THE ARLINGTON INSTITUTE
TAI Alert Global Financial Meltdown

By John L. Petersen

It appears that we may be at the beginning of a major, historical disruption of the world’s financial system.  Here’s what it looks like from here.

More than a year ago, The Arlington Institute sponsored a speech by Dr. David Martin as one of its TAI Presents series.  Dr. Martin explained the problems with the subprime market and how he and his team had analyzed the historical default rate of the underlying mortgage holders.  The defaults will increase significantly beginning the last part of 2007 and become significantly established in the early part of 2008 he said.  That will threaten the integrity of large numbers of banks as they hold a large percentage of their reserves in real estate instruments that are built around the subprime mortgages.   The U.S. will be constrained by its dependency upon China – our banker.  The ultimate stabilization of the system just might come from Islamic financial institutions, over in that part of the world where we’re now bombing the Islamists.  You can listen to (and read) Dr. Martin’s speech here.  http://www.arlingtoninstitute.org/tai/david-martins-speech-economic-fragilities

At the beginning of the sub-prime disintegration analysts discounted the potential impact of the trend, reminding all that would listen that sub-prime mortgages represented only some 4% of the total mortgages (or something like that).  It was impossible that those failures would really be significant. 

What they all missed was the systems nature of the problem.  Narrowly focused on a few fund meltdowns they didn’t take into consideration the interconnections and dependencies of a number of tightly coupled variables that make up the system.  I’m certainly not an economist or financial analyst, but I’d guess that it is fundamentally a non-linear system, subject to vagaries that are not deterministic and predictable ... therefore it is predictable that the system could (or would) exhibit significant shifts in behavior passing certain unanticipated tipping points.  

There are quite a few dependent variables in this system. Personal credit card debt and the Basel II accords mandating international banking changes, as well as hedge funds, and China are important players. Here’s something about hedge funds from my friends at the Asymmetric Threats Contingency Alliance in London.

                                            

Dear ATCA Colleagues


[Please note that the views presented by individual contributors are not necessarily representative of the views of ATCA, which is neutral.  ATCA conducts collective Socratic dialogue on global opportunities and threats.]

Perfect Storm:  Credit Freeze and Distress Selling by Hedge Funds 

Now that the credit boom has officially gone bust and the financial markets are in meltdown, it's time to assess what is going wrong, and what has gone really wrong.  By any stretch of the imagination, this is not a slow leak at all, liquidity is drying up very fast and many deals-in-progress -- including leveraged buyouts, mergers and acquisitions and private equity deals -- are not going to happen because the buyers are beginning to vanish and there are very few bids, and many offers. 
  
Distress selling by hedge funds has emerged as the hidden cause of the contagion spreading through the global financial system.  Billions were wiped from the value of listed companies around the world last week, with several major indices experiencing their worst day in more than four years, despite the injection of over USD 250 billion of liquidity by central bankers -- most notably the European Central Bank, the Federal Reserve and the Bank of Japan.  The silence of the Bank of England has been deafening.  Initially, turmoil was limited to credit markets but it quickly spread to global stock markets after central banks were forced to intervene to keep markets from collapsing completely. 
  
It is becoming clear that hedge funds, which from one perspective are supposed to help stabilise the financial system by diversifying risk and providing liquidity, were instead at the centre of the unfolding turmoil at the end of last week.  Problems spiralled when top investment banks including Goldman Sachs, Lehman Brothers and Merrill Lynch -- whose prime brokerage arms act as lenders to the hedge funds -- insisted that the hedge funds settle a greater proportion of their debts at the end of the trading day than they had done previously.  Other banks are said to have followed in hiking their margin calls.  The increased payments forced hedge funds to perform distress selling of assets to cover their losses.  When analysing trading patterns, Thursday and Friday were characterised by remarkably light but very volatile trading with those who didn't have to sell staying at home while those who were forced to sell being ruthlessly punished for doing so.   
  
This appears to have brought about a one-in-a-100-year event in which there are extremely unusual correlations in financial markets that no one appears to be prepared for and everyone is very scared to take or hold on to risk.  Financial stability was further shaken as hedge funds' losses mounted, compounding fears that some funds could collapse. Goldman Sachs's Global Alpha fund, the US funds -- AQR Capital Management, DE Shaw & Co, Renaissance Technologies -- and New York based Tykhe Capital were significantly down.  In particular, Renaissance Technologies, a USD 26bn fund run by the billionaire and former Mathematics Professor -- James Simons -- said it had lost 8.7% of its value in the last 10 days.  In a letter to investors, Mr Simons suggested that the hedge funds, which rely on computer models were all reacting similarly, causing ripples of downward momentum.  "We have been caught in what appears to be a large wave of de-leveraging on the part of quantitative long/short hedge funds," he said.  Many so-called quantitative funds with supposedly low-risk strategies involving investment in both debt and equities were particularly hard hit because weeks of turmoil in the credit markets made it impossible for them to sell debt, forcing them to sell more stable equity assets at a significant loss. 
  
It has also emerged that many funds had invested in the same companies, causing prices in otherwise unconnected companies to fall dramatically.  Because hedge funds borrow much of the money they invest from banks, the concern is that contagion could spiral again when the markets reopen. 
  
At the root of last week's uncertainty are poorly performing home loans, mostly those given to borrowers with weaker credit histories or who have overextended themselves by taking on large amounts of debt. These so-called subprime loans are going into delinquency and default at alarming rates, and the worst of the problem is still ahead.  The real problem loans are expected late this year and throughout next year. Housing and financial analysts think that lenders dangerously weakened lending standards in 2005 and 2006, when there was a flurry of exotic home loans and adjustable-rate mortgages. Many of these loans are due to bump up to higher interest rates late this year and next year. And since home prices are falling or stagnant, and banks are wary of lending, these loans may prove hard to refinance. 
  
Years ago, banks held home loans on their balance sheets. Today, they're sold on the secondary mortgage market, where they're pooled together, bundled and sold to investors as so-called mortgage-backed securities. The big investment banks such as Bear Stearns, Lehman Brothers and others are deeply involved in this, and may also have extended credit to some of the buyers of these securities.  Generally, better-quality loans are sold to Fannie Mae, the quasi-government agency that does some of this packaging. The riskier loans have been issued by so-called private label issuers, Wall Street firms that sell these bonds to investors in the US and abroad. 
  
Gavyn Davies, Gordon Brown's former economic adviser and former chief economist at Goldman Sachs, has warned that central bankers around the world would need to address serious deficiencies in the regulatory system once this crisis had blown over. Meanwhile the Financial Services Authority has begun to audit UK banks to assess their exposure to the US sub-prime mortgage crisis and to highly leveraged corporate loans following a similar move by the US Securities & Exchange Commission (SEC).  The SEC is looking at the books of major investment banks to see how they are valuing their mortgage-backed securities.  Regulators fear that major Wall Street and European banks might be masking the size of their subprime losses.

The International Monetary Fund has weighed in with an appeal for calm, playing down the extent of underlying problems. The Washington, DC, based institution said, "We continue to believe that the systemic consequences of the reassessment of credit risk that is taking place will be manageable. The fundamentals supporting strong global growth remain in place."  President George W Bush and his economic team are also talking up the US economy and saying that the fundamentals remain strong. Most economists think the housing sector's problems will shave a full percentage point of growth from the US economy this year. As long as employment indicators remain strong and consumer confidence robust, there shouldn't be a recession. But if credit problems in the banking sector become a full-blown credit collapse and people can't get loans to buy homes or cars or to start businesses, the US economy would be hit very hard and the global economy would suffer too. 

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We are grateful to:

.  Dr George Feiger, based in Berkeley, California, USA, for "Two Faces of the Same Coin;"

.  The ATCA Editorial Team, based in Canary Wharf, London, for "Contagion and Systemic Risk? ECB Injects Record Euro 95bn post Major Disturbance;" 

.  The ATCA Editorial Team, based in Canary Wharf, London, for "Flight to Quality as Markets finally Appreciate Risk;"

.  Robert McNally, Chairman, London Chamber of Commerce Property and Construction Group, for "Erosion of Commercial Real Estate as a Solid Asset Class;"

.  Alexander Hoare, CEO, C Hoare and Co, Private Bankers, based in the City of London, for "Destructive Creativity, Leverage and The Derivatives Market;" and

.  Dr Harald Malmgren, CEO, Malmgren Global, based in Washington, DC, for "The Fear of Central Bankers -- Flight from Illiquidity, Derivatives and Heightened Risk of Contagion;"

in response to, "Are the Currency Markets Warning that there is Trouble Ahead?  The Precipitous Decline of the US Dollar and its Impact on the World."

  
For and on behalf of DK Matai, Chairman, Asymmetric Threats Contingency Alliance (ATCA)

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ATCA:  The Asymmetric Threats Contingency Alliance is a philanthropic expert initiative founded in 2001 to resolve complex global challenges through collective Socratic dialogue and joint executive action to build a wisdom based global economy.  Adhering to the doctrine of non-violence, ATCA addresses asymmetric threats and social opportunities arising from climate chaos and the environment; radical poverty and microfinance; geo-politics and energy; organised crime & extremism; advanced technologies -- bio, info, nano, robo & AI; demographic skews and resource shortages; pandemics; financial systems and systemic risk; as well as transhumanism and ethics.  Present membership of ATCA is by invitation only and has over 5,000 distinguished members from over 120 countries:  including 1,000 Parliamentarians; 1,500 Chairmen and CEOs of corporations; 1,000 Heads of NGOs; 750 Directors at Academic Centres of Excellence; 500 Inventors and Original thinkers; as well as 250 Editors-in-Chief of major media.    
 
The views presented by individual contributors are not necessarily representative of the views of ATCA, which is neutral.  Please do not forward or use the material circulated without permission and full attribution.   

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Winner of the Queen's Award for Enterprise in Innovation : 2007 marks 11 years

The financial situation between the U.S. and China is tenuous.

 

                                                                          From The Economist

 

Paul Craig Roberts in Online Journal gives a sense of the role China will play in the U.S. financial future. 

Analysis 
Uncle Sam, your banker will see you now 
By Paul Craig Roberts 
Online Journal Guest Writer 
 
 
Aug 9, 2007, 00:46

Early this morning China let the idiots in Washington, and on Wall Street, know that it has them by the short hairs. Two senior spokesmen for the Chinese government observed that China’s considerable holdings of US dollars and Treasury bonds "contributes a great deal to maintaining the position of the dollar as a reserve currency." [China threatens 'nuclear option' of dollar sales, by Ambrose Evans-Pritchard, London Telegraph, August 9, 2007]

Should the US proceed with sanctions intended to cause the Chinese currency to appreciate, "the Chinese central bank will be forced to sell dollars, which might lead to a mass depreciation of the dollar."

If Western financial markets are sufficiently intelligent to comprehend the message, US interest rates will rise regardless of any further action by China. At this point, China does not need to sell a single bond. In an instant, China has made it clear that US interest rates depend on China, not on the Federal Reserve.

The precarious position of the US dollar as reserve currency has been thoroughly ignored and denied. The delusion that the US is "the world’s sole superpower," whose currency is desirable regardless of its excess supply, reflects American hubris, not reality. This hubris is so extreme that only six weeks ago McKinsey Global Institute published a study that concluded that even a doubling of the US current account deficit to $1.6 trillion would pose no problem.

Strategic thinkers, if any remain who have not been purged by neocons, will quickly conclude that China’s power over the value of the dollar and US interest rates also gives China power over US foreign policy. The US was able to attack Afghanistan and Iraq only because China provided the largest part of the financing for Bush’s wars.

If China ceased to buy US Treasuries, Bush’s wars would end. The savings rate of US consumers is essentially zero, and several million are afflicted with mortgages that they cannot afford. With Bush’s budget in deficit and with no room in the US consumer’s budget for a tax increase, Bush’s wars can only be financed by foreigners.

No country on earth, except for Israel, supports the Bush regime's desire to attack Iran. It is China’s decision whether it calls in the US ambassador, and delivers the message that there will be no attack on Iran or further war unless the US is prepared to buy back $900 billion in US Treasury bonds and other dollar assets.

The US, of course, has no foreign reserves with which to make the purchase. The impact of such a large sale on US interest rates would wreck the US economy and effectively end Bush’s war-making capability. Moreover, other governments would likely follow the Chinese lead, as the main support for the US dollar has been China’s willingness to accumulate them. If the largest holder dumped the dollar, other countries would dump dollars, too.

The value and purchasing power of the US dollar would fall. When hard-pressed Americans went to Wal-Mart to make their purchases, the new prices would make them think they had wandered into Nieman Marcus. Americans would not be able to maintain their current living standard.

Simultaneously, Americans would be hit either with tax increases in order to close a budget deficit that foreigners will no longer finance or with large cuts in income security programs. The only other source of budgetary finance would be for the government to print money to pay its bills. In this event, Americans would experience inflation in addition to higher prices from dollar devaluation.

This is a grim outlook. We got in this position because our leaders are ignorant fools. So are our economists, many of whom are paid shills for some interest group. So are our corporate leaders whose greed gave China power over the US by offshoring the US production of goods and services to China. It was the corporate fat cats who turned US Gross Domestic Product into Chinese imports, and it was the "free trade, free market economists" who egged it on.

How did a people as stupid as Americans get so full of hubris?

Paul Craig Roberts [email him] was Assistant Secretary of the Treasury in the Reagan Administration. He is the author of Supply-Side Revolution : An Insider's Account of Policymaking in Washington; Alienation and the Soviet Economy and Meltdown: Inside the Soviet Economy, and is the co-author with Lawrence M. Stratton of The Tyranny of Good Intentions : How Prosecutors and Bureaucrats Are Trampling the Constitution in the Name of Justice. Click here for Peter Brimelow’s Forbes Magazine interview with Roberts about the recent epidemic of prosecutorial misconduct.  
 
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There are a lot of indicators that suggest that all of this is just the beginning of a major disruption of the global financial system.  At lunch yesterday, I was told that the financial advisor of a friend who had always maintained that the global system had so much redundancy and resiliency built into it that it was impervious to meltdown had abruptly changed his mind.  It was suddenly clear to him that the system really could come apart.  He may well be right.