Wednesday, October 08, 2008

The Financial 9/11: The end of the American Dream?

America Then:

"The American Dream is a gay dream, that dream of a land in which life should be better and richer and fuller for everyone, with opportunity for each according to ability or achievement. ..... It is not a dream of motor cars and high wages merely, but a dream of social order in which each man and each woman shall be able to attain to the fullest stature of which they are innately capable, and be recognized by others for what they are, regardless of the fortuitous circumstances of birth or position."

- James Truslow Adams in his 1931 book Epic of America

America Now:

"Where god parachutes us is a matter of luck. Nowhere is that more true than Wall Street. There are more mediocre people making more money on Wall Street than any other place on earth. Sure, there are some stars, and some earn every nickel they make. The crowd they carry along with them is something else. Wall Street might be the only place in the world where a $100,000 raise is considered a tip.

When you handed someone a check for $10 million, they'd look u in the eye and say, "Ten? The guy down the street just got 12!" "Thank you" was a rare expression"

- Jack Welch in 'JACK'

So what has made the Wall Street, the heart of world's capitalism, come down on it's knees? Why is that now banks go bankcrupt by the day and why is that big, almost $ trillion bail-out thrusted down the throat of the American tax payer?

It was in my school days, i first heard, this philosophy of free market. That the best way forward into faster (economic) development, we indians were counseled, was to let weak companies die, and endure the animal instincts of the market - laissez-faire. Eventually, we were told, this would work wonders. When governments in India, China, Japan and the developing world intervened time and again, using government largess to lift inefficient firms to safety, sparing jobs and containing the financial breakdown, every financial expert worth his name in Wall Street chided and threw up his hands in a you-will-never-learn kind of patronage. So, It is now an irony to see that US' treasury secretary Mr. Paulson (who of course made his name as chief executive of Goldman Sachs, the Wall Street investment giant) announces a $700 bn bailout proposal to rescue banckrupt companies. Why is he rejecting his own medicine and why is he keeping good money after the bad just to own the waste on the Wall Street?

The guy who has criticized China when it shovelled money into companies to limit joblessness and social instability is now ardently advocating to do the same back home. While he is putting almost a trillion dollars of American tax payers money with almost nothing in return for the tax payer, he sure looks like the one referred to when some one said 'A man with a briefcase can steal way more money than any man with a gun'!.
So what is happening in the land of the free market? If Senator Jim Bunning, Republican of Kentucky is to be believed, the free market for all intents and purposes is dead in America. He calls this an act of financial socialism. But then that is entirely misleading especially when the trillion dollars put to rescue are tax-payer dollars and public money and they are being used to rescue the wallstreet firms and not the working-class American families who are loosing their homes, jobs and their savings. In cases of India and China, intervention was done to save public investments in PSUs and to avoid loss of employment. Socialism, atleast, had good intentions for the society as a whole, when it started. What the senator said would make a good sound byte but does not reflect the truth that this crisis is a result of Americas' own failure to regulate its own financial system. Perhaps after smart-selling the developing world that governments can be dumb and that the markets are smart and risk non-existent, the Americans seriously started believing that themselves as foolproof! And that brings them to this hopeless downword spiral.

I am one of those who believe that America has a unique political system — one designed by geniuses so that it could be even run by idiots (I mean look at the many instances American lawmakers got nailed for the wrongs and compare what happens in the same cases in our country, the system there in obviously strong). But then which system can be smart enough to survive this kind of supreme incompetence and recklessness demonstrated by the people charged to run it, like the Bushies?

At the heart of this crisis lies, ironically, the American dream - a house with a yard. Once upon a time in America, building a home was more a work ethic that defined the great american dream. Now this is a product of lier-loans from the unregulated banks and the greed of the big corporations. All those forests of unsold houses across America vouch for this. To cash in on the home loan demand, the US banks which lent the loans continuosly sold their loans to Investment banks like Lehmann Brothers, which in turn broke up these loans into CDO (Collateralised Debt Obligations) packages, sort of funds with unit values called SIVs (Structured Investment Vehicles) to international investors like the central banks of China, Japan, Korea, Sweden etc. The loan-issuing banks were rewarded with upfront payment equivalent to the loan they issued. So they need not wait till the guys who actually took the home loans pay the loan. In addition, the banks also got to keep much of the interest on the loan issued. So they had all the incentive to give away as many loans as possible. It is common that most of them borrowed money from bigger banks and firms to give away loans. They generously lowered the qualification criteria for issuing a home loan so much so that even without income proof, any assets, credit history, sometimes even without a proper job it was possible to avail a home loan. These loans were called NINA — "no income no assets". So the mad scramble increased property rates continuosly for 3 years from late 2003. And what kept the investment banks greedy for more was the commision they earned when they sold their CDOs to international investors. They also got their CDOs insured and they always counted on seizing houses in cases of default and putting them on the market. The only way the property rates could go, they thought with bedrock confidence, was northwards! (talk about the 'brilliant' brains that run the Wall Street). So, even if they get defaults, they thought, they would only end up making more profit. That is what the insurance companies thought as well and so they extended their generous services calling them Credit Default Swaps for these seemingly risk-free premiums. So, if the guy who took the loan defaults, the investment bank wouldnt be able to pay the international investors and the insurance firms have to process the claims. As quality of issuing loans decreased and interest rates peaked, there were more and more defaults before the deluge triggered panic which started the downward spiral of property rates. Within no time, we saw more and more property on the market due to foreclosures and no one to buy them. In July, 2008 the US government had to come up with a bailout for the government-sponsored mortgage companies, Fannie Mae and Freddie Mac. Together, they own or guarantee nearly half of the US' $12 trillion worth of home mortgages. If they collapsed, an already plummeting real estate would have gone bust and the many banks which put their capital in american homes would have slipped deeper into abyss. But then, that wouldnt stop the investment banks like Lehmann Brothers or insurance firms like A.I.G. from banckruptcy. Once the panic set in, all credit died up and no one wanted to issue any loan even for genuine enterprises, for fear of default. A crisis of trust brought everything to a halt and finance ministers from across the world whose national banks have bought american debt through CDOs calls up the US treasury secretary to do anything to keep the credit show going. After all, it is with the backing of US government that these international investors are invested in the US debt market. The US has been financing itself through treasury bonds by leaning heavily on foreigners, particularly China, Japan and the oil-rich nations of the Persian Gulf. To keep its growth engine going and make the international investors continue to trust it, it has to bail-out these corporations and so it did, Bear Stearns, Fannie Mae, Freddie Mac, A.I.G. and gave sweeping powers to the treasury to buy bad property from banks and unclog the financial system and keep the credit cycle alive.



And how will the bail-out pan out? Either the US government will pull more money from citizens as taxes or it will allow the Fed to print more money, letting inflation escalate. Whatever be the way the American citizen will dish out the money now. With the trillion dollars spent by now, the american tax payer (and future american tax payers) got a debt of $ 2400 per head. It is a matter of time before Mr. Paulson goes back to congress and says the $ 700 bn isn't enough. There is just too much waste to buy and in not too many days from now this money may look like a pebble tossed into a churning sea.

All these bail-outs are ad-hoc solutions. We are not even sure they may work. Even if they do for now, sometime later when things get calm, all the excesses in policy, execution and Wall Street better be investigated and corrected. All the 'golden parachutes' need to be grounded and all the fat pay slips need to be accounted for.

The ramifications are already there to see in the rest of the world in stock markets of Russia, Brazil, Indonesia, India and the Middle East. The Russian stock market dropped 19.1 percent yesterday, the biggest decline since the fall of the Soviet Union and the return of capitalism. Bail-outs are being dished out in Europe for the banks exposed to the money market in US. The president of the World Bank, warned that the crisis could be a "tipping point" for the developing world. Most of the Asian banks may withstand the current problems because Asia generally saves more rather than lend in international money markets. However, this would also mean Asians spend less and so are heavily dependent on overseas demand. The American consumer has for decades served as the engine of world commerce, using borrowed cash to generate demand, from clothes and computers to cars. Most of these in turn are produced in factories in Asia and Latin America. If the demand dries up, the pain would swallow whole of some national economies! Developing nations simply cant grow if the Americans dont borrow from them and buy from them! We are facing one of the biggest ever global crisis, almost about to put all major economies in recession at once.

When i visited US the previous year,as an indian, i was amused to see how important a credit card is in American life. I wondered how can a national economy be based on credit cards. Credit initially started as a facilitation for entrepreneurship in the land of the free, to lung at their dream, to achieve. Now, thanks to reckless deregulation, it has become just a financial instrument for unbridled greed, but allowed to threaten stability worldwide.

How America reacts and handles this credit crisis would define its future standing as a world power and a great civilization. Is it the end of the American Dream?

11 comments:

Ramesh Babu said...

Mama, thanks for your nice blogs, but, i suggest, these things are only a matter for the rich and upper middle class, i feel there are more real and true problems which the lower class and poor people are experiencing, lets concentrate on them and get suggestion of how to resolve them and bring soem light into their darker lifes.

its just a suggestion...

vijay said...
This comment has been removed by the author.
vijay said...

What about the land prices in hyderabad?Will they decrease?
Because NRIs are the major cause for rising land prices in hyderabad.

Praddy said...

I am more worried about the Inidan lot that has adopted western "culture" (makes sense?..anyways) of comfortable living...big foreign holidays and a no-savings lifestyle. we are not used to a lifestyle of remaining jobless, borrowing etc. and especially people of our generation who have seen jobs with fat salaries waiting for them in queue rather than it being the other way. Good luck guys! we gonna have a tough time ahead.

Reddy said...

Amar,
I don't agree that we are seeing an end of an American Dream. But rather a begining of solution for a global economic crisis with american leadership. America is swift in coming with new laws when required. I don't think there is any other country as quick as america. I agree that american makes mistakes, but their creativity, entrepreneurship, cultural export makes it leader of the world for atleast next 50 to 100 years.
I agree that american society is not fundamentally fair in rewarding it's people based on their work, but tell me where else it's more fair than america.
Wait for another 3 weeks, America will have it's next biggest cultural export "OBAMA". Obama election will be such a symbolic event, that it will stablize economy, it will give world another example of great american dream.
-Bhasker

Amar said...

Hi Anna,

Nice to see u here.
I did not mean 'American supremacy' when i said 'American Dream'. There is no challenge to its supremeacy in foreseeable future. I rather was wondering whether the spirit that made America what it is today,is dying. And of course i wanted to point at the paradox that 'a american home' is at the center of both the 'american dream' and this credit crisis.

What you said is entirely correct.
Americans are providing leadership in this crisis. But we did see the confusion with the bailout plan. Paulson firstly, didnt foresee anything even a couple of weeks before he proposed the bailout. Athoughtnd when he proposed, he adamantly ignored all suggestions about the swedish model in handling the credit crisis, which obviously was looking better. Infact, i think, just as many others do, that the UK got up with a better plan in handling the crisis by insisting on injecting money into banks directly, in return for ownership, rather than buying their bad assets. Now, paulson seems to come around to accept this approach, weeks after he was suggested. Was it lobbying from wall street that was holding him back? Anyway, my point is Americans (for all their tax dollars being spent) deserved better leadership, atleast in a crisis like this.

And yes, as you said, Americans are quick any day. I cant think about any other country which can pass a $700bn bailout within a week with all required legislation. All that was missing was clarity on behalf of administration and so they tried to rush everything through. They failed to clearly communicate the problem and solution to the american public.

And as you said, their entrepreneurship is unmatched. But is this not on a steady decline? When we need this all the more in face of energy crisis that may engulf us sooner or later, in absence of viable renewable energy sources and biofuels, Bush didnt seem to do enough.

Obama, definitely is a good bet considering that neither America nor the world can afford a McCain now. McCain will be no change for America. For all practical reasons, Not many (apart from the hardcore Jihadis hell-bent to enjoy with 72 virgins in paradise would like to see a weakening America.

This is nice conversation.Keep your comments coming.

Amar said...

Hey Praddy,

I am not sure though that this crisis is in anyway going to stop the 'credit lifestyle' in India. We are right on our way into that lifestyle and i think its irreversible. This crisis would atmost slow down this process by an year or two. Well it may not be a bad idea to build some credit history urself :)

Amar said...

Hey Vijay,

NRIs are i guess only a part of the reason for real estate price escalation in Hyd. Anyway, ups and downs are cyclical and i guess we in that 'down' right now. I really dont think prices will come down unless ofcourse we head into a recession ourselves loosing jobs and stuff. And not many see that coming.

Amar said...

Hey Ramesh,

I think most of the Americans reacted to this crisis the way you did, atleast now initially. But the truth is that we dont anymore live like islands. Thanks to the regulations here in India,we dont have to worry about our pension finds, insurances and savings accounts in the banks. But lots of Americans, poor and lower middleclass, got their loans, finances, savings endangered in this crisis because their banks are involved in mortagage bonds and credit markets. So they need this bailout all the more to rescue themselves.

This crisis is a lesson for India in how not to let caution slip away. And when these instuments of credit are properly used, we can as well tackle effectively the issues you are referring to.

sachin said...

Hey Amar,
Nice to see your blog on hot issue of credit crisis. As always ur blog is carefully written with all the facts and figures.
I think, the situation we are witnessing today is just an eye wash. In reality the situation is really worse in wall street. I think the real picture would come out after elections and I also believe that it would have an considerable impact on our economy.
One can imagine the outcome of this situation where banks of more than 150 yrs lost there identity in just a week .. when I was in London last week I saw fall in the stocks of RBS... It was trading for around 8 Pounds and within one week it was trading for less than a pound .... I would say we must be prepared for the worst and it seems to be the mantra of lots of people there ......

sachin said...

Guys I would request you all to watch the conversation of YSR (CM of AP) and Karan Thapar (Devils Advocate) on youtube ...