6 May 2009


Henry Lui

By its role of lender of last resort to an irresponsible, dysfunctional banking system, the Fed has essentially banished free markets from the financial sector. Worst yet, the Fed has in the past two decades mutated into a lender of first resort, by providing high-power central bank money to commercial banks to create bank money based on fractional reserve to feed a debt bubble the eventually burst in 2007. Structured finance enabled banks to securitize risky loans and remove them from their balance sheets by selling them in globalized credit markets. Non-bank financial institutions in the so-called shadow banking system could monetize their liabilities through debt securitization and sell the collateralized debt obligation as risk-compensatory securities to investors.

I warned in 2002,
... assessment of risks is complicated by recent structural financial developments in the advanced nations' financial systems, including increasing global market power concentration in large, complex banking organizations (LCBOs), the growing reliance on over-the-counter (OTC) derivatives and structural changes in government securities markets. Despite all the talk of the need for increased transparency, these structural changes have reduced transparency about the distribution of financial risks in the global financial system, rendering market discipline and official oversight impotent.

Even blue-chip global giants such as GE, JP Morgan/Chase and CitiGroup have overhanging dark clouds of undisclosed off-balance-sheet risk exposure. Ironically, banks in emerging markets are penalized with disproportionate risk premiums when they fail to meet arbitrary BIS Basel Accord capital requirements, while LCBOs with astronomical risk exposures in derivatives enjoy exemption from commensurate risk premiums. (The auto giants were not mentioned because even in 2002, they were no longer considered as blue-chip companies. See The BIS vs national banks Asia Times Online, May 14, 2002).

Alan Greenspan, as chairman of the Fed from 1987 to 2006, proclaimed in 2004: "Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose, as we noted in our mid-1999 congressional testimony, to focus on policies to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion."

By "the next expansion", Greenspan meant the next bubble, which manifested itself in housing. The "mitigating policy" was another massive injection of liquidity into the US banking system. There is a structural reason that the housing bubble replaced the high-tech bubble. Houses cannot be imported like manufactured goods, although much of the content in houses, such as furniture, hardware, windows, kitchen equipment and bath fixtures, is manufactured overseas. Construction jobs cannot be outsourced overseas to take advantage of cross-border wage arbitrage. Instead, some non-skilled jobs are filled by low-wage illegal immigrants.

Total outstanding home mortgages in 1999 were US$4.45 trillion and by 2004 this amount grew to $7.56 trillion, and by 2007 to $11.2 trillion, most of which was absorbed by refinancing of higher home prices at lower interest rates. When Greenspan took over at the Fed in 1987, total outstanding home mortgages stood only at $1.82 trillion. On his watch, outstanding home mortgages quadrupled. Much of this money has been printed by the Fed, exported through the trade deficit and re-imported as debt. (See Greenspan, the Wizard of Bubbleland, Asia Times Online, September 14, 2005.)

When time comes for the Fed to "mitigate the fall out", the Fed is not the lender of last resort to the average private citizens in whose name it derives its money creation power. While the Treasury takes money from private citizens in the form of taxes, only banks can receive sovereign credit support from the Fed - not surprisingly, since the Fed, while enjoying the state-granted power to create high-power money, is a private entity owned and run by its member banks.

Normally, in a free market, when a financial institution gets itself into financial trouble, the party coming to its rescue would have the right to take over ownership of the distressed institution and be entitled to all future profit after the rescue. That is the basic rule of the game of capitalism: you default on your liabilities; you lose your company to the party that bails you out. Only when no private party steps in as rescuer because of the unappetizing prospect of future profit would the government act as a rescuer of last resort with taxpayer money. It is not nationalization; it is just business, albeit for the common good.

Henry C K Liu is chairman of a New York-based private investment group. His website is at http://www.henryckliu.com.


No comments: