Call Out the Leviathan

By Frank Schell

Like the captain of Longfellow’s ill-fated ship Hesperus, America has not listened to much advice. When a country’s store of value is also the world’s reserve currency, it creates a moral hazard larger than any other: an all pervasive culture of debt, also known as leverage. America’s bad listening skills about trade and treasury deficits have embraced several decades and administrations, but to be fair, crises are never predicted, except by a few seers to whom no one pays much real attention.

It is no secret that America has been consuming and living well beyond its means for some time, engaged in a non-partisan frenzy of gluttonous leveraging up, resulting in an outsized standard of living, where seldom was heard the word “enough.” The Hummer, the tall latte with nutmeg, and 65-inch flat screen TVs are but a few examples of the nomenclature of indulgence.

No doubt some view excess as great – if you can get away with it. But in a world of free movement of labor, capital, ideas, and electrons, it will eventually be reckoned with by the world’s credit and capital markets, which are beyond the real control of sovereign or consumer forces.

Falling housing values have impaired loan to value ratios, the immense mortgage backed securities market, the ability to refinance, and reduced the incentive to service debt on property. Through the technology of securitization – creating securities out of pools of residential mortgages – and with instant telecommunications, the problem has infected investors globally, from the G-7 to the emerging markets, often at the speed of light.

For several decades, a mosaic of deregulation, competition, and a short term view of performance and incentive compensation have led to the assumption of undue concentrations of risk. And mark to market or Fair Market Value accounting, recently relaxed by the SEC but never intended to bring the United States to its knees, has done just that by initially making bad decisions even worse.

It is very early to judge the longer term implications of this economic emergency. Besides the interventions by the Department of the Treasury and its recent focus on putting $250 billion of equity into the banking system, and besides the actions of the Fed and FDIC, and the G-7 acting in concert, further recapitalization of our banking system must occur. Estimated write-downs or losses thus far exceed $500 billion, and some predict twice this figure or more. This capital must be replaced from domestic or foreign sources, including sovereign wealth funds that have already ridden to the rescue.

It is hard to imagine that a global recession can be avoided. The vital commercial paper and London Interbank markets must function well for daily funding of the global corporate and banking sectors. Further, residential foreclosures continue to mount, and over $8 trillion of stock market capitalization capital has been wiped out in the U.S. in the past year. There is a climate of fear about how bad it will be for IRAs, employment levels and small businesses, which have limited alternatives to raise capital and employ over half of the U.S. work force. And as the American consumer deleverages, our standard of living will decline.

The nation’s economy is built on the principle of access to capital – debt and equity. Until confidence is restored in our financial system, we will not see a return to normalcy. We are reaching a point where after the U.S. Treasury and other G-7 systemic actions, only time will tell. What has not been publicly discussed much is their effect on the nation’s money supply, its relationship to future inflation, and what this means for future spending priorities.

On a philosophical level, this crisis will call into question the notion of the risk free rate, long a staple of financial theory. Pricing debt off a Treasury instrument of similar maturity, U.S. government risk has been assumed to be zero, with interest to reflect a premium for inflation. But the debt, equity, and contingent exposure being assumed by the Department of the Treasury, at this time an unknowable but vast figure, will affect how the world sees and prices U.S. sovereign risk.

This crisis has been consistently underestimated since early 2007, when the first shots were fired in the write-off of subprime loans in the U.S. Since then, we have seen wild gyrations in the stock market, and in the summer of 2007 a contraction in the now $1.6 trillion commercial paper market, affecting the ability of corporations to fund short term. Until the very recent systemic remedies, government interventions have been situational or ad hoc, directed only at certain floundering institutions. The disturbing question is how can so many brilliant minds and mathematical models be caught so unprepared?

Decades of free market theology and the principle of laissez-faire have been abandoned in a matter of weeks. Even some of the most ardent believers in deregulation have cried out for intervention, hoping there is a giant sovereign somewhere that can mitigate the mayhem – like the all powerful Leviathan of Thomas Hobbes – to avert a descent into chaos.

Frank Schell is a former banker specializing in international trade, treasury, and risk management. He is member of the National Strategy Forum and the Dean's International Council of the Harris School of Public Policy Studies at the University of Chicago.