The Global Debt/Financial Crisis, “Wall Street” Financing of “Main Street” and Rising Financial Risk

The Global Debt/Financial Crisis, “Wall Street” Financing of “Main Street” and Rising Financial Risk
Carlos M Pelaez

The objective of this post is explaining the adverse trend of financial variables that threatens the recovery of the world economy. The regulatory shock is explained in terms of the fake dichotomy of the political discourse of (I) “Wall Street” financing of “Main Street”; four factors explaining financial turbulence in (II) the global/debt financial crisis; (III) rising financial risk; the economy not growing at rates that alleviate unemployment and underemployment of 26.9 million people as revealed by (IV) economic indicators; risk flight explaining (V) interest rates; and the final section providing some (VI) conclusions.
I “Wall Street” Financing of “Main Street.” The motivation for ongoing financial regulation consists of four major objectives: (1) preventing speculators from taking risky positions in expectation of bailouts with taxpayer funds; (2) creating the tools required in preventing another crisis; (3) holding Wall Street accountable and protecting consumers; and (4) providing transparency and oversight of derivatives to avoid risks that can undermine the economy (http://www.whitehouse.gov/blog/2010/04/16/every-member-congress-going-have-make-a-decision ). The political discourse emphasizes the dichotomy of the economy into separate compartments: a financial sector or “Wall Street” and a truly employment-creating productive sector or “Main Street” (http://www.whitehouse.gov/the-press-office/remarks-president-wall-street-reform ). In fact, analytically and in reality there is no dichotomy but rather one indivisible general economy. Regulatory shocks on banks and the financial sector, or “Wall Street,” have similar adverse effects on the general economy as the legislative restructurings of the business models, or “Main Street,” jeopardizing the creation of opportunities for 26.9 million people who are unemployed, working part-time because they cannot find any other occupation or who have given up search for a job. The complex interrelations of banking, finance and business models developed over decades. Legislative surgeries of business models in regulatory rush may make unviable individual parts and the whole, fracturing the job-creating function of the private sector. The truly constructive effort by government consists of regulation and an institutional framework that fosters the structures and functions of finance and the general economy (Pelaez and Pelaez, Government Intervention in Globalization, 1-12).
The approach of Functional Structural Finance (FSF) is proposed by Professors Robert Merton and Zvi Bodie (cited in Pelaez and Pelaez, Regulation of Banks and Finance, 234-6, Financial Regulation after the Global Recession, 34-7). FSF considers six functions of the financial system. (1) Clearing and settlement systems are provided by the Fed wire and funds transfers by depository institutions such as banks with technology that enhances efficiency in the form of lower transactions costs that promote business. (2) Mobilization of savings agglutinates small funds of investors in financing large-scale projects through the distribution of small shares in corporate stock, allowing the public to benefit from capital appreciation increasing savings and retirement. (3) Transfer of resources across time and space allow households to invest in education and training for future jobs and business to create new opportunities of progress through research and development. Innovation and education have driven US prosperity. (4) Risk management identifies and measures risk in deriving the best opportunities. (5) Information in financial markets is required for business decisions. The collection of short and long exposures reveals the prices of equities and debt, signaling the opportunities in the economy while allowing hedge of risks. (6) The financial system or structure provides incentives for the reduction of information asymmetries. Modern banking theory considers the monitoring role of banks in evaluating information on the creditworthiness of borrowers to issue unmonitored deposits. Another function is transforming illiquid business projects into immediately liquid demand deposits (Douglas Diamond, Philip Dybvig and Raghuram Rajan cited in Pelaez and Pelaez, Regulation of Banks and Finance, 55-66).
The federal government chartered in 1970 the Federal Home Loan Mortgage Corporation, Freddie Mac, with the objective of guaranteeing mortgage-backed securities (MBS) that were created by bundling mortgages originated by thrift institutions (Pelaez and Pelaez, Financial Regulation after the Global Recession, 43). The household in “Main Street” identifies a suitable home and requests a loan from the local bank by mortgaging the home. The local bank obtains the funds from bundling many similar loans in maturity and credit risk into a MBS sold to investors through “Wall Street” that distributes the MBS to savings and retirement funds that obtain the money from various sources including family savings. Car loans, credit cards, student loans, home equity loans and most credit is processed through the bundling of loans into asset-backed securities (ABS) which are similarly sold to investors that ultimately obtain the money from savings. The financial system transforms illiquid bricks, land and construction labor in a home into instant liquidity in the form of a housing loan by mobilizing savings with a technological innovation that goes by the name of securitization or risk transfer used by banks in avoiding concentration of risks in their portfolio through the bundling of many loans into a security that is sold to final investors. The creation of liquidity can occur through sale and repurchase agreements (SRP) by which the temporary investor in the ABS finances it with cheaper short-term SRPs. The financial regulation bill emerging from Congressional reconciliation may frustrate innovation back to the Stone Age before certificates of deposits and commercial paper in which there were pure credit panics in less diversified and smaller banks. Between 1929 and 1933, 9440 commercial banks in the US or about 40 percent of close to 23,600 commercial banks were suspended. Britain, Canada and ten other countries with more concentrated banks experienced remarkable banking stability during the Great Depression (Pelaez and Pelaez, Regulation of Banks and Finance, 204). George Benston finds that only 10 of the 9440 failed banks were national banks and the others were more vulnerable unit banks or banks with only one or few branches (cited in Pelaez and Pelaez, Regulation of Banks and Finance, 118). There were no problems in big banks per se in the credit crisis after 2007 but instead in mortgage banks and investment banks affected by the nonprime mortgages. The amputation of lines of business of banks by the finance bill may cause individual bank failures by disrupting viable business models and a more unstable or even unviable financial system with risk concentrated on pure lending.
Securitization or risk transfer worked smoothly over the past half century without a major crisis. The identification of the causes of the credit/dollar crisis and global recession after 2007 requires clear thought instead of distortions of the actual working of the financial system. The problem was in the form of excessive leverage or debt, low liquidity and unsound decisions on credit risk. The crisis consisted of the flooding of securitization with subprime and liar or Alt-A mortgages. Government policy caused the crisis (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). The combination of the fed funds rate of nearly zero in 2003-4 with the lowering of mortgage rates by suspending the auction of 30-year Treasuries and the yearly housing subsidy of $221 billion encouraged excessive construction of houses under the illusion that prices would increase forever. The near zero interest rates penalized liquidity, encouraging cheaper short-term borrowing. Unsound home-buying credit was encouraged by the illusion of permanently increasing house prices and the purchase or guarantee of $1.6 trillion nonprime mortgages by Fannie Mae and Freddie Mac that caused generalized lowering of lending standards. The failure of more than 200 regional and community banks spreading throughout the country has an evident cause in the concession of excessive credit when interest rates were extremely low by Fed money creation and real estate prices were perceived to have a floor guaranteed by government policy (http://professional.wsj.com/article/SB10001424052748703957604575272333920494398.html?mod=wsjproe_hps_LEFTWhatsNews ). Section III below provides the data on the collapse of the stock market on May 25 led by bank stocks that was partly arrested when a leader in Congress had the wisdom to inform the public of the softening of bank swap-desk spinoffs in the reconciliation of the financial regulation bill.
II The Global Debt/Financial Crisis. Financial markets are under renewed stress. There are four causes of this stress that may determine the trend of financial variables that could be masked by daily oscillations. First, there are recurring fears about tightening monetary policy in China that could depress commodity futures prices and interregional trade among countries in Asia, which is an important source of growth in the region and the world economy. These fears alternate with optimism causing oscillation of Asia Pacific stocks. The Dow Jones Asia/Pacific Total Stock Market Index declined by 11.7 percent from a recent peak on Apr 15 to the close of market on May 28 and the Shanghai SE Composite declined by 16.1 percent in the same period (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_intl_dtabnk&symb=DWAP&page=intl ). Second, the sovereign risk crisis in Europe also has intermittent episodes of fear and optimism that add to stock market volatility. The STOXX Europe 50 stock index fell by 11.9 percent from the recent peak on Apr 15 to the close of market on May 28 (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_intl_dtabnk&symb=ST:SX5P&page=intl ). Third, US budget deficits in excess of 10 percent of GDP, government debt in the unsustainable path toward 100 percent of GDP and the Fed balance sheet of $2.4 trillion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ) may prove to be the strongest shock to the world economy. The Dow Jones Industrial Average declined by 9.5 percent from the recent peak on Apr 26 to the close of market on May 28 (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_uss_dtabnk&symb=DJIA ). Fourth, the regulatory shock of financial institutions analyzed in the preceding section can exacerbate financial turbulence with likely adverse effects on growth and employment worldwide. The NYSE Financial Index declined by 15.5 percent from the recent peak on Apr 15 to the close of market on May 28 (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_uss_dtabnk&symb=NYKID ).
III Rising Financial Risk. There are increasing perceptions of financial risk and in particular of counterparty credit risk in transactions among financial institutions. The Dow Jones Industrial Average suffered the deepest decline in the month of May since 1940 when FDR was president: 871.98 points or 7.92 percent (http://professional.wsj.com/article/SB10001424052748703957604575272930884830398.html?mod=wsjproe_hps_LEFTWhatsNews ). The drop was characterized by wide daily oscillations. The decline of the DJIA in an individual bad day such as 1.2 percent on May 28 is partly explained by events such as news of the downgrade of the credit rating of Spain by Fitch Ratings from AAA to AA+ (http://professional.wsj.com/article/SB10001424052748704596504575272641759918662.html?mod=wsjproe_hps_LEFTWhatsNews ). The DJIA dropped 292 points during the first 10 minutes of trading on May 25 because of concerns with rising LIBOR costs of banks amid higher risk perceptions of counterparty transactions and incidents in Korea but recovered to lose only 22.82 points in the day or -0.23 percent. The Nikkei average declined 3.1 percent, Hong Kong’s Hang Seng dropped 3.5 percent, the London FTSE fell 2.5 percent and the Paris CAC 40 lost 2.9 percent, copper futures declined 3.3 percent and crude-oil futures lost 2.1 percent. Copper declined 9 percent in the year to May 25 and oil 13 percent (http://professional.wsj.com/article/SB10001424052748704026204575266010587315860.html?mod=wsjproe_hps_TopLeftWhatsNews ). A contributing factor of the recovery of the market was the announcement by the Chairman of the House Financial Services Committee that the provision forcing banks to spinoff swap desks would be modified (http://professional.wsj.com/article/SB10001424052748704026204575266300665355526.html?mod=wsjproe_hps_LEFTWhatsNews ). Financial regulation legislation is affecting adversely financial markets and the recovery of the economy and jobs. The rise of the DJIA in a good day such as the gain of 2.9 percent on May 27 is explained by events such as the announcement by China that it would continue to position European securities (http://professional.wsj.com/article/SB10001424052748704269204575270003727602386.html ). The VIX implied volatility index declined in the week to 31 at the close of market on May 28 but is still above the long-term average of 20 (http://www.ft.com/cms/s/0/60dd1a72-6a9e-11df-b282-00144feab49a.html ). Indicators of risk perceptions in financial markets remained slightly lower on May 28 relative to a day earlier (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aOQ0XERiNFqw ). The dollar interbank loan rate LIBOR for three months was fixed at 0.536 percent compared with 0.538 a day earlier after doubling from levels before the current turbulence. The dollar LIBOR rate is significantly below the stratospheric peak of 4.81875 percent in 2008; the increase is substantial from 0.25 percent in Mar; there are increasing costs of $360 trillion instruments indexed to LIBOR; and higher bank borrowing costs are reflecting the $2.8 trillion debt of European banks to highly-indebted countries in Europe under sovereign risk stress (http://professional.wsj.com/article/SB10001424052748704792104575264883867618368.html?mod=wsjproe_hps_TopMiddleNews ). There was also a marginal decline of the LIBOR-OIS spread from 30.7 basis points (bps) to 30.6 bps, measuring the differential risk between interbank lending for three-months at the LIBOR rate and lending overnight at the fed funds rate. The LIBOR-OIS spread was only 9 bps on average in the first three months of 2010. The dollar swaps of the Fed with other central banks could have played a role in alleviating pressure on dollar rates. While it is true that the LIBOR-OIS spread is well below 364 bps after the Lehman Bros event in Sep 2008, counterparty risk perceptions have increased because of the global debt crisis and bank exposures to highly-indebted countries. The swap spread, or difference between the two-year swap rate and the yield of the corresponding Treasury note, increased by 11.96 bps on May 25, reaching 64.21 bps and then retreating to 49.56 in New York but still well above the year’s low of 9.63 bps (http://www.bloomberg.com/apps/news?pid=20601087&sid=a187sGWkbQtE&pos=5 ).
IV Economic indicators. The economy continues to expand led by manufacturing. There are doubts about the strength of the recovery in housing and growth may not be sufficient to provide relief to the 26.9 million persons in job stress. Existing home sales increased 7.6 percent in Apr and 22.8 percent relative to a year earlier (http://www.realtor.org/press_room/news_releases/2010/05/ehs_april ). New home sales in Apr 2010 were at a seasonally adjusted annual rate of 504,000, rising 14.8 percent relative to the Mar rate of 439,000 and 47.8 percent higher than 341,000 in Apr 2009 (http://www.census.gov/const/newressales.pdf ) but 63.3 percent below the rate of 1,374,000 in Jun 2005 (http://www.census.gov/const/newressales_200506.pdf ). The jump in Apr was motivated by the expiration of the tax credit for buying new homes. The Case-Shiller index is showing some weakness in house prices, with a decline of the National Home Price Index by 3.2 percent in the first quarter even if remaining above the level a year earlier (http://www.standardandpoors.com/spf/docs/case-shiller/CSHomePrice_Release_052506.pdf ). New orders of durable goods grew by 16.8 percent in the first four months of 2010 relative to the same period in 2009, by 14.3 percent excluding transportation and by 16.9 percent excluding defense (http://www.census.gov/manufacturing/m3/adv/pdf/durgd.pdf ). GDP was revised to 3.0 percent for the first quarter from the preliminary estimate of 3.2 percent (http://www.bea.gov/newsreleases/national/gdp/2010/pdf/gdp1q10_2nd.pdf ). The annual seasonally adjusted quarterly percentage rates during this recovery of 2.2 in IIIQ09, 5.6 in IVQ09 and 3.0 in IQ10 have been quite inferior to those during the recovery of the similar recession in the 1980s of 5.1 in IQ83, 9.3 in IIQ83, 8.1 in IIIQ83, 8.5 in IVQ83, 7.1 in IQ84 and above 3 percent in the following quarters (http://www.bea.gov/national/nipaweb/TablePrint.asp?FirstYear=1983&LastYear=1984&Freq=Qtr&SelectedTable=2&ViewSeries=NO&Java=no&MaxValue=9.3&MaxChars=5&Request3Place=N&3Place=N&FromView=YES&Legal=&Land= ). Personal income increased 0.4 percent in Apr but personal consumption expenditures (PCE) were flat while the PCE price index, which is used by the Fed, increased by less than 0.1 percent (http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm ). The Chicago ISM business barometer seasonally adjusted index declined from 63.8 in Apr to 59.7 in May, which is still well above the expansion tradeoff of 50 for the eighth consecutive month (https://www.ism-chicago.org/chapters/ism-ismchicago/files/ISM-C%20May%202010.pdf ). Initial jobless claims in the week ending on May 22 fell 14,000 to the seasonally-adjusted level of 460,000 from the revised 474,000 in the earlier week (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).
V. Interest Rates. The yield curve of Treasuries, much as those of other major countries, continues to have a flat segment of nearly zero percent and a rising slope above two years. The 10-year Treasury yield declined to 3.30 percent on May 28 from 3.21 percent a week ago and 3.67 percent a month ago (http://markets.ft.com/markets/bonds.asp ). The decline in yields is caused by flight out of risk in other financial assets and currencies. The German 10-year bond traded at 2.68 percent on May 28 for a negative spread of 62 points relative to the 10-year Treasury. The relative attractiveness of Treasuries may change with the worsening trend of the ratio of government debt to GDP.
VI Conclusions. Fears of decline of China’s economic growth, repercussions in financial markets and economies of the sovereign risk crisis in Europe, the worsening fiscal situation of the US and the financial regulation shock drive adverse trends in financial risk. The increase in the debt to GDP ratio of the US together with the eventual unwinding of the bloated balance sheet of the Fed anchor the economy at low rates of growth. Job creation will be insufficient to provide relief to the 26.9 million people in job stress. (Go to http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )