Monthly Archives: November 2009

As the financial media looks agape at the developments of Dubai’s debt troubles, this is a good time to focus on how the next financial crisis might develop.  Recognizing trouble signs can help investors avoid costly panic declines in equity and bond markets and be prepared with cash to buy near market lows.

Before we dive into the analysis, we need to make one clear distinction: Dubai is not the harbinger of a new financial crisis.  Rather, it might best be described as an “aftershock” from the 2008 crisis.  A country so grossly in debt to fund its outrageous construction plans should not shock the world in this environment when it announces that it needs help meeting its payment obligations.  As we showed on Friday, elevated credit default swap prices, though down from their extreme highs of a year ago, foretell additional “aftershocks.”  Markets around the world dropped because they were overbought, but recovered as soon as they hit certain technical levels, like the 50-day moving average.  European markets recovered on Friday, and Asian markets are rising as this column is being written.

The next crisis, if it the present course remains unaltered, will look much like the most recent one.  That is because it will share many of the same causes (see How Government Economic Policies Caused the Financial Crisis of 2008).  In the wake of the credit crisis that began last September, the U.S. government undertook several measures to stem the panic and restore confidence in the financial industry so it could resume operating at “normal conditions.”  These measures included the $700 billion Troubled Asset Relief Program (TARP), lowering the federal funds rate to near zero percent, and embarking on quantitative easing programs such as buying Treasuries and mortgage-backed securities.  These measures were necessary because a financial crisis demands forceful government intervention to avoid an all-out panic and ensuing depression.  However, as Simon Johnson of the Peterson Institute for International Economics recently testified to the Congressional Oversight Panel (created to oversee the use of TARP funds), “Unless bank regulators limit the direct and indirect risk exposure of US financial institutions to this new supposedly low-risk ‘carry trade,’ we face the very real prospect of another even larger crisis.”

The problem, in the simplest terms, is this:  the government policies that have staved off a depression have driven down the value of the dollar and lowered yields on the safest assets to near zero, while the banking system and those who run it remain largely intact and unchanged; therefore, bankers and investors are encouraged to take on extreme risk once again to achieve acceptable gains and they do this by borrowing dollars generally to buy risky assets, generally in emerging markets that have strong growth potential.  Thus, the asset bubbles that formed in U.S. real estate that caused the 2008 financial crisis appear to be forming again, but rather in non-U.S. assets (see U.S. Current Account Deficit Likely the Cause of Next Financial Crisis).  Johnson points out specific examples, “As the world recovers, asset markets are also turning buoyant. Recently, residential real estate in elite neighborhoods of Hong Kong has sold at $8,000 US per square foot. A 2,500 square foot apartment now costs $20 million. Real estate markets are also showing signs of bubbly behavior in Singapore, China, Brazil, and India.”

Another crisis can be avoided, but it will take forceful government action to reform the U.S. financial industry.  The following is what Johnson believes is the best practice:

Best practice, vis-à-vis saving the banking system in the face of a generalized panic involves three closely connected pieces:

a. Preventing banks from collapsing in an uncontrolled manner: This often involves at least temporary blanket guarantees for bank liabilities, backed by credible fiscal resources. The government’s balance sheet stands behind the financial system. In the canonical emerging market crises of the 1990s—Korea, Indonesia, and Thailand—where the panic was centered on the private sector and its financing arrangements, this commitment of government resources was necessary (but not sufficient) to stop the panic and begin a recovery.

b. Taking over and implementing orderly resolution for banks that are insolvent: In major system crises, this typically involves government interventions that include revoking banking licenses, firing top management, bringing in new teams to handle orderly unwinding, and—importantly—downsizing banks and other failing corporate entities that have become too big to manage. In Korea, nearly half of the top 30 precrisis chaebol were broken up through various versions of an insolvency process (including Daewoo, one of the biggest groups). In Indonesia, leading banks were stripped from the industrial groups that owned them and substantially restructured. In Thailand, not only were more than 50 secondary banks (“finance houses”) closed, but around one-third of the leading
banks were also put through a tough clean-up and downsizing process managed by the government.

c. Addressing immediately underlying weaknesses in corporate governance that created potential vulnerability to crisis: In Korea, the central issue was the governance of nonfinancial chaebol and their relationship to the state-owned banks; in Indonesia, it was the functioning of family-owned groups that owned banks directly; and in Thailand it was the close connections between firms, banks, and politicians. Of the three, Korea made the most progress and was rewarded with the fastest economic recovery.

Lest anyone rush out to sell all of their holding, investors must recognize that bubbles and crises take time to develop.  Even though we can see some early signs that global easy monetary policy is inflating bubbles in certain assets, mainly through dollar devaluation, this does not mean that another crisis is imminent.  What to watch for is whether the current conditions remain unaltered, whether through poor government decisions or external factors, like currency exchange rates, which keep the dollar depressed.

I continue to believe that the U.S. central bank will raise rates in 2010 and, even if Congress fails to act, encourage tougher regulation of banks.  This will bolster the dollar, while likely keeping equity returns muted.  However, such action will help to avoid another crash.  The U.S. will also need to work closely with the other G-20 nations to ensure a coordinated monetary policy that will not disrupt global markets.

To read the full text of Simon Johnson’s testimony, please click the following link:  The Impact of the Troubled Asset Relief Program on the US Financial System and Economy.