Sub-Prime Crisis Moves US Toward A Different Future
By Terrell E. Arnold
4-17-8

In the past few weeks we have watched frantic movement of the Federal Reserve and the US Treasury to stanch the financial bleeding of major American financial institutions that gambled quite freely on a gigantic pyramid. If asked, any official of one of those institutions might look you in the eye and say "there is no pyramid," then explain that what they did was produce securities that were based on reasonable risks backed by collateral of the most reliable form: mortgages on identified parcels of developed American real estate." Indeed, the real estate, per se, was not the problem.

However, their paper was not land titles or mortgage documents themselves; it was a security backed by bundles of so-called "sub- prime" mortgages, but the bundles-based securities had received AAA, that's triple A ratings by the country's leading rating agencies. Those ratings were based on the apparent notion that bundling the underlying mortgages would spread the risks of loans to "subprime" borrowers, and in any case it would take a bundle of defaults for the risks to be significant. The ratings, as it emerged after the fact, were also made by organizations that had a vested interest in the outcome.

After that balloon burst, in a late March 2008 interview with Deborah Solomon for the New York Times, former Treasury Secretary Paul O'Neill blew the raters' assertions out of the water by saying: "If you have 10 bottles of water, and one bottle had poison in it, and you didn't know which one, you probably wouldn't drink out of any of the 10 bottles." By this measure, the ratings themselves were a sham. Bundling would be risk enhancing, not risk mitigating, and that is the way markets for those securities have responded to defaults.

From the beginning the high risk mortgages in the bundles, many written
for a favorable "come on" rate to the borrower, were scheduled to move upward to higher interest rates. Over time, average returns on these mortgages would be greater than that of fixed rate mortgages; that represented good business for the lenders, and of course for their hedge fund collaborators. It was an incredible pyramid built not on the Giza stone that would make it last for millennia, but on the sands of economic vulnerability and risk that would bring us to where we are. Through an incredible permutation, high risk loans at the lender-borrower level were transformed into allegedly risk-free and highly profitable CDOs (collateralized debt obligations) at the top.

To be sure, the probability that one of a bundle of ten mortgages might go belly up was materially higher than the risk that all ten would fail, so bundling appeared to be a risk mitigation strategy. However, that risk mitigation potential was intrinsically low because all ten were in a high risk, sub-prime category for which a default could be triggered by an economic slowdown, worst case a recession, or significant increases in mortgage interest rates. Those higher rates began to kick in at about the same time an economic slowdown caused real estate values to falter. Facing higher interest rates and disappearing equity, borrowers began to default in large numbers. At that point, at least in market perception, the AAA-rated bundles were suddenly worthless. The problem was compounded by a surge in defaults on fixed rate mortgages that also was triggered by sharp declines in the market value of the properties involved.

As real estate values-the heart of most personal asset pools-went galley west, it was time for everybody to register shock and for affected financial institutions to run for cover. However, the immediate official concern was not about homeowners but about the builders of the sub-prime pyramid. As IMF analysts put it in their March 2008 World Economic Outlook, the United States was "plagued by profound errors in risk management among its leading financial institutions."

While we taxpayers were never asked, the Fed and Treasury moved briskly to bail out one of the major gamblers, Bear Stearns, to the tune of $19 billion that we are unlikely ever to see again. In the above-cited New York Times interview, Paul O'Neill also shot down that maneuver, saying: "They saved the financial system from a panic collapse. I reject the notion that they helped Bear Stearns. Bear Stearns was destroyed." He may be right in the sense that Bear Stearns may never recover from the loss of market confidence in its judgment, but if the bailout actually staved off a financial collapse, our money may have been well spent.

However, Bear Stearns was not alone. Too many people had put too many eggs in one speculative basket. Even the peaks of the pyramid builders, Citibank, Morgan-Stanley and others, wrote off multi- billion dollar exposure strings that would boggle the mind, while a stock market built on the unrealistic profitability of such gambling, threatened to collapse if its wanton expectations were not assuaged. As reported in Timesonline, the Wachovia bank suddenly had to raise $8 billion to cover losses, heavily in the California sub-prime market. According to a Wachovia official, "the propensity to default rises dramatically once equity in a borrower's property falls to zero". That propensity appears to have applied with equal rigor to more affluent fixed rate mortgage borrowers.

The damages were not confined to the United States. The sub-prime based securities were attractive to foreign investors as well. In truth the crisis is a vivid demonstration of how easily both risks and opportunities move in today's international markets. British, German, French, Japanese and other banks had bitten into this sweetbread, and they were now carrying bundles of this paper that marketwise were worthless and asset wise represented a mess of bad investment judgment calls that had to be explained to shareholders. In a report on the global implications of this crisis, the Global Financial Stability Report (GFSR) of the International Monetary Fund, IMF analysts estimated that the global losses associated with or otherwise contributing to the crisis approached a trillion dollars, the great bulk but not all of it in the United States.

Assessment of this crisis and what to do about it dominated discussions in meetings this past weekend of the International Monetary Fund (IMF) and the World Bank in Washington, with discussions of the advanced economy Group of Seven on the side. The IMF report appears to have dominated the discussion without leading to any fresh courses of action for dealing with the crisis. That was because each G-7 member-and others to be sure-naturally sought to protect its own position in the matter, while the general opinion appears to have been that it was mostly up to the United States to clean up its own mess, even if others had to clean up pieces of it. As the Governor of the People's Bank of China put it in his written statement, "The biggest risk to the global economy remains the financial crisis emanating from the U.S. sub-prime mortgage sector." He may have said that looking uncomfortably over his shoulder at China's trillion dollar plus foreign exchange holdings, mostly in dollars.

The crisis has underscored the increasingly discomfiting reality that the global financial system consists of an aggregate of national systems that do not add up to a global financial manager. The IMF and the World Bank, originally created in 1945 with a view to provision of global financial management, have not gotten very far. Sixty plus years later, there still is no international banker or lender of last resort. More depressing, there is no global banking rule maker or regulator. The global system is actually based on the coincident, case by case evolved compatibility of nearly 200 national systems.

But there is more to the story. The sub-prime crisis grew in the context of real and portentous developments across global trade, financial and economic systems. The Fed, Treasury and Wall Street, distracted by their own crisis, probably have had little time to focus on the tectonic plate shifts in the global system that probably mean they cannot go home again. The epicenters of international trade and finance simply are shifting. In essence, a good part of the wealth that might be needed to finance a recovery is in the wrong places or pockets, mostly in Asia, and when the dust settles, the global configuration will be different.

Some say the first effects of the crisis will be downsizing or consolidation. That would mean the write-offs of major institutions would just disappear, making the global asset pool cleaner but smaller. That could also mean that the great bulk, if not all of the transactions of banking and other financial institutions would show up on their books, making the system transparent by shedding a multitude of off balance sheet transactions that dominated the sub- prime securities mess.

Whatever the approaches, the system is unlikely ever to be the same again, because the facts underlying global developments are profound. For starters, the solutions do not lie merely with changes in liquidity. They lie with recognition and adjustments around real changes in global economic structures including the scale and distribution of productivity and wealth. The sub-prime crisis simply adds to the adjustments already made necessary by those global changes.

The first base in this new configuration is what has been happening to the dollar. Mirroring the dynamics and strength of the American economy, the dollar has been the dominant world currency ever since World War II. It has served as medium of exchange, as the core of many personal asset hoards, and as a reserve currency for countries with weak or US trade-linked national monetary systems. Of long term importance, international oil prices have been stated in dollars, a nod both to the historic strength of the dollar and the dominant US roles in oil trade.

However, as other economies have grown, diversified and prospered the dollar has faced rising competition from the Japanese Yen, then the Euro and, most recently, from the Chinese Renmembi or Yuan and the Brazilian Real. These new challenges reflect both the growing global strength of other economies and accumulating flaws in the strength of the American economy, notably continuing Federal deficits, rising international debt and growing import dependence. Those developments weakened the Dollar by exposing it to the competition of other currencies, reduced its traditional role as a stabilizing international trade benchmark, and sent its value plunging as resource prices rose in response to increasing global demand for oil and industrial materials.

To the degree that the United States is able to reduce its debt, curb its appetites for imported goods, adjust its affluent lifestyles, extricate itself from absurd levels of military expenditure, and restrain inflation, in short, put its economic house in order, declines in the value of the Dollar can be mitigated. However, the declining role of the Dollar in the world economy appears persistent.

Moreover, the exposure of Americans to foreign exchange risks they never experienced before is an already visible consequence of the change. The as yet incomplete Iranian and other oil exporter efforts to switch to Euro-denominated oil prices will only make US exchange risk exposure worse. Whereas the United States in the past has enjoyed comfortable trade surpluses while trading partners carried discomfiting deficits, the shoe is now tightly on the other foot.

These gross shifts have been developing for decades. In every year since 1990 real GDP growth in leading developing countries has been faster than in advanced countries. In the years since the mid-1990s, China has grown faster than either the United States or the European Union and it has overtaken Japan as the global second place national economy. Those tendencies have grown since the beginning of the new century. In terms of GDP stated at purchasing power parity, the United States is now not only behind the European Union, it is being rapidly overtaken by Asian economies. World Bank estimates show that the Asian combination of China, Japan and India exceeds the United States and is breathing down the neck of the European Community for global first place. With the numbers for smaller Asian economies such as Malaysia, Asia is already globally in the lead.

Estimated GDP in 2007 at Purchasing Power Parity

(Billions of Current Dollars)

World - 65,820

European Union Â* 14,450

United States Â* 13,860

China Â* 7,043

Japan Â* 4,346

India Â* 2,965

Germany Â* 2,833

United Kingdom Â* 2,147

Russia Â* 2,076

France Â* 2,067

Brazil Â* 1,838

Italy Â* 1,800

This list of ten accounts for more than 80% of world GDP, while the United States alone accounts for 20%. As a rude benchmark of the change, in the early 1990s the United States accounted for 30% or more of global GDP. That means the relative weight of the US in the world economy has declined in a decade by roughly the GDP (at purchasing power parity) of China and India combined.

These developments affect every political, economic and financial calculation for the future. The most unfortunate feature of the immediate crisis is that it was precipitated by a combination of greed and runaway risk miscalculation. It probably cannot be rectified without substantial losses by many financial and banking institutions, not all of them large and multinational. It has already caused enormous hardship for a multitude of homebuyers, and in a recessionary period there is more of that to come. This is as much a crisis of expectations as it is a problem of ability to pay. The default on fixed rate mortgages is due to diminished expectations, the loss of asset value.

It remains to be seen whether the bailouts being contemplated in Washington will rescue the institutions involved or the homebuyers. Advance signals indicate the institutional players will fare best, and one hopes they will emerge leaner and more prudent. At the same time, it seems clear enough that the best interests of troubled homebuyers lie with a solution that enables them to hold on to their real estate and wait out the restoration of their equity as markets rebound. It also remains to be seen to what extent the crisis will result in more effective regulation and oversight of banking and other financial institutions, including the rating organizations who blessed the sub-prime fiasco with AAA ratings. There were lessons learned on all sides here, but they will take some digesting.

Global changes may be slowed while this American misadventure works itself out. But those global changes are pervasive and enduring. It is not in the interest of humanity at large to have the development of other economies truncated by American efforts to feed its excesses. The elitist reaction to that might be the famous remark of Marie Antoinette "Let them eat cake." However, in a world where easily half of humanity is hungry and a slice of that population wants to correct the defect by violent means, assuring that there is enough to feed everybody is the more humane and prudent choice. Aggravating food scarcity by turning basic foodstuffs into motor fuel is neither an economic nor a humanitarian response. It does show that in a pinch national needs take precedence over global ones.

America's real choices and opportunities have evolved in a compelling fashion over the years since World War II. As the most advanced nation left standing at the end of that conflict, The United States saw work to do. The home agenda was to bring itself out of a war economy and into a peacetime environment. The foreign policy agenda was to promote and support the recovery of post war Japan and Europe and, in some measure, their surroundings. Happily, those two agendas combined at the level of good policy is good business. The country had virtually automatic markets for everything it could produce. Altruism and self interest combined in a most productive manner. The relatively affluent American society was a natural dividend, and it remained so, even as the restored economies became increasingly productive and competitive.

But things began to change, especially with the end of the Cold War. The containment strategy that ultimately dominated the US Cold War posture actually provided an umbrella for potentially pre- emptive military moves that positioned the US virtually everywhere any economic resource of importance could be had. The altruistic agenda slowly fell behind the self-interested one as global resource procurement and market competition became more forceful.

When the Project for the New American Century (PNAC) surfaced in the early Bill Clinton presidency with plans to invade Iraq and with a global military power agenda, the altruistic side of American foreign policy had pretty well atrophied. The game had become power maintenance by military dominance. The PNAC designers appeared to have no clear-cut economic agenda, but their military scheme, if it succeeded, would have provided more than adequate cover for a self-centered and pre-emptive resource acquisition strategy. As perceived by other advanced and advancing nations, this scheme drove 21^st century global resource acquisition strategies toward a nineteenth century capitalist model. One only has to look at Darfur, the Congo, Zimbabwe, and much of Central Asia as well as the Middle East to see how neo-colonial present day resource acquisition has become.

That others, e.g., China, India, Brazil, other advancing countries, are coping more or less successfully with this resource acquisition environment is part of America's current problem set. Prices are rising globally for virtually everything. In the case of foodstuffs, the increases are devastating. This faces US policy makers with across the board price inflation for most goods and services at a time when the US economy is diving toward a recession made worse, if not actually driven, by the sub-prime mortgage crisis.

The global tragedy of the sub-prime mess is that the securities that were designed to exploit the eventual high rates of return on those mortgages were of little to no benefit to global economic advancement. What their failure has done is to seriously distract US policy managers from the vital business of working through the large and fundamental changes that are occurring in the US economic environment. In the end, the sub-prime mess is likely to accelerate the transition of the US economy to a new position in the global system. Unless several major world economies-Japan, European Union, China, India, Brazil, and others-suddenly contract instead of continuing to grow at faster than US rates, the US weight in the global system will continue to decline; the Dollar will continue to play a reduced role in the global trade and payments system.

Such is the price of success. An economic diversification that the United States led through the early post World War II years has now caught on. The only thing that could prevent the US role in this future system from declining would be for the rest of the system to fail. The real policy challenge for US leadership therefore is to face this prospect, assess the realistic weight of the United States in likely future configurations, and try to maximize the US opportunity in them.

A military power strategy won't cut it. We are already going deeply into debt to sustain the present military posture. Other countries are not enamored of a US trying to run the world at the real or implied point of a gun. The system now needs truly global leadership. The United States can lead in that direction, helping to create and strengthen the institutions that will provide global leadership in the common interest. It is not leading now; it is forcing or trying to force global conformity to a self-centered US model, and that strategy eventually will fail. Such failures as the sub-prime fiasco only hasten the time when the present US model must be abandoned.

http://www.rense.com/general81/sub.htm