The resumption of its dance by finance capital is what seems to be reviving markets worldwide, even though the reasons for the July downturn remain.
THE first of October brought more bad news about the adverse impact of the subprime loan crisis in the United States. On the one hand there was news from Swiss banking major UBS that it was writing down the value of its fixed income assets by $3.4 billion. This was based on the banks own assessment of the likely market value of its, possibly unmarketable, investments in subprime mortgage-backed securities. As a result of the adjustment, the bank is expected to regis ter a third-quarter loss of anywhere between 600 and 800 million Swiss francs. According to Financial Times, this would be UBS first quarterly loss since 1998, when it was forced to write off its investment in Long-Term Capital Management, the hedge fund that collapsed. Not surprisingly, the banks head of investment banking is being shown the door. Unfortunately, so are 1,500-odd other employees of the bank.
On the same day, Citigroup went even further. It declared that it expects a 60 per cent drop in third-quarter profits, implying a close to $3.5 billion fall relative to the $5.5 billion earned in the corresponding quarter of 2006. This was presented as the likely result of $6 billion of write-offs on account of a wide variety of losses: $1.4 billion on account of bad-performing loans that went to finance leveraged buy-outs; a $1.3-billion cut in the value of mortgage-backed securities; another $250 million on account of other collateralised debt obligations; $600 million to cover other losses in credit trading; and $2.6 billion as provisions to cover increases in credit costs in the consumer-lending area. In sum, all the new products and activities that financial expansion has discovered and multiplied to deliver high profits are now proving a heavy burden.
These developments, though troubling because of their possible effects on output and employment growth the world over, were not wholly unexpected. In fact, what is surprising is that despite reports of the closure or increased vulnerability of financial firms, a number of Wall Street banks, such as Lehman Brothers, Goldman Sachs and Bear Stearns, that were known to be exposed to the subprime mess have released profit figures that are not just positive but even reasonable. That, analysts argue, is because the figures relate to the three months to end-August, which included at least a month of profits before the downturn began.
However, what is truly surprising is that stock markets, which turned downwards in July as the reality of the subprime crisis was acknowledged, have been on the rise in recent weeks. In fact, on October 1, when the bad news was breaking, the Dow Jones industrial average closed at a record 14,087.55. The index had touched a peak of 14,000.41 at closing on July 19 when the subprime crisis-induced market downturn had begun.
What is more, Citigroups share prices, which had fallen 16 per cent this year prior to the profit warning it issued, rose by 2.3 per cent, to $47.42, immediately after that warning. The financial boom is riding on financial losses and not profits. This is not a purely U.S. phenomenon. In Europe, too, where the effects of subprime exposure have been more damaging, the FTSE reflects similar trends, even if market recovery has not been as sharp.
This is indeed bizarre. For quite some time now financial firms had been speculating on the losses that may result from the subprime crisis. Evidence emerging in the weeks preceding the most recent announcements had pointed to significant potential losses, which many argued were still underestimated. Meanwhile, figures on employment trends, housing sales and housing prices indicated that this has started telling on aggregate spending and growth.
On account of these developments, three outcomes seemed inevitable. First, a liquidity crunch as banks and other financial institutions threatened with losses, and needing to make provisions for them, curtail their lending and investments. Second, a weakening of markets as these institutions unwind some of their more liquid assets to meet margin and other commitments. And, third, a further deterioration in stock markets as expectations of reduced earnings of corporations adversely affects investor sentiment.
In the circumstances, the revival and even boom in stock markets is paradoxical. One explanation offered is that subprime losses were lower than expected and easily accommodated by most of the majors. The resulting correction of the excess caution that had overwhelmed markets was seen as triggering a boom.
On the surface, there appears to be some substance to this view. Citgroups $6 billion write-off and provisioning package is small money when seen in the context of its estimated $2 trillion in assets. Further, its proposed write-off of a billion on its $13 billion subprime asset base points to a loss of less than 10 per cent when these assets are marked to market. On the basis of such assessments Citibank declared that its profit outlook was still good and the third quarter was more of an aberration, resulting ostensibly from unexpected developments in the mortgage-backed securities market.
If this view holds, the problem is merely one of illiquidity. The downturn was as sharp as it was, it could be argued, because firms faced with short-term losses, resulting from unusual circumstances, found themselves strapped for cash and/or starved of credit. This worsened a minor blip on the financial map, turning it into a crisis.
Clearly, it was this kind of argument that was used to defend the decision of the U.S. Fed and the Bank of England to ease credit availability and reduce interest rates in order to save financial firms that had violated all prudential norms. However, if the problem is the unwillingness of banks to lend and of other financial firms to invest because they see no profitable and low-risk opportunities in financial, real estate and consumer markets, improved liquidity is no solution. The enhanced liquidity will remain unutilised.
There are reasons to believe that the crisis in the market for subprime loans and similar financially leveraged investments is no mere aberration. The write-offs necessitated by that crisis have to be compared not with assets but revenues and profits, when assessing their implications for markets. Moreover, assessments of the warranted magnitude of write-offs are controversial. Much uncertainty surrounds the mark-to-market values attributed to assets that are not saleable at present. The little information available points to a much sharper decline in the value of illiquid mortgage-backed securities than what is reflected in actual provisioning. Bear Stearns, for example, had to declare worthless the mortgage-backed securities two of its funds had bought into. If this be the case, further investments in sensitive financial and real estate markets must be abjured. Even if liquidity is available, such investments must be avoided so as to postpone a crisis that can only be worse when it materialises in the future.
But this may not be the view that finance capital takes. In its view, the better route to take may be to invest in markets and work them up so that speculative profits can be made and losses can be neutralised on the basis of valuations that may have little to do with the performance of the real economy.
For this, however, liquidity matters: therefore the efforts of governments and central banks to support the financial sector with cheap and easy money. In fact, there seems to be a further element of collusion in this game. Thus, Citigroup is reportedly tying up with private equity firm Kohlberg Kravis Roberts (KKR) to set up an entity financed with $5 billion of equity and $10 billion of debt that would buy into doubtful loans at a discount, possibly with the hope that they can be packaged and sold for a profit. This is expected to include some being held by Citigroup.
Citigroup and KKR have had a close relationship in the past, with Citi having helped finance many of KKRs leveraged buyout deals. Overall, easily accessed and cheap credit can be used to make speculative bets, which, if profitable, can help dress up profit-and-loss accounts and balance sheets.
That finance holds such a view has been known for some time. Thus, even when the subprime saga began, Charles Prince, chairman and chief executive of Citigroup, refused to see the need for caution. When confronted with the prospect of a subprime meltdown in July, he is reported to have told Financial Times, When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, youve got to get up and dance. Were still dancing.
The injection of liquidity into the system by central banks and governments, which otherwise preach commitment to letting markets work, has got the music playing again. The resumption of its dance by finance capital is what seems to be reviving markets worldwide, even though all the reasons that set off the July downturn remain. It is more this factor than the claim that the recent write-offs were mere aberrations that seems to explain the paradox of a financial recovery in the midst of a downturn in the real economy.
In fact, there are signs of a worsening situation on the ground. Growth is expected to slow substantially in the coming months. Unemployment is ruling high. The dollar is depreciating, threatening inflation in the U.S. The era of stagflation appears once again round the corner. The boom in financial markets is, therefore, not based on fundamentals. What is more, it does not seem to be based on any grounds for confidence generated within financial markets either. Financial firms are still busy toting up losses. The boom seems engineered.
If this be the case then the current boom in financial markets is only postponing the day of reckoning, unless governments that are injecting liquidity into the system find ways to revive the real economy as well. If they do not, this dance may well be one with the devil.
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