A dramatic end for reckless American finance

This week has been dramatic for Wall Street and the American economy. After weeks of huge writedowns, the collapse of IndyMac and of Bear Stearns (parked withing JP Morgan) and the virtual nationaliziation of Fannie Mae and Freddie Mac, this week the American financial system reached the verge of collapse. Without a buyer and no government rescue, Lehman Brothers was forced into bankruptcy, Merrill Lynch sold itself to Bank of America and the US government was forced to lend $85 billion to AIG the world’s largest insurer virtually taking it over. This chaos led investors’ flight to safety and a loss of confidence that could turn illiquid institutions insolvent and led to a freezing up of Bank lending. As a result after investing billions of dollars the US federal government is now seeking a wider solution to the crisis to restore confidence by creating a fund that will be able to purchase up to $700 billion of residential or commercial mortgage securities at the heart of the problem to remove them from the banking system. While this action may restore investor confidence by creating a credible market, the American taxpayer risks to lose a fortune after all no one wants to own these toxic mortgage assets. The problem is that the alternative, collapse of the banking system, could cost a lot more: an average of 16% is what banking crises around the world have cost in the past 30 years according a recent study of the International Monetary Fund. In the end however even after the panic of 2008 will subside, pain will continue and recovery will be distant because banks and households have just started to cut their borrowing, which reached irrational proportions during the housing boom. Some people claim that this is the end of American capitalism but if anything this crisis shows the need for well regulated and transparent markets and the dreadful costs of rigging markets with distorted mortgage subsidies and the emergence of shadow banking and derivative systems.

Living Beyond our Means

Credit seems one of those wonderful things in life that can help people make ends meet in difficult times. The financial system is one of mankind’s greatest creations when we think about it because it enables us to leverage other people’ savings to invest in and produce new things. Think about it: we may not trust some of our neighbors and yet in search of some kind of return, through banks, we lend money to and borrow from people we never met. The problem with credit however is that most consumers today use it regularly to increase their spending rather than leveraging it judiciously in difficult times. Consumers have been increasing the use of credit across the world (see chart) and millions of people today struggle every month to make payments on high interest credit cards. The credit card industry is excellent at peddling its wares but the credit crisis afflicting consumers is something that each of us needs to take responsibility for. Let’s face it, unlike previous generations who led modest lives, the new generations have become spoiled, we want it all, we want it now and living beyond our means has become a dangerous addiction. As with all addictions the cure will be long and painful and admitting we have a problem would be a good first step in long journey.

The Green & the Blues

There are more worrying signs that America’s long party is over. The dollar continues to lose significant value with the exchange rate reaching new lows against the euro and yen (see chart). This is partly due to the financial uncertainty following the sub-prime mess and the Federal Reserve’s action to aggressively lower interest rates. The greenback’s loss of value is however mostly a result of Americans’ addiction to borrowing and living well beyond their means through OP(iu)M (Other Peoples’ Money, mainly the borrowed capital provided by Asian savers). Given the dollar’s role as the world’s preferred reserve currency, the devaluation could have been fiercer and no doubt the dollar will rebound somewhat over the long run but the loss of purchasing power and the impact on American consumers will have long lasting repercussions.

Deep Cracks in the Wall

New York has enjoyed the unrivaled status of being the financial capital of the world for some time. The animal spirits of capitalism after all are nowhere more ebullient than on Wall Street where fortunes can be quickly created and destroyed. Unprecedented greed however has undermined this financial titan. Wall Street has seen and survived booms and busts before but in a world where the American economy is not the only powerful engines anymore, Wall Street may have sawn the seeds of its own demise. The sub-prime craze, the high levels of debt and leverage, corporate fraud, not to mention the crumbling dollar are the sign that mark the end of an era. Wall Street, being rescued by Sovereign Funds or the Feds (see the virtual collapse and rescue of Bear Stearns this week) point to diminished future in a world where capital flows can be directed quickly to many hungry markets. Wall Street will always have its bulls but the era of sole supremacy is over. It is now up to Washington to determine whether the American economy will remain competitive or go down the same sorry path of slow decline.