On Tuesday, November 27, the Dow Jones Industrial Average rose by 215 points. The next day, it rose by 330 points.
The financial press had an immediate answer on Tuesday. The news had broken that morning of the offer by the government of Abu Dhabi to pay $7.5 billion for 4.9% of America’s largest and most prestigious bank, Citigroup.
The news reports failed to explain the 4.9% figure. It has to do with U.S. government rules against allowing any single purchaser of stock to buy more than 4.9% without getting permission from the U.S. government.
Abu Dhabi bought the limit of what it was allowed to buy. I have no doubt that it could have negotiated more than 4.9% for its $7.5 billion if there had not been a government-imposed limit, which would have eaten up precious time. The participants on both sides recognized that the bank was facing an emergency. It had squandered at least this much money and possibly much more in its ill-fated subprime mortgage lending schemes. Without warning, the bank in August suffered horrendous losses. There is no way that Citigroup would have sold 4.9% of the company last July. Citigroup was fat and sassy. Its president, the now-departed Charles Prince, was riding high.
The stock fund managers started buying as soon as the news hit. The official interpretation: “This decision by Abu Dhabi indicates that America’s largest bank is in good shape. This is the end of the subprime crisis.”
Here is my interpretation:
A small percentage of a gigantic pool of oil-generated capital, which is managed by government bureaucrats in a city-state whose nation did not exist as recently as 1970, was used to buy 4.9% of the largest bank in the United States because this purchase was perceived as a better deal than buying T-bills denominated in a falling dollar.
Here is a city-state that until half a century ago was an underdeveloped town in a desert. The Wiki Encyclopedia describes it in 1958.
Into the mid-20th century, the economy of Abu Dhabi continued to be sustained mainly by camel herding, production of dates and vegetables at the inland oases of Al Ain and Liwa Oasis, and fishing and pearl diving off the coast of Abu Dhabi city, which was occupied mainly during the summer months. Most dwellings in Abu Dhabi city were, at this time constructed of palm fronds (barasti), with the wealthier families occupying mud huts. The growth of the cultured pearl industry in the first half of the twentieth century created hardship for residents of Abu Dhabi as pearls represented the largest export and main source of cash earnings.
Today, the residents of Abu Dhabi are doing better financially. The net worth of each of the 420,000 citizens is $17 million. Of course, they can’t actually get their hands on this money. It is administered on their behalf by salaried bureaucrats.
These bureaucrats are in charge of allocating billions of dollars worth of oil revenue. They have decided to get into the banking business, a profession that is prohibited by Islamic law: usury taking. They have no experience in banking. But they thought, “Gee, let’s buy part of a bank that is suffering major capital losses.” Result? The Dow rose 215 points. Why does Abu Dhabi have this kind of money to invest? Because oil is up, and the world’s economy is repeating the experience of 1973—79: a massive transfer of wealth to Arab, Iranian, and other oil kingdoms. To this group, add Russia, which now has almost $500 billion in foreign currencies, third only to China and Japan.
In 1988, Gorbachev went begging to the West for money. Today, the West is at the mercy of the good graces of Putin. “Please sell us oil. Please sell us natural gas. We’ll be good. We promise!”
The only thing that will send oil back to 2006’s level ($55) is a worldwide recession. Supply and demand favor the oil exporters from now on. This is permanent. The world’s economic power will shift inexorably to the oil kingdoms and to China.
Abu Dhabi’s purchase points to the future: the sale of America’s economic crown jewels to foreign owners. The profits from American-based companies will then flow to foreigners who own the companies. This scenario is unlikely to change in my lifetime or yours.
Yet this purchase caused a 215-point rally in the Dow. Investors are short-sighted. They regard as a cause of celebration the most visible private transfer of American capital to foreigners in our lifetimes.
On Wednesday, November 28, the Dow climbed 330 points. Why? Because of a vague remark by a member of the FED’s Board of Governors in a speech to the Council on Foreign Relations. He said that the FED should be pragmatic. So what? This has been the FED’s position since 1933. Here is what he said: “In my view, these uncertainties require flexible and pragmatic policymaking — nimble is the adjective I used a few weeks ago.”
This comment was interpreted to mean that the FED will lower the target rate for overnight bank loans by another .25 percentage point. Other than serving as a symbol of the FED’s commitment to liquify the banks by a small percent, such a decline will have no impact on the massive, multi-billion dollar losses that have been sustained by the financial sector and which will continue, everyone admits, through 2008 and maybe into 2009.
Kohn’s actual speech was anything but reassuring. He began with an open admission of what is now apparent: financial experts don’t know what is happening in the capital markets.
Central banks, other authorities, and private-market participants must make decisions based on analyses made with incomplete information and understanding. The repricing of assets is centered on relatively new instruments with limited histories — especially under conditions of stress; many of them are complex and have reacted to changing circumstances in unanticipated ways; and those newer instruments have been held by a variety of investors and intermediaries and traded in increasingly integrated global markets, thereby complicating the difficulty of seeing where risk is coming to rest.
In other words, those AAA-rated credit instruments back in April may today be worth approximately what Abu Dhabi was worth in 1958.
The economy is facing uncertainty on a massive scale. Notice his phrase, “especially adverse outcomes.”
Another consequence of operating under a high degree of uncertainty is that, more than usually, the potential actions the Federal Reserve discusses have the character of “buying insurance” or managing risk — that is, weighing the possibility of especially adverse outcomes. The nature of financial market upsets is that they substantially increase the risk of such especially adverse outcomes while possibly having limited effects on the most likely path for the economy.
When we see this sort of analysis from a high official, we had better understand what he is saying. Here is what he is saying:
“When great chunks of that AAA-rated paper turns into something suitable for fan-hitting, don’t blame the Federal Reserve when it finally hits.”
Then he launched into a theme made popular by Alan Greenspan: moral hazard. “Moral hazard” refers to a mental outlook that says, “The Federal Reserve will intervene to save the capital markets whenever it looks as though those markets are about to fall apart.” Greenspan assured us again and again that this was not the FED’s goal at all. Then he and the FOMC inflated the dollar, lowered the Federal Funds rate, and proved that the moral hazard effect was alive and well at the FED, as always. Kohn continued:
Central banks seek to promote financial stability while avoiding the creation of moral hazard. People should bear the consequences of their decisions about lending, borrowing, and managing their portfolios, both when those decisions turn out to be wise and when they turn out to be ill advised. At the same time, however, in my view, when the decisions do go poorly, innocent bystanders should not have to bear the cost.
Innocent bystanders: you know, the average Joe investor. Well, maybe the average head of Citigroup, who got a severance settlement of about $40 million. It’s hazardous out there!
Asset prices will eventually find levels consistent with the economy producing at its potential, consumer prices remaining stable, and interest rates reflecting productivity and thrift.
That’s what we need: productivity and thrift! And how will we get more productivity and greater thrift? By selling off our capital assets to oil-exporting governments that confiscated the oil in the name of the People 70 years ago.
To be sure, lowering interest rates to keep the economy on an even keel when adverse financial market developments occur will reduce the penalty incurred by some people who exercised poor judgment. But these people are still bearing the costs of their decisions and we should not hold the economy hostage to teach a small segment of the population a lesson.
Bearing the cost of their decisions, yes. Like the former head of Merrill Lynch, who walked away with $160 million for his trouble. It’s tough being out there in the trenches!
The Federal Reserve’s reduction of the discount rate penalty by 50 basis points in August followed this model. It was intended not to help particular institutions but rather to open up a source of liquidity to the financial system to complement open market operations, which deal with a more limited set of counterparties and collateral.
The “financial system,” yes. But how was this accomplished in August? By lowering interest rates that banks charge to reach other, i.e., lowering capital costs for commercial banks. Banks, in fedspeak, are “the financial system.” Unfortunately, things are looking a little dicey.
However, the increased turbulence of recent weeks partly reversed some of the improvement in market functioning over the late part of September and in October. Should the elevated turbulence persist, it would increase the possibility of further tightening in financial conditions for households and businesses. Heightened concerns about larger losses at financial institutions now reflected in various markets have depressed equity prices and could induce more intermediaries to adopt a more defensive posture in granting credit, not only for house purchases, but for other uses a well.
In other words, November’s data point to a possible credit crunch, or, as he put it, “a more defensive posture in granting credit.” How far will the ripple effect spread? He doesn’t know.
The underlying causes of the persistence of relatively wide-term funding spreads are not yet clear. Several factors probably have been contributing. One may be potential counterparty risk while the ultimate size and location of credit losses on subprime mortgages and other lending are yet to be determined.
Do you recognize the phrase, “counterparty risk”? No? Let me clarify. It refers to contractual guarantees by major financial institutions to compensate holders of bonds and other credit assets if the market creates losses for them. Sadly, the net worth of most of the guarantors is far less than the contractual obligations incurred. Then who is holding the bag? Nobody knows: “. . . the ultimate size and location of credit losses on subprime mortgages and other lending are yet to be determined.”
Finally, banks may be worried about access to liquidity in turbulent markets. Such a concern would lead to increased demands and reduced supplies of term funding, which would put upward pressure on rates.
What would be the effect of upward pressure on rates? A fall in the market price of bonds. Then the bond holders will contact the “counterparties” and ask them to cut a check for the loss.
If you do not understand what this means, think “fan.”
All of this was the groundwork for Kohn’s statement that caused a 330-point rise in the Dow.
In my view, these uncertainties require flexible and pragmatic policymaking — nimble is the adjective I used a few weeks ago. In the conduct of monetary policy, as Chairman Bernanke has emphasized, we will act as needed to foster both price stability and full employment.
He laid the groundwork to say that central banks are unable to do much about what is happening, because nobody knows what is happening, or to whom, or when it will end.
This is not the stuff of a 36,000 Dow. This is the stuff of stock fund managers’ optimism, which as recently as July was shared by the head of Citigroup and the head of Merrill Lynch.
The investing community wants to believe that the FED and Abu Dhabi can change the fundamentals of the economy, thereby restoring confidence in the stock market. In other words, the fund managers believe that symbols are more fundamental than the reality of the highly leveraged, self-monitored debt market which has created so many liabilities that the solvency of some of America’s largest banks is at stake.
The stock market will need many more interventions by Abu Dhabi and other Arab oil states, which now control the flow of funds America’s capital markets.
The great fire sale has begun. Senior American managers have begun to sell the nation’s seed corn to the Arabs. They will continue to do so as the economic agents of American people. The sale of 4.9% of Citigroup is a visible turning point.
Stock market investors cheered. They bought. Why? Because they expect to be able to sell later on to the Arabs.
This is the greater-fool strategy. “Buy now; sell to a fool later.” But the greater fools are the American buyers who are planning to sell their claims to the future of America’s productivity. The only way that the Arabs will turn out to be greater fools is if America ceases to be productive.
Without thrift, this is a real possibility. American households have been in a net negative position for two years. They are borrowing their way to the good life. In short, they are imitating the U.S. government.
This is not going to turn out well.
Copyright © 2007 LewRockwell.com