Article
In his annual Chairman’s letter to shareholders of Berkshire
Hathaway Inc for year 2001, Warren Buffet set out his perspective on financial
derivatives — particularly credit derivatives1, and concluded that “We try to
be alert to any sort of megacatastrophe risk, and that posture may make us
unduly apprehensive about the burgeoning quantities of long-term derivatives
contracts and the massive amount of uncollateralised receivables that are
growing alongside. In our view, derivatives are financial weapons of mass
destruction, carrying dangers that, while now latent, are potentially lethal”.
The 2008 US Financial Crisis :
An overview :
Indeed, Warren Buffet’s words of wisdom in his 2001 letter to
shareholders seem almost prophetic in the wake of the catastrophic financial
meltdown that is redefining the landscape of global finance at the speed that
perhaps makes Hurricane Ike look like a minor high tide. The historic US
government takeover2 of twin mortgage buyers — Fannie Mae3 and Freddie Mac4 on 7
September, 2008, bankruptcy of the 158 years’ old Lehman Brothers5, acquisition
of the 94 years’ old Merrill Lynch6 by Bank of America on 15 September, 2008, US
Fed and US government $ 85 billion loan bailout of American International Group7
(AIG) on 16 September, 2008, and scrambling for capital or other survival kits
by the remaining two independent investment banks and financial brokerages in
the US market, namely, Goldman Sachs and Morgan Stanley, all in a matter of two
weeks, is unprecedented in the US — the sacred land of capitalism, where
nationalising private investors’ losses through taxpayers’ bailouts has been
sacrilege, ever since the establishment of the US Fed system after the Great
Depression in the 1930s.
And yet even this did little to stave off the financial storm
whose end is nowhere in sight. Much like the stages of a scenario of systemic
financial meltdown associated with this severe economic recession that Professor
Nouriel Roubini of the Stern School of Business at New York University outlined
in February 20088 : “A vicious circle of losses, capital reduction,
credit contraction, forced liquidation and fire sales of assets at below
fundamental prices could ensue leading to a cascading and mounting cycle of
losses and further credit contraction. In illiquid market actual market prices
are lower than the lower fundamental value that they then have given the credit
problems in the economy. Market prices include a large illiquidity discount on
top of the discount due to the credit and fundamental problems of the underlying
assets that back the distressed financial assets. Capital losses then lead to
margin calls and further reduction of risk taking by a variety of financial
institutions that are then forced to mark to market their positions. Such a
forced fire sale of assets in illiquid markets leads to further losses that
further contract credit and trigger further margin calls and disintermediation
of credit. The triggering event for the next round of this cascade is the
downgrade of the monolines and the ensuing sharp drop in equity markets; both
will trigger margin calls and further credit disintermedia-tion . . . . . A
near-global economic recession could ensue as the financial and credit losses
and the credit crunch spread around the world. Panic, fire sales, cascading fall
in asset prices will exacerbate the financial and real economic distress as a
number of large and systemically important financial institutions go bankrupt.”
US Treasury Secretary Henry Paulson watched aghast on 17
September 2008 as his dramatic actions of rescuing Fannie Mae, Freddie Mac, and
AIG were met by worldwide stock market panic while inter-bank lending remained
stubbornly frozen. Running out of alternatives, on 21 September 2008 the Bush
administration led by Henry Paulson sent a draft of proposed legislation to the
US Congress asking for $ 700 billion in taxpayer money to get bad mortgage
assets off the books of troubled US financial institutions in a bid to end the
U.S. economy’s worst financial nightmare since the Great Depression. As a
measure of its relative size, this mother of all financial bailouts in modern
history, at $ 700 billion is approx 7.2% of the current outstanding US national
debt of $ 9.67 trillion9, about 24% of the 2008 US government budget outlay of
$ 2.93 trillion10, a tad over 5% of US GDP at $ 13.67 trillion (2007 est)11,
nearly 64% of India’s GDP at $ 1.09 trillion (2007 est)12, and 1.29% of World
GDP at $ 54.31 trillion (2007 est). Ironically, Henry Paulson, who previously
ran the world’s most powerful investment bank Goldman Sachs as its
free-marketeering former chairman now finds himself leading a nationalisation
programme that would make both Fidel Castro and Hugo Chavez blush ! Can the
government really take on the notorious financial instruments tied to sub-prime
mortgages, whose unfathomable loss of value has made the US credit crisis
self-perpetuating, and bury them in a vault funded by the taxpayer ? Time will
tell.
The on or off-balance sheet obligations of Fannie Mae and
Freddie Mac, the two independent government-sponsored enterprises (GSEs) is just
over $ 5 trillion. Together, Fannie Mae and Freddie Mac own or guarantee about
half of the $ 12 trillion of mortgages in the U.S.13 The government accounts for
these GSEs as if they are unconnected to its balance sheet. Notably, their
obligations at over $ 5 trillion exceed 50% of current US national debt14. The
net exposure to US taxpayers is difficult to determine at the time of the
takeover and depends on several factors, such as declines in housing prices and
losses on mortgage assets in the future. Over 98% of Fannie’s loans were paying
timely during 200815. Both Fannie and Freddie had positive net worth as of the
date of the takeover, meaning the value of their assets exceeded their
liabilities16.
As Domnic Rushe17 points out, two things seem to be clear :
First, the economic influence of American presidents is severely limited.
Secondly, US financial markets have become so complex and reliant on highly
technical trading instruments that even some of the country’s best-known
economists declared themselves bewildered by the head-spinning turn of events.
“As an economist, I am supposed to have something intelligent to say about the
current financial crisis”, said Professor Steven Levitt, the author of
Freakonomics, a best-selling guide on the way markets work. “To be honest,
however, I haven’t the foggiest idea what this all means”18.
