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Between a terrible option and a catastrophic one in financial affairs

An interview with the analyst Peter Cohan, September 20

Understanding the roots of the two weeks crisis of Sept 11-19

Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm, based in Boston, USA

This was an incredible week! Some will say it was the worst week for financial markets since 1929. We went from an ugly mood in the first half to euphoria in the second half. Stock markets went down in the US, Europe and Japan, and crash violently in Russia, Brazil and Shanghai. Then, we had a miracle Thursday afternoon and Friday. The stock market ended the week reacting joyously – just saw the pictures published by the media from the traders’ corners.

The first half of the week showed a terrible reality: amidst an utter lack of confidence in the financial markets, private and institutional investors with liquidity and famous sovereign wealth funds were no longer willing to supply needed capital – high finance people no longer know what exactly they are investing in, nobody knows what anything really is worth. May be it’s trash - dot. We have around to many nervous sellers and not enough confident buyers. And that’s a true drama for the all system.

With the tsunami at the gates of Wall Street and around the financial global network, the US FED chairman Mr. Ben Bernanke, Treasury Secretary Mr. Henry Paulson Jr. and SEC (Securities and Exchange Commission) Chairman Christopher Cox engineered an emergency rescue hyper package. They tell the US Congress and the President Bush that the other option will be chaos and global panic. A few analysts claimed that may be they do not know exactly what will be the feedback and outcomes in medium and longer term from this pricey, trillionaire plan. And probably they do not target the right roots. Peter Cohan in this interview points out that the American Financial Czars and the Politicians moves in a true dramatic dilemma – the problem is their dilemma impacts in all of us around the Planet. Peter hopes that the “terrible” option – better than the other one – will restore confidence. If not, we will have big trouble worldwide,soon.

Summarizing the all big plan:

- Immediate action: kill the short-selling ‘bandits’ (for the moment until Oct.2 in the US), even if we know that in July and August short interest in financial stocks declined by 20 per cent!

- The centerpiece: A state agency (a remake of the Resolution Trust Corp of the savings and loans crisis of the 1980’s and 1990’s) to be created soon will clean all the toxic trash off the system and pay for it with tax payer money – may be from 500 or 700 billion dollars to 1 trillion, who knows! Congress could begin considering legislation to enable the program next week.

- Money around the world: Pumping a record 300 billion dollars into global financial markets, a plan orchestrated with the other central banks of the OECD.

Interview

How suddenly the tsunami was reversed last week almost at the last minute?

Peter Cohan: The sudden shift at the end of the week had to do with three policy changes: First, there was the announcement of a proposal for the government to buy illiquid assets from banks – these assets are a source of all the financial failure.  Second, the government banned short selling for two weeks on 799 financial stocks – this forced short sellers to go into the market and buy stock to repay the lenders who let them borrow the stock at the beginning of their trades.  Third, the government announced a $50 billion fund to provide a guarantee for money market funds.

It seems it will be a huge shower of dollars around. Until when will last this medicine?

PC: I think it will not be enough to cover all the problems.  For instance, the estimate for the RTC (Resolution Trust Corp) II – what I will refer to as the entity that will be discussed this weekend to buy up the illiquid assets – will need to be enormous to buy up all the illiquid assets.  But the estimate floated this morning was $500 billion.  There are at least $13 Trillion worth of illiquid assets — $6.9 trillion worth of mortgage-backed securities and another $6.1 trillion of Collateralized Debt Obligations (CDOs).

1^st conclusion: “There are two options at this point: terrible or catastrophic”

Politically speaking, we saw the shift from neutrality to total bailing out engineered by state financial institutions “nationalizing” insurers and lenders, given tax payer money to default institutions. Has the FED and the Treasury other options? Or they are jailed in a financial strategic dilemma?

PC: There are two options at this point: terrible or catastrophic.   Terrible means using trillions of taxpayer money to keep the global financial system from collapsing.  Catastrophic means doing nothing and letting the global financial system freeze up – this would mean there would be no money in people’s bank accounts, no value in their retirement accounts, no lending to businesses or individuals – in short – utter economic chaos.  Nobody in Washington has explicitly uttered these words on the record but I am inferring that Paulson told Congress something along these lines and Congress believed him.

2^nd conclusion: “Banning short selling does provide a temporary reprieve”

Analysts and politicians elected a target – the short sellers’ guys. SEC will ban these types of operations covering 799 stocks until midnight October 2.  The British will do that until January. Short-selling is the bandit responsible for this crash? This temporary legislation will attack the roots of the financial crisis?

PC: No – but banning short selling does provide a temporary reprieve.  There was a brilliant negative feedback loop that short sellers were pushing along – and they were profiting handsomely in the bargain while driving Wall Street firms into bankruptcy or into the hands of merger partners. Hedge funds and others shorted the Wall Street banks. As their prices dropped, the ratings agencies threatened to lower their debt ratings.  The threat of lower ratings required the Wall Street banks to raise more capital.  This threat also caused the premiums they had to pay to insure their debt to rise – in some cases seven fold in a week.  These sudden changes forced the banks to go out and raise tens of billions of dollars.  When the capital was not immediately forthcoming, their stock prices plummeted.  Then the ratings agencies pulled the trigger by lowering the ratings – and driving the companies out of business.  The shorts accelerated this process and profited from it.

Do you think the independent investment banking segment will be taken over by the big commercial banks from US and abroad?

PC: I think there is a chance that the latest moves will help some of the investment banks to survive.  Merrill Lynch shareholders might decide that it is better off not being acquired by Bank of America.  Morgan Stanley may slow down its urge to merge.  And Goldman Sachs may be able to survive as a standalone entity.

3^rd conclusion: “This episode should mark the end of securitization”

Are we near the end of all the so-called innovative financial instruments which fed a complex array of company board tricks, subjective ratings agencies, off-balance sheet manipulations and a larger group of «rentier» agents?

PC: I think that this episode should mark the end of securitization – the practice of bundling individual loans, wrapping them in an AAA rating, and selling them to investors.  The problem with securitization is that there is no way to put a value on the securities because there is not enough information about the individual loans.  If investors had detailed, specific, accurate, and timely information about each individual loan in the bundle, then it might be possible to value the securities and the process of securitization could survive.  If not, it should perish.

Can this shadow banking system – born with magician Alan Greenspan – go offshore for countries with looser laws, geopolitical strategic hidden agendas and a hot market of liquidity?

PC: It might go offshore as long as those countries don’t incur any financial risk if the trades go bad.

4^th conclusion: “Greenspan was a big supporter of securitization which is an enormous part of the current problem”

Alan Greenspan and his policies as FED chairman throughout the 1990’s and the first half of the 2000’s are the great architects of this mess?

PC: Alan Greenspan certainly deserves some of the blame.  His contribution to this mess include his actions to bail out markets when they failed – this created a perception that deregulation of financial services was viable both as a way to enrich Wall Street and as good social policy.  Although markets failed many times during his tenure – such as the 1987 crash and the collapse of long-term capital management – his skills at bailing out the markets created the false impression that the Fed could bail out any problem and therefore it was OK to take big risks to get big bonuses.  Second, Greenspan was a big supporter of securitization which is an enormous part of the current problem. This week Washington will debate a plan to buy up the toxic waste that securitization produced.  Its cost will probably be at least $1 trillion – it will dwarf any government rescue plan ever created.  And without securitization, this would not have been necessary.

^5th conclusion: “Deregulation is dead politically. The irony is that Bush is the one who is driving a stake into its heart”

Is there an ideological consequence for this political option for the “terrible” measures using the tax payer money, so-called “socializing” the financial trash and temporary “nationalizing” private assets?

PC: Since Ronald Reagan, there has been a push towards deregulation. That idea is dead politically.  And the irony is that Bush – who likes to see himself as the reincarnation of Reagan – is the one who is driving a stake into its heart.  Some new regulatory structure will emerge from this and there is no well-established set of talking points on either side of the aisle for what this structure will look like.

What are the political consequences?

PC: As far as the November election, it appears that the financial crisis strengthens Obama’s position compared to where it was just before.  Instead of debating Sarah Palin’s lipstick, people in the country are realizing that they could lose their savings, their jobs, and their houses.  They are starting to ask whether John McCain is mentally up to the task or re-architecting the global financial system.

6^th conclusion: “The costs of doing nothing would be even worse”

With all this money around, inflation will jump and the stagflation scenario is more likely?

PC: Traditional ways of thinking about increases in the money supply and inflation seem to be suspended when this type of financial crisis emerges.  The basic problem is that the key players in the financial system – consumers, businesses, investors, and banks are losing confidence and don’t want to play anymore.  They are all afraid that if they do the things they are used to doing – such as depositing money in a bank and trusting that it will be there; putting funds into an investment and expecting that it will earn an attractive return; lending money to another bank or to a company and getting that money paid back with interest – all these activities are now seen as too risky to undertake. The U.S. has decided that one way to restore confidence in this system is to tell the public that it will use its money to cover any losses.  If this promise restores confidence and the system starts to function again, then things will be fine.  In fact, it is too early to tell how much money will actually be added to the supply through these government moves.  Most of the big figures thrown around are the maximum amount that could be spent — they do not take into account the proceeds from the sale of assets that would reduce the final cost to taxpayers. Having said that, it is likely that massive amount of additional money will be added.  But the costs of doing nothing would be even worse.  Probably it would lead to global panic – people trying to get their money out of banks and money market funds and not being able to do so (this already happened with people who hold some of the $330 billion worth of Auction Rate Securities-ARS); lenders demanding their money back and finding it is not there; and investors selling their securities and withdrawing the proceeds. It is hard to put a cost on a global panic – but it does not take too much imagination to realize that these events could lead to the dissolution of governments and social order. So there is a risk of inflation but my guess is that if we make it out of this situation with some order, there will still be a nasty economic slowdown which will reduce demand for goods – thus the risk of inflation might be less and prices could actually drop until supply adjusts downward.

But do you think this Paulson’ plan will work? If not, if you are suspicious about his reverse auction strategy, what would fix the problem?

PC: A better option - using taxpayer money to recapitalize our banks. Why? Banks need capital. Washington DC pushed the banks to raise it from foreign governments. After loosing money on their initial investments, those foreign governments are no longer willing to take that risk. In exchange for that state capital injection, taxpayers will get their equity at today’s low prices. If the economy recovers, we can sell those equity stakes to the public at far higher prices and recoup that taxpayer money. The Democratic proposal is moving in this direction as it discusses giving the Government so-called contingent shares in exchange for financial assistance. I think BusinessWeek offers an excellent critique of Treasury Secretary Henry Paulson’s $700 billion plan. But more importantly, it proposes a solution that could be just what we need to solve the problem — recapitalizing the strongest banks and letting the weakest merge or fail.

© Jorge Nascimento Rodrigues, 2008