Liu: Americanism and the "Too Big To Fail" Syndrome, Part I

Les Schaffer schaffer at
Sat Jan 6 09:37:37 MST 2001

[ bounced > 30 kB from Henry Liu, Part I ]

"Too big to fail" is the cancer of moral hazard in the US finance
system.  Moral hazard is a term in banking circles that describes the
tendency of bankers to make bad loan based on an expectation that the
lender of last resort, either the Federal Reserve domestically or the
IMF globally, to bail out troubled banks.  The term also applies to
bad loans made to borrowers that are considered "too big to fail" such
as GE, Citigroup, JP Morgan Chase or General Motors, or borrowers such
as Third World governments. In general, the principle of moral hazard
states that bailouts encourage future recklessness. Brady bonds to
bail out Latin debts are labeled instruments of moral harzard in some

Most bankers reject the moral harzard charge because they welcome
government intervetion when it comes to protecting their profits.
They only want to get government off their backs when it tries to help
the poor. In global finance, the issue of moral harzard is more
complex.  Economic imperialism uses moral harzard as an argument to
oppose debt forgiveness for the poorest economies.  During the Asian
finacial crisis of 1997, the IMP imposed harsh "conditionalities"
(namely high interest rates, corporate restructuring that results in
lay off and massive unemployment, austere fiscal policies) justified
by moral hazard arguments, punishing the poor in debtor nations for
the sins of their bankers.

Many, including myself, have observed that the shrinking intermediary
role of banks in funding the economy, brought about by the rapid
growth the non-bank credit and capital markets, has increased system
risk in recent years.  This risk manifests itself only in a bear
market. This is now building up to a crisis. Banks have also
compensated for their shrinking funding role by moving into equity
investing and securitization and trading through their investment
banking subsidiaries, not to mention derivative finance and trades.

There is no doubt that GE, the nation's biggest financial
conglomerate, whose commercial papers are the bellwether for the
dollar and euro CP markets, will fall from borrower defaults and its
size will be the "too big to fail" reason for Fed intervention.  GE's
acquisition of Honeywell is an attempt to shift, in market image if
not in reality, back toward an industrial conglomerate, with heavy
defence potentials.  It is very clear that troubled debt-ridden
corporations will turn to the banks for help, not because bankers are
friendlier than bondholders, but because banks have access to the Fed
discount window.  Greenspan's recent message to banks to continuing
lending is a clear signal that he will provide all the liquidity that
is needed to prevent a systemic collapse.  The trouble is that the
inter-linkage through structured finance makes even tiny companies
"too big to fail".  The Nasdaq alone has made $3 trillion of market
cap disappear in the last nine months of 2000 which has put many
corporate bonds under water.  Unless the Fed is prepared to inject
that much reserves into the banking system, the debt crisis cannot be
solved.  And if the Fed does that, what will happen to inflation and
the exchange rate of the dollar? Cash denominated in dollars is
looking less a safe haven everyday. Flight to euros?

It is an irony that at the very time when the US financial system is
showing signs of structural failure, the global trend to adopt
American business and finance practices is reaching its peak. All over
the world, governments are rushing to privatize assets, securitize
debts and deregulate their transitional economies with the hope of
reaping the enviable results that the US economy has enjoyed for a
decade.  The bill of this enviable boom is now fast coming due and
much of the world will to have pay without ever having enjoyed the
benefits.  The "race to the bottom" syndrome in trade competition has
been replaced by the "race toward risk" syndrome in finance

The marketplace of ideas, not unlike financial and commodity
marketplaces, often operates on mis-information until cruelly pulled
back into reality by unforgiving facts.  Much governmental and
institutional aping of American practices is based on a
misunderstanding of what Americanism really is.

There is some truth in the popular myth that American ways are more
flexible, more willing to innovate and to adopt to change. In the last
decade, American innovation and quick response in business have
produced a record long boom, with spectacular rise in profits and
asset value. US household net worth, until the recent (and first wave)
market crash, peaked at over $24 trillion, rising 50% in a decade.
The end of the Cold War and the global eclipse of socialist tenets
have left American faith in market fundamentalism with the aura of a
natural philosophy.

Americans call their system capitalist democracy.  In doing so, care
is taken to distinguish democracy from equalitarianism.  Conceptually,
while the Declaration of Independence claims that "all men are created
equal", it readily accepts the premise that men do not create wealth
equally.  The American system rejects social democracy which aims to
remove economic differences between people.  The American system
claims it promotes equality of opportunities rather than equality of
rewards.  It believes that the logic of the market is the most
equitable arbitrage.  Free-marketeers decry intimate relationships
between government, finance and business and oppose even corporatism
as an adjunct to the welfare state.  They believe that the market's
unforgiving rules of selecting and rewarding winners and penalizing
losers is inherently fair, efficient and necessary for maximizing
overall economic growth.

The trouble with this view is that it is a fallacy to assume that
truly free markets can exist.  Markets are always constrained by local
customs and rules, unequal conditions and unequal information access
by participants. In fact, markets come into existence through
artificial construction by initial participants with rules that
subsequent participants must observe as a price for entrance.  These
artificial rules generally favour the market founders and put later
comers at a perpetual disadvantage.  WTO rules are the latest visible
example.  Often the only option left to late comers is to start
alternative markets hoping that they will enjoy the very privileges
and advantages they oppose in existing markets.

Thus all markets require a wide range of regulations to check and
balance their inherent march toward inequality and unfairness. Trade,
by definition, is based on mutually balanced weaknesses.  Mutual
strength leads only to war, and unequal strength leads to conquest of
the weak.

Adam Smith advocated "free trade" in the mercantilist context as an
activist government policy to breakdown the protectionist policies of
other nations while subsidizing national industries to competition in
a tariff-free and open world market.  'Free enterprise' was first
developed by royal charters and grants from the sovereign for business
operations and for land development within his domain, and for trading
rights and command of the high seas to "freely" exploit colonies and
foreign locations. In other words, free enterprise was begun and
fostered with government aid and grants that private investors found
too risky or whose potential rewards too remote.  Royal charters,
letters of patent, patents and copyrights are all instruments of
government for the privilege of exploiting the resources in the
sovereign's domain Government and free enterprise have always
co-operated in conceert.  Modern free enterprise manages to prevent
the monopolistic or oligarchist control of markets only by government
action.  Business always wants government help before the market is
mature and after the market is saturated.  It only wants "free"
markets when there is easy profit.  Business by nature abhors

The notion of "too big to fail" is sacred in US regulatory philosophy.
This remains true even as the anti monopolistic restraint of trade
regulatory regime of the New Deal has been steadily modified in recent
decades to permit mergers and acquisition toward increased size and
market share to achieve strategic advantage.  The scenarios of the
ideal free market is that there should be only five entities in every
sector: two market leaders and three window dressing market followers
to keep regulators at bay. The US economy has always been organized
along oligarchistic lines in its core industries, allowing a high
degree of centralization while preserving only a token degree of
competition.  The rules of competition are generally set by market
leaders of every industry. Self-regulation is the mantra. While the US
promotes globalization, American attitude on foreign ownership remains
schizophrenic.  Furthermore, there is an inherent contradiction in
globalization in that while capital is allowed to move freely across
political borders, labor is not.  It is now conveniently forgotten,
when the IMF was established by the Bretton Woods Conference, its
Articles of Agreement specifically sanctioned restriction on movements
of capial across national borders.  Until labor can also move freely,
the lopsided globalization is nothing but economic neo-imperialism.
It is not a march toward one world, it is a march towards an
hierarchical world of structural inequality.

Another defining characteristic of modern US finance is the broad
access to credit. American business has long enjoyed access to open
credit markets. Today, the developing credit crunch notwithstanding,
no US corporations of any size is effectively shut out of the highly
developed credit market, regardless of credit rating.  Low credit
ratings only affect the interest rate rather than market
accessibility.  In fact, debt securitization has brought virtual
security to credit unworthiness on a massive scale. The commercial
paper market first burgeoned in the 1960s and today, collaterallized
loan obligations dominate the global credit market.  Securitization is
a process of turning nonmarketable credit instruments into marketable
ones through pooling.  Securitization creates credit worthiness out of
the theory of large numbers and the theory of averaging to manage the
risk of default by spreading it to a large pool.  When a lender lends
to a risky company, he bears the full risk of default.  But if he
invest in a collateral loan obligation instrument, he is lending to a
pool of companies whose default rate may be, say, 6%, a risk level
coverable by the interest rate spread.  The fatal enemy of
securitization is a liquidity crisis when all exits from purportedly
open markets will be suddenly closed, when all participants move to
the sell side, leaving the buy side empty at any price.  Today, Fed
Funds Rate target is 6.5% (this was written before the Fed action on
January 3 2001 lowering ffr to 6%) and prime rate posted by 75% of the
nation's 30 largest banks is 9.5%, while commercial paper rate placed
directly by GECC is 5.67% for for 230-270 days, and dealers CP (high
grade unsecured notes sold through dealers by major corporations) is
6.25% for 90 days.

Derivatives are financial instruments whose values are derived from
thevalue of another instrument. Among other effects, derivative tend
to lower the systemic credit standard of the markets by manipulating
the assignment of risk.  Highly rated corporations can now arbitrage
their high credit standing to further lower their cost of funds by
issuing long-term fixed rate debt and then swapping the proceeds
against the obligation to pay a floating rate.  In other words, they
monetized their high rating by taking on more risk.  Simultaneously,
lower-rated corporations that otherwise would be frozen out of the
credit markets as the credit cycles mature can use derivatives to lock
in long-term yields by borrowing short and swapping into long-term
maturity obligations. In other words, they pay more interest to buy
higher credit ratings, not withstanding that fact that high interest
cost would actually further lower their credit ratings.  The
intermediaries, banks and other financial institutions who make credit
markets and trade these obligations enjoy the illusion of being
relatively risk free by linking their risks system wide.  The credit
rating of these banks appear relatively normal, but in fact they
appear normal only because the overall credit rating of the system has
declined.  When individual risks are passed on to systemic risk,
individual creditors are comforted by the safety of the "too big to
fail" syndrome.

The growth of pension and retirement funds can be viewed as a process
in the socialization of capital formation.  This process has brought
about a corresponding growth in professional asset management based on
competitive performance measured by short term market value, placing
distorted emphasis on technical trends rather than fundamentals.  The
quest to socialize risk has led to indexation which works better in
rising market to capture optimal systemic returns, but can also cause
the categorical downgrade of entire families of debt instruments and
their issuers without regard for individual strength.  This can cause
unnecessary and violent systemic damage, as it did in Asia in 1997.
This socialization of risk associated with the socialization of
capital formation means that a financial collapse will affect not
merely the rich investors who may be able to afford the loss, but the
entire population who can ill afford to lose their pension.  The "too
big to fail" notion then comes directly into play and government is
forced to step in, putting an end to the myth of the free market.
Moral hazard will be in full bloom as the nature of the beast.  The
Fed has been repeatedly held hostage to the "too big to fail" syndrome
since 1930 and will again and again until its becomes the main agent
to herald socialism to America, as Schumpeter predicted.  Creative
Destruction, of which Greenspan is so fond, will eventually destroy

Leverage is another development that not only magnifies volatility,
but the abnormally high rates of leveraged return distort market
judgement, making normally respectable returns look unattractive.
Derivatives and hedging techniques have created the illusion of safety
by risk management, while they merely reshuffle risks system wide and
heighten exponentially the penalty of misjudgement.

Litigiousness is a byword of the American notion of the rule of law.
Innovative contracts and financial and business relationship are often
inadequately defined to meet rapidly changing conditions, and disputes
are settled in courts whose judgements can have drastic consequences
to the litigating parties as well as the system.  Major bankruptcies
have been routinely caused by court decisions.  The tobacco time bomb
is a good example. Texaco was forced into bankruptcy when faced with a
judgement that exceeded its entire market cap value, based on the
legal definition of what contituted a valid offer in a merger. The
list is long.  The stabilizing value of legal precedents is greatly
discounted in a world of constant unprecedented developments. Courts
are frequently confronted with controversies that the judges and their
law clerks are grossly unqualified to comprehend.  Court decisions
often hark back to symbolic posturing based on dated concepts. The
anti-trust case against Microsoft is a classic example: the issue
raised in the case are operationally obsolete, yet the courts are
asked to make determinations based on them that will affect the future
of software monopoly.

The most fundamental flaw in American financial market system is its
inherent drive towards excess. The market boom will only end with a
market crash unless government intervenes in mid course.  The quest
for the short term maximization of returns leads inevitably a
speculative bubble.  The traditional demand/supply business cycle has
been genetically modified into a debt-propelled cycle that requires
more debt to prolong.  And the speed of the expansion dictates that
more debt can only be added by a lowering the credit quality.  This is
what Greenspan means when he refers to unbalances in the system, that
physical expansion of productivity cannot possible keep pace with
credit expansion associated with the sudden wealth effect. At their
peak in March 2000, stocks were valued at 181% of GDP (Dada from
Bianco Research) while at the beginning of the decade they were 60% of
GDP.  One of the characteristics of a bubble economy is the delinking
of the equity markets from the actual performance fo the economy.
That is clear eveidence that the wealth effect does not reflect the
performance of the economy.  One of the few valid points made by
Greenspan was that the wealth effect created imbalances that was more
than the conventional time lag. The government budget surplus
resulting from the credit induced extended long boom is merely a false
signal of the illusionary soundness of the current US economy.  It
measures the size of the debt bubble rather than the size of the real
economy.  Some economists have been vocal that the budget surplus is
the fact an indicator of economic trouble ahead.  Those who proudly
point to the budget surplus as the Clinton adminstration greatest
achievement will live to look extremely foolish. Private debt, both
consumer and corporate, has been growing at record pace in the US for
the past decade, drawing funds from lenders all over the globe. Much
of this debt is taken on by telecom companies whose revenues have
fallen as much as 90% through deregulation.  Telecom debt now matches
real estate debt both standing at about $150 billion, but unlike reale
state where rents are stabilized by by long term leases, telecom
revenues can change in a matter of weeks, drastically affect share
prices of the debtor companies.  As the equity markets collapse from
an earnings shortfall caused by an expanding market capitalization
outpacing slower earning growth, the political pressure for the Fed to
inject more debt into the system by lower interest rates will become

The emergence of an unregulated open credit market diminishes
significantly, though not negates, the ability of central banks to
manage the economy through conventional monetary policy measures,
because of the banks' shrinking intermediary role in the credit
market.  A credit binge in which loose lending to borrowers of dubious
credit worthiness is always followed by a credit crunch, as surely as
gluttony leads to obesity that will outgrow the wardrobe.  Bad loans
are made in good times, as Greenspan is fond of quoting.  A credit
crunch is an interruption in the supply of credit which can be caused
by destruction of the lenders' incentive through regulatory rigidity,
or serious defaults by borrowers on loans taken out during a credit
binge.  When that happens, the central bank's only option is to alter
the financial structure to reconnect credit supply in a timely manner.
And in the current markets of electronic trading, timeliness is a
matter of hours, not weeks.  Yet Greenspan told Congress in his July
1999 Humphrey-Hawkins testimony: "But identifying a bubble in the
process of inflating may be among the most formidable challenges
confronting a central bank, putting its own assessment of fundamentals
against the combined judgement of millions of investors."  Investor
judgements are now mostly based on technical analysis while the Fed is
still looking down on it nose at fundamentals.

This explains why the record of Greenspan's recognition of market
trends has been consistently six months late. Yet the Fed cannot
afford to wait for market discipline to correct a credit crunch. And
because of the recognition time lag, coupled with the diminished
ability of the Fed to affect market decisions, and the compressed
chain reaction time of collapse, each subsequent intervention would
need to be escalated or overshot to achieve comparable effect, which
in turn increases moral hazard to fuel the next abuse.  It is
intervention inflation, similar to the narcotic syndrome of pushing
towards the edge to reach new highs which always leads to fatal

[ to be continued ]

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