Deus Forex Machina (Page 3 of 3)

So you’ve got a period of great suspicion as to where the losses are. Many suspect that the losses have occurred in hedge funds. If not – if the losses are in endowments and pension funds, that means un-leveraged – then these investors will just grin and bear it. It will not present a systemic risk.

Ironically, that is what we always thought was the virtue of these new [financial] products: that they would be able to allocate the risks to people or institutions that weren’t brittle, which had a lot of resilience and could take a very long-run view. But if it turns out that this is not what’s happening and that a significant part of this risk has been allocated to a group of people or institutions that have no resilience whatsoever because they’re leveraged, then that’s a different world.

Even if the pension funds and the insurance companies own these structured products and they can withstand the pain from the losses, they will also bring lawsuits. Lawsuits will effectively close the window for the whole securitisation machine. Who will the market sell these products to? In other words, there will be a change in the demand for the assets that are generated by the securitisation machine. This means a change in the demand for the underlying assets that feed the securitisation process.

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That may be no bad thing. That may be a medium-term correction we all have to go through. If you talk to people who run operating companies – shopping malls, for example, or electricity generating facilities or distribution facilities – they’ve been complaining for years that the sort of assets they want to buy and operate have become more expensive. The prices of everything they need to operate have been driven up by the investment banks. These banks have developed off-market vehicles that go out and bid for this stuff, securitise it and then sell it on to investors.

It’s very similar to private equity. The securitisation process drives up the cost or value of physical assets. If the scale of that activity is reduced, it won’t be a bad thing for the world economy at all. We’re in a process of bringing the risk spreads back to normality. This will inevitably drive some players out of the securitisation business.

What if the critical issue today isn’t sub-prime mortgages? What if the event at hand is simply that there’s a permanent re-pricing of capital in an upward direction? That should mean that investors actually get a greater return for the risks they take. In the past they’ve been paid relatively little for the risk they take. Ultimately, this is good for the real economy. Now you will get paid for the work you’re doing.

Yes. It’s almost like Main Street getting its own back against Wall Street.

It’s very interesting because no one is thinking about this advantage in Main Street. Main Street is afraid.

No, the problem is that in the process they may both suffer. This is the big worry that the Fed’s got to face. The Fed, in my view, isn’t keen to bail the system out because it’s a very good central bank and it has a very long view. Deep down, central bankers worry about what people will think of them in 10 years’ time. They are not just worried about what people will think about them in one year’s time. The way to be thought popular in one year’s time is to cut interest rates. But, if you are just engendering the fifth financial crisis a few years down the track, it will be held against you in 10 years’ time, and so it should be.

So this is actually tougher than anti-inflationary policy. It used to be tough to raise interest rates when inflation was rising. Central banks that did became extremely unpopular. The governments asserted their power over them to make sure they didn’t. Now the situation has changed and they can do that. It’s much easier than it used to be. But the new challenge is to not too readily bail out the system when there is a financial crisis. And again this will be very unpopular. I read recently someone saying “Bernanke’s made a rooky error by not already cutting interest rates”. What sort of idiot is making these comments? This is obviously someone who is very inexperienced, with an incredibly short time horizon.

One difficulty is that central bankers, particularly members of the Federal Reserve, direct their comments primarily to Congress and the public. While the markets are an important part of the audience, they’re not the main focus. But the markets assume they are. So when US Senator Dodd calls a press conference with Ben Bernanke and US Treasury Secretary Hank Paulson and is quoted saying, “The Fed has agreed to use all possible tools,” the market interprets this to mean a rate cut is guaranteed. But what most likely occurred is the Senator was reassured that all possible tools are available, but that the assessment hasn’t yet been made and it may be that the Fed Funds rate isn’t the right tool. So the markets misinterpret what has happened.

I sincerely hope so. It’s amazing that Wall Street, within days of the first open-market operations to keep the markets lending, had already priced-in two rate cuts.

Ian Macfarlane was interviewed by Dr Philippa Malmgren for

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