[NYTr] Kolko: The Predicted Financial Storm Has Arrived

[All the News That Doesn't Fit]

Z Magazine - Aug 29, 2007
http://www.zmag.org/sustainers/content/2007-08/29kolko.cfm

The Predicted Financial Storm Has Arrived

By Gabriel Kolko
 
Contradictions now wrack the world's financial system, and a growing
consensus exists between those who endorse it and those who argue the
status quo is both crisis-prone as well as immoral. If we are to
believe the institutions and personalities who have been in the
forefront of the defense of capitalism, we are on the verge of a
serious crisis-if not now, then in the near future.

The International Monetary Fund (IMF), the Bank for International
Settlements, the British Financial Services Authority, the Financial
Times, and innumerable mainstream commentators were increasingly
worried and publicly warned against many of the financial innovations
that have now imploded. Warren Buffett, whom Forbes ranks the second
richest man in the world, last year called credit derivatives-only one
of the many new banking inventions-"financial weapons of mass
destruction." Very conservative institutions and people predicted the
upheaval in global finances we are today experiencing.

The IMF has taken the lead in criticizing the new international
financial structure, and over the past three years it has published
numerous detailed reasons why it has become so dangerous to the world's
economic stability. Events have confirmed its prognostication that
complexity and lack of transparency, the obscurity of risks and
universal uncertainty, especially regarding collateralized debt and
loan obligations, will cause a flight to security that will dry up much
of the liquidity of banking. "…Financial innovation itself," as a
Financial Times columnist put it, "is the problem". The ultra-creative
system is seizing up because no one understands where risks are located
or how it works. It began to do so this summer and fixing it is not
very likely.

It is impossible to measure the extent of the losses. The final results
of this deluge have yet to be calculated. Even many of the players who
have stakes in the countless arcane investment instruments are utterly
ignorant. The sums are enormous.

Only a few of the many measures give us a rough estimate:

The present crisis began-it has scarcely ended there--with subprime
mortgage loans in the U.S., which were valued at over $1.3 trillion at
the beginning of 2007 but are, for practical purposes, worth far, far
less today. We can ignore the impact of this crisis on U.S. housing
prices, but some projections are of a 10 percent decline-another
trillion or so. Indirectly, of course, the mortgage crisis has also
brought many millions of people into the larger financial world and
they will get badly hurt.

What the subprime market did was unleash a far greater maelstrom
involving banks in Germany, France, Asia, and throughout the world,
calling into question much of the world financial system as it has
developed over the past decade.

Investment banks hold about $300 billion in private equity debts they
planned to place-mainly in leveraged buy-outs. They will be forced to
sell them at discounts or keep them on their balance sheets-either way
they will lose.

The near-failure of the German Sachsen LB bank, which had to be saved
from bankruptcy with 17.3 billion euros in credit, revealed that
European banks hold over half-trillion dollars in so-called asset
backed commercial paper, much of it in the U. S. and subprime
mortgages. A failure in America caused Europe too to face a crisis. The
problem is scarcely isolated.

The leading victim of this upheaval are the hedge funds. What are hedge
funds? There are about 10,000 and, all told, they do everything. Some
hedge funds, however, provided companies with capital and successfully
competed with commercial banks because they took much greater risks. A
substantial proportion is simple gamblers; some even bet on the
weather--hunches. Many look to their computers and mathematics for
models to guide their investments, and these have lost the most money,
but funds based on other strategies also lost during August. The
spectacular Long-term Capital Management 1998 failure was also due to
its reliance on ingenious mathematical propositions, yet no one learned
any lessons from it, proving that appeals to reason as well as
experience fall on deaf ears if there is money to be made.

Some gained during the August crisis but more lost, and in the
aggregate the hedge funds lost a great deal-their allure of rapid
riches gone. There have been some spectacular bankruptcies and
bailouts, including some of the biggest investment firms. Investors who
got cold feet found that withdrawing money from hedge funds was nigh on
impossible. The real worth of their holdings is hotly contested, and
valuations vary wildly. In reality, there is no way to appraise them
realistically-they all depend largely on what people want to believe
and will take, or the market.

We are at an end of an era, living through the worst financial panic in
many decades. Now begins global financial instability. It is impossible
to speculate how long today's turmoil will last-but there now exists an
uncertainty and lack of confidence that has been unparalleled since the
1930s-and this ignorance and fear is itself a crucial factor. The
moment of reckoning for bankers and bosses has arrived. What is very
clear is that losses are massive and the entire developed world is now
experiencing the worst economic crisis since 1945, one in which
troubles in one nation compound those in others.

All central banks are wracked by dilemmas. They have neither the
resources nor the knowledge, including legal powers, to remedy the
present maelstrom. Although there is clamor from financiers and
assorted operators to bail them out, the Federal Reserve must also
weigh the consequences of its moves, above all for inflation. Then
there is the question of "moral hazards." Is the Federal Reserve's
responsibility to save financial adventurers from their own follies?
Throughout August the American and European central banks plunged about
a half-trillion dollars into the banking system in an attempt to
unfreeze blocked credit and loans that followed the subprime crisis-an
event which triggered a "flight to safety" which greatly reduced banks'
willingness to loan. In effect, the Federal Reserve relied on banks to
restore confidence in the financial system, subsidizing their efforts.

Central banks' efforts succeeded only very partially but, in the
aggregate, they failed: banks and investors now seek security rather
than risk, and they will sit on their money. The Federal Reserve
privately acknowledges its inability to cope with an inordinately
complex financial structure. European central bankers are in exactly
the same dilemma: they simply don't know what to do.

But this scarcely touches the real problem, which is structural and
impinges wholly on the way the world financial structure has evolved
over the past two decades. As in the past, there is a critical split in
the banking and finance world and each has political leverage along
with clashing interests. More important, central banks were not
designed to cope with today's realities and have neither the legal
powers nor knowledge to control them.

In this context, central banks will have increasing problems and the
solutions they propose, as in the past, will be utterly inadequate, not
because their intentions are wrong but because it is impossible to
regulate such a vast, complex economy-even less today than in the past
because there is no international mechanism to do so.
Internationalization of finance has meant less regulation than ever,
and regulation was scarcely very effective even at the national level.

Not only leftists are naïve but so too are those conservatives who
think they can speak truth to power and change the course of events.
Greed's only bounds are what makes money. Existing international
institutions-of which the IMF is the most important--or
well-intentioned advice will not change this reality.