings this past weekend of the International Monetary
Fund (IMF) and the World Bank in Washington, with discussions of the advanced
economy Group of Seven on the side. The IMF report appears to have dominated
the discussion without leading to any fresh courses of action for dealing
with the crisis. That was because each G-7 member-and others to be sure-naturally
sought to protect its own position in the matter, while the general opinion
appears to have been that it was mostly up to the United States to clean
up its own mess, even if others had to clean up pieces of it. As the Governor
of the People's Bank of China put it in his written statement, "The
biggest risk to the global economy remains the financial crisis emanating
from the U.S. sub-prime mortgage sector." He may have said that looking
uncomfortably over his shoulder at China's trillion dollar plus foreign
exchange holdings, mostly in dollars.
-
- The crisis has underscored the increasingly discomfiting
reality that the global financial system consists of an aggregate of
national systems that do not add up to a global financial manager. The
IMF and the World Bank, originally created in 1945 with a view to provision
of global financial management, have not gotten very far. Sixty plus years
later, there still is no international banker or lender of last resort.
More depressing, there is no global banking rule maker or regulator. The
global system is actually based on the coincident, case by case evolved
compatibility of nearly 200 national systems.
-
- But there is more to the story. The sub-prime crisis
grew in the context of real and portentous developments across global
trade, financial and economic systems. The Fed, Treasury and Wall Street,
distracted by their own crisis, probably have had little time to focus
on the tectonic plate shifts in the global system that probably mean they
cannot go home again. The epicenters of international trade and finance
simply are shifting. In essence, a good part of the wealth that might
be needed to finance a recovery is in the wrong places or pockets, mostly
in Asia, and when the dust settles, the global configuration will be different.
-
- Some say the first effects of the crisis will be downsizing
or consolidation. That would mean the write-offs of major institutions
would just disappear, making the global asset pool cleaner but smaller.
That could also mean that the great bulk, if not all of the transactions
of banking and other financial institutions would show up on their books,
making the system transparent by shedding a multitude of off balance sheet
transactions that dominated the sub- prime securities mess.
-
- Whatever the approaches, the system is unlikely ever
to be the same again, because the facts underlying global developments
are profound. For starters, the solutions do not lie merely with changes
in liquidity. They lie with recognition and adjustments around real changes
in global economic structures including the scale and distribution of
productivity and wealth. The sub-prime crisis simply adds to the adjustments
already made necessary by those global changes.
-
- The first base in this new configuration is what has
been happening to the dollar. Mirroring the dynamics and strength of the
American economy, the dollar has been the dominant world currency ever
since World War II. It has served as medium of exchange, as the core of
many personal asset hoards, and as a reserve currency for countries with
weak or US trade-linked national monetary systems. Of long term importance,
international oil prices have been stated in dollars, a nod both to the
historic strength of the dollar and the dominant US roles in oil trade.
-
- However, as other economies have grown, diversified and
prospered the dollar has faced rising competition from the Japanese Yen,
then the Euro and, most recently, from the Chinese Renmembi or Yuan and
the Brazilian Real. These new challenges reflect both the growing global
strength of other economies and accumulating flaws in the strength of
the American economy, notably continuing Federal deficits, rising international
debt and growing import dependence. Those developments weakened the Dollar
by exposing it to the competition of other currencies, reduced its traditional
role as a stabilizing international trade benchmark, and sent its value
plunging as resource prices rose in response to increasing global demand
for oil and industrial materials.
-
- To the degree that the United States is able to reduce
its debt, curb its appetites for imported goods, adjust its affluent
lifestyles, extricate itself from absurd levels of military expenditure,
and restrain inflation, in short, put its economic house in order, declines
in the value of the Dollar can be mitigated. However, the declining role
of the Dollar in the world economy appears persistent.
-
- Moreover, the exposure of Americans to foreign exchange
risks they never experienced before is an already visible consequence
of the change. The as yet incomplete Iranian and other oil exporter efforts
to switch to Euro-denominated oil prices will only make US exchange risk
exposure worse. Whereas the United States in the past has enjoyed comfortable
trade surpluses while trading partners carried discomfiting deficits,
the shoe is now tightly on the other foot.
-
- These gross shifts have been developing for decades.
In every year since 1990 real GDP growth in leading developing countries
has been faster than in advanced countries. In the years since the mid-1990s,
China has grown faster than either the United States or the European Union
and it has overtaken Japan as the global second place national economy.
Those tendencies have grown since the beginning of the new century. In
terms of GDP stated at purchasing power parity, the United States is now
not only behind the European Union, it is being rapidly overtaken by Asian
economies. World Bank estimates show that the Asian combination of China,
Japan and India exceeds the United States and is breathing down the neck
of the European Community for global first place. With the numbers for
smaller Asian economies such as Malaysia, Asia is already globally in
the lead.
-
- Estimated GDP in 2007 at Purchasing Power Parity
-
- (Billions of Current Dollars)
-
- World - 65,820
-
- European Union 14,450
-
- United States 13,860
-
- China 7,043
-
- Japan 4,346
-
- India 2,965
-
- Germany 2,833
-
- United Kingdom 2,147
-
- Russia 2,076
-
- France 2,067
-
- Brazil 1,838
-
- Italy 1,800
-
- This list of ten accounts for more than 80% of world
GDP, while the United States alone accounts for 20%. As a rude benchmark
of the change, in the early 1990s the United States accounted for 30%
or more of global GDP. That means the relative weight of the US in the
world economy has declined in a decade by roughly the GDP (at purchasing
power parity) of China and India combined.
-
- These developments affect every political, economic and
financial calculation for the future. The most unfortunate feature of
the immediate crisis is that it was precipitated by a combination of
greed and runaway risk miscalculation. It probably cannot be rectified
without substantial losses by many financial and banking institutions,
not all of them large and multinational. It has already caused enormous
hardship for a multitude of homebuyers, and in a recessionary period there
is more of that to come. This is as much a crisis of expectations as it
is a problem of ability to pay. The default on fixed rate mortgages is
due to diminished expectations, the loss of asset value.
-
- It remains to be seen whether the bailouts being contemplated
in Washington will rescue the institutions involved or the homebuyers.
Advance signals indicate the institutional players will fare best, and
one hopes they will emerge leaner and more prudent. At the same time,
it seems clear enough that the best interests of troubled homebuyers lie
with a solution that enables them to hold on to their real estate and
wait out the restoration of their equity as markets rebound. It also remains
to be seen to what extent the crisis will result in more effective regulation
and oversight of banking and other financial institutions, including the
rating organizations who blessed the sub-prime fiasco with AAA ratings.
There were lessons learned on all sides here, but they will take some
digesting.
-
- Global changes may be slowed while this American misadventure
works itself out. But those global changes are pervasive and enduring.
It is not in the interest of humanity at large to have the development
of other economies truncated by American efforts to feed its excesses.
The elitist reaction to that might be the famous remark of Marie Antoinette
"Let them eat cake." However, in a world where easily half of
humanity is hungry and a slice of that population wants to correct the
defect by violent means, assuring that there is enough to feed everybody
is the more humane and prudent choice. Aggravating food scarcity by turning
basic foodstuffs into motor fuel is neither an economic nor a humanitarian
response. It does show that in a pinch national needs take precedence
over global ones.
-
- America's real choices and opportunities have evolved
in a compelling fashion over the years since World War II. As the most
advanced nation left standing at the end of that conflict, The United
States saw work to do. The home agenda was to bring itself out of a war
economy and into a peacetime environment. The foreign policy agenda was
to promote and support the recovery of post war Japan and Europe and,
in some measure, their surroundings. Happily, those two agendas combined
at the level of good policy is good business. The country had virtually
automatic markets for everything it could produce. Altruism and self interest
combined in a most productive manner. The relatively affluent American
society was a natural dividend, and it remained so, even as the restored
economies became increasingly productive and competitive.
-
- But things began to change, especially with the end of
the Cold War. The containment strategy that ultimately dominated the US
Cold War posture actually provided an umbrella for potentially pre- emptive
military moves that positioned the US virtually everywhere any economic
resource of importance could be had. The altruistic agenda slowly fell
behind the self-interested one as global resource procurement and market
competition became more forceful.
-
- When the Project for the New American Century (PNAC)
surfaced in the early Bill Clinton presidency with plans to invade Iraq
and with a global military power agenda, the altruistic side of American
foreign policy had pretty well atrophied. The game had become power maintenance
by military dominance. The PNAC designers appeared to have no clear-cut
economic agenda, but their military scheme, if it succeeded, would have
provided more than adequate cover for a self-centered and pre-emptive
resource acquisition strategy. As perceived by other advanced and advancing
nations, this scheme drove 21^st century global resource acquisition
strategies toward a nineteenth century capitalist model. One only has
to look at Darfur, the Congo, Zimbabwe, and much of Central Asia as well
as the Middle East to see how neo-colonial present day resource acquisition
has become.
-
- That others, e.g., China, India, Brazil, other advancing
countries, are coping more or less successfully with this resource acquisition
environment is part of America's current problem set. Prices are rising
globally for virtually everything. In the case of foodstuffs, the increases
are devastating. This faces US policy makers with across the board price
inflation for most goods and services at a time when the US economy is
diving toward a recession made worse, if not actually driven, by the sub-prime
mortgage crisis.
-
- The global tragedy of the sub-prime mess is that the
securities that were designed to exploit the eventual high rates of return
on those mortgages were of little to no benefit to global economic advancement.
What their failure has done is to seriously distract US policy managers
from the vital business of working through the large and fundamental changes
that are occurring in the US economic environment. In the end, the sub-prime
mess is likely to accelerate the transition of the US economy to a new
position in the global system. Unless several major world economies-Japan,
European Union, China, India, Brazil, and others-suddenly contract instead
of continuing to grow at faster than US rates, the US weight in the global
system will continue to decline; the Dollar will continue to play a reduced
role in the global trade and payments system.
-
- Such is the price of success. An economic diversification
that the United States led through the early post World War II years has
now caught on. The only thing that could prevent the US role in this
future system from declining would be for the rest of the system to fail.
The real policy challenge for US leadership therefore is to face this
prospect, assess the realistic weight of the United States in likely future
configurations, and try to maximize the US opportunity in them.
-
- A military power strategy won't cut it. We are already
going deeply into debt to sustain the present military posture. Other
countries are not enamored of a US trying to run the world at the real
or implied point of a gun. The system now needs truly global leadership.
The United States can lead in that direction, helping to create and strengthen
the institutions that will provide global leadership in the common interest.
It is not leading now; it is forcing or trying to force global conformity
to a self-centered US model, and that strategy eventually will fail. Such
failures as the sub-prime fiasco only hasten the time when the present
US model must be abandoned.
-
- ***********
-
- The writer is the author of the recently published work,
A World Less Safe, now available on Amazon, and he is a regular columnist
on rense.com. He is a retired Senior Foreign Service Officer of the US
Department of State whose major postings included economic centers such
as Cairo, Calcutta, Manila and Sao Paulo. He also served as Chairman of
the Department of International Studies of the National War College and
as Deputy Director of the State Office of Counter Terrorism and Emergency
Planning. He holds a Master's degree in political science and economics
from San Jose State University and on assignment for State he did graduate
study in development economics at Berkeley. He will welcome comment at
<mailto:wecanstopit@charter.net>wecanstopit@charter.net
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