The Thought of Chairman Liu

The diagnosis misjudged the current credit crisis as only a temporary liquidity quandary instead of recognizing it as a systemic insolvency.

The misdiagnosis led to a flawed prognosis that the liquidity crunch could be uncorked by serial injections of more government funds into intractable credit and capital market seizure. This faulty rationale was based on the fantasy that distressed financial institutions holding assets that had become illiquid could be relieved by wholesale monetization of such illiquid asset with government loans, even if such government loans are collateralized by the very same illiquid assets that private investors have continued to shun in the open market. Its not that government officials knows more than market participants about the true value of these illiquid assets; it is only that government officials with access to taxpayer money have decided to ignore market forces to artificially support asset overvaluation, the original root cause of the problem. Instead of being the solution, the government with flawed responses backed by the people’s money has become part of the problem.

Bear Stearns and the failure of the repo market debt

For example, the trigger point behind Bear Stearns’s near failure came from the repo market where banks and securities firms routinely extend and receive short-term loans, typically made overnight and backed by top grade securities. Hours before 7:30 am on March 14, 2008, Bear Stearns was faced with the problem of not being able to roll over its huge repo debt because its high-rated collaterals had fallen in market value. If the firm did not repay the maturing debt on time with new funds from new repo contracts, its creditors could start selling the collateral Bear had pledged to them at fire sale prices to cause substantial loss to Bear Stearns. The implications would go far beyond losses for Bear Stearns. The sale receipts might not repay all investors and cause losses to conservative institutional investors such as pension funds and money market funds. If investors begin to question the safety of loans collateralized by triple-A securities they make in the repo market that are now worth less than their face value, they could start to withhold funds from the credit market when other investment banks and companies need to roll over their maturing short-term debts. Hundred of firms would default and fail from a seizure of the $4.5 trillion repo market, bringing down banks which have issued standby credit to them in a financial chain reaction.

the Logic of Repo Failures

As with other financial markets, repo markets are subject to credit risk, operational risk and liquidity risk. However, what distinguishes the credit risk on repos from that associated with uncollateralized instruments is that repo credit exposures arise from volatility (or market risk) in the value of collateral. For example, a decline in the price of securities serving as collateral can result in an under-collateralization of the repo. Liquidity risk arises from the possibility that a loss of liquidity in collateral markets will force liquidation of collateral at a discount in the event of a counterparty default, or even a fire sale in the event of systemic panic. Leverage that is built up using repos can exponentially increase these risks when the market turns. While leverage facilitates the efficient operation of financial markets, rigorous risk management by market participants using leverage is important to maintain these risks at prudent levels.


The Basic Principle of Structured Finance

Companies involved in structured financing arrangements often consult with credit rating agencies to determine how to structure individual tranches of debt so that each receives a desired credit rating to certify its risk exposure. For example, a firm may wish to borrow a large sum of money by issuing debt securities. However, the amount is so large that the return investors may demand on a single issuance would be prohibitive. Instead, it decides to issue three separate bonds, with three separate credit ratings -- A (medium low risk), BBB (medium risk), and BB (speculative), using Standard & Poor’s rating system. The firm expects that the effective interest rate it pays on the BB-rated bonds will be more than the rate it must pay on the A-rated bonds, but that, overall, the amount it must pay for the total capital it raises will be less than it would pay if the entire amount were raised from a single bond offering. This is the basic principle of structured finance: the squeezing of financial value out of unbundling of debt.

The Fed Supports Money Market Mutual Funds

The US Federal Reserve on October 21 announced it would create a Money Market Investor Funding Facility (MMIFF) to support a private-sector initiative designed to provide liquidity to U.S. money market investors. MMIFF will finance up to $540 billion in purchases of short-term debt from money market mutual funds to shore up a key pillar of the US financial system. It will provide senior secured funding to a series of special purpose vehicles to facilitate an industry-supported private-sector initiative to finance the purchase of eligible assets from eligible investors. Eligible assets will include US dollar-denominated certificates of deposit and commercial paper issued by highly rated financial institutions and having remaining maturities of 90 days or less. Eligible investors will include US money market mutual funds and over time may include other US money market investors.

Money market funds are facing severe redemption pressures since the financial crisis deepened last month, forcing them to raise cash by scaling back their short-term lending to banks and selling their holdings of commercial paper. This retreat has contributed both to a freeze in the interbank market and a steep decline in activity in the commercial paper market, which has made it difficult for banks and companies to raise short-term funds.

Government Strategy Ignores Fundamental Problem of Asset Overvaluation

Although each step by the government in reaction to the credit crisis was a logical, targeted response to new systemic financial upheavals, the result was to prop up select distressed firms deemed too big to fail and support failing markets as they occurred, hoping in vain that it would be the last move needed to resolve the systemic crisis to put the economy on a path of recovery. The Fed and the Treasury appeared to be rushing from emergency to emergency without a strategic plan to deal with the fundamental problem of a debt bubble collapse.

The disjointed interventions appeared designed to keep a collapsing debt bubble from collapsing, a hopeless task that even Alan Greenspan, the bubble wizard par excellence, was not naive enough to try. Greenspan merely replaced a burst bubble with a new bigger bubble, never tried to keep stop a collapsing bubble in mid course. Greenspan’s approach was that of a post disaster cleanup crew, not rushing into a collapsing structure as the current bailout team appears to be trying to do. Throwing good money after bad merely makes good money into bad. Spending good money after the collapse would infinitely buy more in the cleanup task

Global Bank Bailout by Central Banks

Prompted by the US, governments across Europe took action to bail out their respective banks and protect their separate banking systems after the G7 meeting in Washington during the weekend of October 11.

France extended state guarantee to $435 billion of senior bank debt to help jumpstart French credit markets. It created a state company with up to $54 billion in capital to recapitalize distressed French banks. The UK guaranteed $434 billion of bank debts and injected $64 billion into Royal Bank of Scotland Group, HBOS, a banking/insurance group in the UK, and Lloyds TSB Group, as part of its already announced £400 billion bail-out plan. Germany guaranteed up to $544 billion inter-bank debts, setting aside $27 billion for potential losses and injected up to $109 billion equity in German banks. Italy announced it will recapitalize Italian banks and guarantee bonds on a case-by-case basis. Spain will guarantee $136 billion in Spanish bank debts, set up preventive facility to inject new capital into distressed Spanish banks until 2009 and established up to $68 billion to buy Spanish bank assets. The Netherlands is injecting €10 billion ($13.4 billion) into ING Group, the banking and insurance gaint who just weeks earlier was the white knight to bail out troubled Fortis NV. Austria, Portugal and Norway joined the effort, committing a total of €501 billion in guarantees and capital for banks in their respective jurisdiction.