Tag: US Economy

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Crisis in the USA: Is America too big to fail?

Introduction
September has been a disastrous month for the US whose leading presidential candidates like to refer to it jarringly as the greatest country on earth. Natural disasters with hurricanes coming one after the other pale into insignificance compared with the meltdown in that country’s housing and financial sectors. The country that boasts of the triumph of the free market is now adopting some of the most extreme forms of government intervention normally associated with the socialist system – the very antithesis of the free market. In fact, haunted by the ghosts of the Great Depression, the US government is considering bailing out the entire banking system as one by one the banks and other financial houses collapse like a pack of cards.

While it may have originated in the mortgage crisis that has been brewing for the past two years, the wave of nationalisation in the US began on September 8 when the Treasury took over Fannie Mae and Freddie Mac, two companies which hold or guarantee more than half of the US mortgage debt, together owning assets of over $5 trillion or five million million!

In a month when it seemed that Usain Bolt could break just about any record, Lehman Brothers overtook WorldCom as the largest bankruptcy filing in US history. The firm which was founded in 1850 and boasts that its growth in having over $600 billion in assets and 25,000 employees parallels the prosperity of the US, describes itself on its website as “an innovator in global finance,” serving the financial needs of corporations, governments and municipalities, institutional clients, and very wealthy individuals worldwide. To understand the scale of this bankruptcy, consider that WorldCom’s assets prior to bankruptcy were just over $100 billion.

A week is a long time
Then earlier this past week the US central bank, the Federal Reserve, took a 79.9% share in American International Group (AIG) in exchange for a two-year, $85 billion credit facility at the penal rate of LIBOR plus 8.5%. AIG has assets of over $1 trillion and over 100,000 employees worldwide – bigger than either Lehman Brothers or Fannie Mae. And just announced is an ambitious plan for the government to buy seven hundred billion dollars of illiquid debt from ailing American financial institutions to save the sector from further shocks. Those in this region may well recall a similar approach by Jamaica government when in response to the financial sector meltdown of the 1990s that country’s government established FINSAC “to guide the banking sector through the recovery process.”

The one underlying reason with all the failures or near failures in the US was their inability to attract or retain further financing. Fannie Mae and Freddie Mac were set up as the bedrock of the housing market to guarantee mortgages meeting certain conditions. To do this they issued debt effectively backed by the government. But they were poorly regulated and went over the line when they bought securities secured by what has come to be known as subprime mortgages. Clearly the government could not allow them to collapse and ended up taking them over. In Lehman’s case, it was rolling over some $100 billion in short term-debt each month − more than it could bear; its borrowing costs increased and its share price fell to a record level following a massive write-down and credit losses occasioned by the financial crisis.

AIG too was the victim of the subprime crisis writing down some $57 billion of insurance contracts with the real possibility of further losses if the housing market did not improve. AIG’s credit rating was downgraded making it all the more difficult for it to borrow.

Begging the question
Now all of this begs the question what caused the subprime crisis in the first place? Identifying this is the easy part. The explanation is harder and takes us back to the early part of this decade. During that time there was an unrealistic increase in house prices and the belief by prospective and existing homeowners that the prices of their homes would keep rising allowing them to continue borrowing. With their risks creatively reduced, lenders eased their standards and permitted borrowers to buy more expensive homes than they could afford. There was also the phenomenon of adjustable mortgage loans which in simple terms transferred the greater part of a risk from the lender to the borrower. Greed stepped in as brokers found they could charge excessive commissions on such loans. A combination of a flagging economy, deregulation, poor oversight and equally, carelessness by banks and other lending institutions meant that borrowers were unable to carry and could not refinance their debt. This resulted in a mounting number of foreclosures and an extreme decline of house prices.

The subprime loans meanwhile were packaged into “derivatives,” part of creative but unreal wealth which the smart guys in Wall Street conjured up as assets which were sold and resold among the banks and financial institutions. Readers will recall from the series I did on Enron in 2002 that such “derivatives” were equally prominent in the demise of that giant. Sadly such assets are hardly regulated by the central bankers and are far too complex for the simple minds of the accountant to understand, let alone value for purposes of accounting. No wonder the investor guru Warren Buffett describes these as “financial weapons of mass destruction.” Players engaged in this game are as likely to succeed as the optimist in the Casino – yet they still play.

Darwin questioned
That was capitalism at its creative best or destructive worst, depending on whether you are the recipient of millions of the new wealth created by the free market or the victim of just another in the long line of bubbles. But an integral part of such a market is the Darwinian principle – the survival of the fittest, promoted with the usual American arrogance to the entire world since the end of WWII. The question is whether the fundamentalist adherence to such dogma excludes any interventionist action. The US government which has been preaching the mantra of liberalisation, lecturing the Asians and the Europeans to abandon their own economic model and adopt the US’s New Economy in which the ‘D’ word was not the dreaded ‘depression’ but ‘deregulation’  has found itself once again in a dilemma. It ignored the fact that the savings and loan crisis was sparked by the same deregulation and weak accounting standards, as was the Dotcom bubble which took with it not only Enron and WorldCom but the accounting giant Arthur Andersen well.

Too big to fail
Why then are some allowed to fail such as Lehman Brothers but not Bear Sterns, AIG, Freddie Mac and Fannie Mae? There is the principle, ‘too big to fail,’ that if the consequence of failure is too great it must be avoided at any cost. With their stake in the mortgage market so huge, the collapse of these institutions would threaten the whole system of finance for American housing, endangering those American banks that put money into the housing market and precipitating a catastrophic fallout across the world.

Globalisation means that the central banks of China and Japan have indirectly invested billions of dollars in the US housing market through Fannie and Freddie’s bonds, while commercial banks from South Korea to Sweden hold investments linked to American mortgages. Not only would there be huge worldwide losses if the credit crunch in the US escalated, but the very global financial system could be imperilled. In the process of looking at all of this an even more visceral possibility has been raised by Peter Goodman in the International Herald Tribune – is America too big to fail? With the USA being by far the largest economy in the world, the mere thought of that is spine-chilling.

Paradoxically the very decision to save the financial sector can lead to reckless conduct by dealmakers knowing that there will be a safety net sometimes referred to by critics such as Alan Greenspan as “moral hazard.”

Guyana
There is also the irony and the glee of many Guyanese (and Hugo Chavez) that America is being humiliated by it all. For decades the USA and its surrogates like the IMF and the World Bank have used their preeminent position − particularly since the fall of the Berlin Wall and the triumph of the West − to dictate the conditions for accessing assistance, loans and capital. The first item on the prescription was the surgical removal of weak companies as we saw with our own Development Bank and GNCB, among others. The double irony for us is that we were proud to be paraded by those countries and institutions as “success stories,” even as our economy has continued to sub-perform.

According to the Governor of the Bank of Guyana the current crisis in the US is not likely to have any direct impact on Guyana. Our banks are all very liquid and profitable and for the first time Guyanese may have to concede that the ultra conservatism of the local banks has had one good effect. I am only aware of one company that has direct insurance placed with AIG, but it is quite likely that indirectly some of our insurance companies’ reinsurance business is placed with AIG.

Remittances will be one of the immediate casualties as the cost of the bailouts of the American banks and financial businesses are borne by the rest of the economy and taxpayers, among whom would be members of the Guyana diaspora. Investment flows into Guyana are likely to reduce and high value projects like hydroelectricity would find financing hard to come by and therefore very expensive. The international and regional financial institutions will have less soft money to lend and further justification to stall support to Guyana if the government is perceived as having little interest in regulation and accountability.

Our larger exporters may also be impacted because the uncertainty over jobs overseas will ultimately lead to a contraction in spending, so those who export consumer items will feel the squeeze. Any of our major industries which must necessarily tap into overseas markets for large sums of US dollar financing may have to shelve any major expansion plans. What this signifies for the power and agricultural sector is yet to be determined, but it does not look good. We must be thankful that Guyana does not have the kind of creative financing as the US. Tax evasion and money-laundering are the preserve of the privileged and the connected while regulations are seen as things to be ignored and resisted. The Companies Act 1991 is honoured more in the breach while even our more prominent companies feel that they are at liberty to challenge the Securities Council and the insurance regulator at will.

But it would be foolhardy to be complacent or to try to predict the outcome of all of this over the next year or so, when a week seems such a long time. The most we can do is fasten our seatbelts.

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Recession in the US: impact on Guyana

Introduction

If nothing else President George Bush is an incorrigible optimist. And on this occasion it is not about the Iraq War that defies costing in the sense that by the time this column appears two days after its submission the cost has gone up by more than US$650 million dollars, or by that much more than the half a trillion spent in the five years since the US invaded that country. It is about the state and outlook of the US economy which some say is already in a recession while others say in language more suited to diplomats that the economy is “moving sideways.”

What effect does the state of the US economy have on the rest of the world and more directly how will it affect us in Guyana? The answer to these questions is complicated by one further uncertainty – the presidential elections later this year. All the signs point to a race involving Senators Barack Obama for the Democrats and John McCain, a seasoned campaigner and maverick, for the Republicans. Obama is relatively new to foreign policy and his external connections have been mainly Indonesia where he spent part of his early life and Kenya, the country of his father.

Obama v McCain

Obama has made exit from Iraq a major plank of his campaign commitment, and assuming that he wins, getting out of Iraq may be far more complicated than he believes and resolving that may very well take the better part of a year. Any policy towards the Caribbean will be wrapped up in the wider Latin American question and the Free Trade Area of the Americas (FTAA). For all the support he has received from the Caribbean, he is unlikely to give our region any kind of priority.

John McCain, on the other hand, has strong foreign policy credentials but these have been manifested mainly towards Europe, Asia and the Middle East, including his unwavering support of the Iraq War. Regardless of who wins, unless that person appoints someone with clout and a genuine interest in the Caribbean, the region will not receive much attention in the first year or two of the new presidency.

Exchange rate

Yet what happens to the US economy is important to us mainly for two reasons – the Guyana dollar is largely measured in relation to the United States dollar and second, the Guyana economy benefits heavily from remittances from Guyanese in the United States. In 2007 the Guyana economy grew faster than that of the US and our international reserves did not deteriorate, yet counter-intuitively the rate of exchange of the Guyana dollar to the US fell, albeit slightly. To make matters worse, because the US dollar was falling against the other major international currencies, those declines were reflected in the rate of the Guyana dollar against those currencies, resulting in increased prices for imports from those countries.

Another major imported product – fuel – is priced in United States dollars and a significant part of the increase in the price of a barrel of oil is attributable to the fall in the rate of the US$. In passing, it should be noted that Guysuco and other exporters to non-US currency destinations would have benefited from the fall in the rate of the US$ and by extension of the Guyana dollar.

Remittances

The second major reason for the relevance of the outlook of the US economy to Guyana was shown in an article in this newspaper earlier this week referring to a report by the Multilateral Investment Fund (MIF) of the Inter-American Development Bank (IDB) that Guyana leads the Latin America and Caribbean region in remittance receipts in 2007 as a percentage of GDP, with US$424M or 43 per cent of GDP received. These are truly staggering numbers and warrant a response by way of an analysis from the Bank of Guyana and our academics.

The obvious question is whether such levels can be maintained. If the US economy continues to under-perform causing a loss of jobs and a fall in income, it would be difficult for Guyanese in the US to maintain the level of remittances they have been sending back home. It is true that increasing numbers of Guyanese are taking their chances in the Caribbean – with Antigua, Barbados and Trinidad and Tobago being the more prominent countries – and that so far the economies of these countries have been steady. This should mean that remittances from those countries should not be affected and may even increase as more Guyanese head in their direction. The real fear therefore lies with respect to the US economy.

Recession or not? – OECD

The Organisation for Economic Co-operation and Development (OECD), a grouping of 30 mostly developed democratic countries, including the three powers of North America, most of Europe and Asian Pacific members Australia, Japan, South Korea and New Zealand, in an assessment released in Paris last week was only prepared to say that the US economy is “teetering on the brink of recession” – defined as two consecutive periods of negative growth. The US economy is expected to grow 0.1 per cent in the first quarter, a sharp reduction from the 0.3 per cent estimated in December, and to show zero growth in the second, a sudden halt compared with the 0.4 per cent projection given previously. Despite the sharp downward revision, acting chief OECD economist Jorgen Elmeskov is of the opinion that “it may be premature to declare a recession” in the United States.

For the year as a whole, 2008 is projected by the OECD to grow 1.4 per cent, down from the December estimate of 2.0 per cent, Given the recent swings in the economy it would be surprising if this estimate is not subject to a number of revisions as the quarters progress.

IMF

The assessment is likely to be confirmed by the IMF in its twice-yearly World Economic Outlook, a leaked draft of which shows that it also believes that the US economy “remains very weak, certainly close to a possible recession.” Despite the dollar’s recent steep losses, the draft also suggested that the IMF saw its present value as still “rather strong.”

US businesses

The Conference Board, a major and influential US business group in a report released within the past 48 hours has reported that its index of future economic activity dropped for the fifth consecutive month in February, suggesting that the weakening American economy could, indeed, be slipping into recession. The index is designed to forecast where the nation’s economy is headed in the next three to six months.

Businesses and think tanks attribute the situation to rising gas prices, falling home prices and tightening credit markets which have begun squeezing consumers and businesses, forcing them to cut spending.

Billionaire US investor Warren Buffett dismissed the theoretical definition of recession saying that it is not a question of whether the American economy was in a recession but how far it will go. The legendary billionaire investor expressed concern about the declining wealth, purchasing power, employment and income and does not rule out the possibility that the country’s economic woes could worsen.

More positively, however, Buffett does not consider current conditions as bad as the downturn of 1973 and 1974 when Americans were also battered by skyrocketing oil prices, and he expressed optimism that the economy would rebound strongly in time. Buffett also repeated his belief that the US dollar will continue weakening for as long as the United States maintains a hefty current account deficit, particularly with China and the countries of the Middle East from which it imports oil.

Conclusion

These fears are not without merit. The dramatic meltdown and bail-out of Bear Stearns, one of the US’s largest underwriters of mortgage bonds resulting from the collapse in June of two of their internal hedge funds that had been heavily invested in mortgage securities, emphasises the continuing crisis in the housing sector which is affecting not only the pockets but the psyche of American consumers, who could always count on having some equity in their homes (the value less any debts owed on the house). Even the proverbial dream is evaporating to such an extent that illegal migrants are now voluntarily going back to their homes, something which would have been considered unthinkable one year ago.

The collapse in the US housing market coincides with rising food, energy and raw material costs, raising the spectre of inflation for consumers, but making it more difficult for central banks facing a choice between cutting interest rates to spur growth and keeping them high to curb prices.

As the US braces for troubled waters, those remittances may indeed be in doubt.