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By Henry M. Seggerman
President of International Investment Advisers
Ten years ago, Asian economies suffered a massive financial
crisis. The International
Monetary came in to bail out the mess, with Korea
singled out as perhaps the worst economy, due to its uncontrolled
borrowing. As a pre-condition
for the $53 billion Korea
bailout, the IMF required the Korean government to mandate that Korean
corporates reduce their debt-to-equity
ratios from the stratospheric 1,000+% level down to below 200%. The message from the world’s august
financial regulators was loud and clear: Korean was an undeveloped,
emerging, primitive country whose financial system was nearly
destroyed by out-of-control borrowing.
With this perspective, I thought it might be
worthwhile to look at the debt crisis unfolding right now in the United States,
that pillar of sound, rational, fully-developed economic brilliance.
Ten years ago, Korean financial institutions
were accused of lending to financially unworthy chaebol
affiliates, companies which did not have the capacity to repay their
debts. The lending banks
performed little or no credit analysis. The loans were granted on a
no-question-asked basis, the assumption being that the chaebol parent company was “too big to fail.”
Today, U.S. financial
institutions have been lending to financially unworthy homeowners
with subprime loans. Real estate in the U.S.
has been enjoying an extended rally spanning nearly a decade. This was fueled by aggressive
mortgage lenders, pushing 80%, 90% mortgages and “exotic loans.” Because this proved extremely lucrative,
they opportunistically extended the game board further, into the high
risk subprime mortgages, lending to
homeowners far less likely to pay back the loans, often on a “no
docs” basis (aka no-questions-asked).
The lending banks performed little or no credit analysis.
Ten years ago, Korean financial institutions
were accused of allowing the massive debt problem to be concealed in
the chaebols’ Byzantine cross-ownership
structures, with layer upon layer of debt guarantees hiding the
reality that bad loans had been made.
These in turn were concealed further by an elaborate system of
government guarantee agencies, meaning Korean taxpayers would be the
ultimate victim in any breakdown of the system.
Today, U.S. financial
institutions have hidden the subprime loans
in Collateralized Mortgage Obligations (CMOs),
which mix all the bad loans in with a diversified portfolio of other
mortgages. As if that were not
enough, various CMOs are then repackaged
into Collateralized Debt Obligations (CDOs),
even larger debt instruments in many trillions of dollars, as with Korea,
assumed “too big to fail.”
It’s a Ponzi Scheme, with promoters
pushing “you can’t lose” CMOs to one group
of naïve investors, then more promoters repackaging the CMOs into CDOs and
pushing them to a new group of naïve investors.
Are CMOs and CDOs well-established financial practices, known
to be reliable for decades?
Quite the opposite, this type of securitization was prohibited
by law in 1933, and only got relegalized
recently. Noted economist
Christopher Wood has called these and other asset-backed securities,
“the greatest financial experiment in the history of the world.”
Ten years ago, Korean financial institutions
were accused of “underprovisioning” for
non-performing loans, of refusing to assign a high enough
likelihood-of-default measure for those many unworthy affiliates,
with their obviously window-dressed financial statements, within chaebols deemed “too big to fail.”
Today, U.S. financial
institutions almost automatically give CMOs
and CDOs the favored AAA “Investment Grade”
rating, even many holding subprime
mortgages. Through some
bizarre logic, these products are “Senior” debt, are considered
well-diversified, with real estate collateral being viewed as more
reliable. Moreover, underwriters
actually conspire with ratings bureaus in packaging these products,
getting an upfront guarantee they will receive the highest
ratings. With Sir John
Templeton warning, “I think 20% of people who have mortgages on their
homes are likely to lose them in foreclosures,” these AAA ratings are
not only deceitful and irresponsible, but downright insane. No wonder criminal investigations
are now underway.
Ten years ago, Korean financial institutions
were accused of relying heavily on government policy in their
lending. Korea’s
economy was subject to the dictat of an
“Iron Triangle” between big business, the government, and the
banks. When a chaebol affiliate could not afford to service its
debt, a call came from the ministry, a loan
was rolled over, a capital injection made. These were Korea’s
notorious “Policy Loans.” Korea
suffered from acute moral hazard, because the corporates
knew their loans would be rolled over, so they made no effort to
turnaround their failing businesses.
Today, American financial institutions know
that the Fed will bail them out when their irresponsible lending
starts imploding, as with Long-Term Capital Management. Last week’s Fed capital injection
into the markets – followed by the European Central Bank’s mirror
move – shows that government will gladly deploy public-sector money
to clean up private-sector fiascos.
Although expressing vigilance against inflation just weeks
ago, Ben Bernanke has just cut 50 basis
points. But he didn’t cut it
from the Fed funds target, but instead from the discount rate, a
special rate reserved not for good-credit homeowners seeking
mortgages, but rather for financial institutions borrowing government
money. The only goal of this
was to prop up all the bad paper out there. If that’s not moral hazard, what
is?
Ten years ago, Korean financial institutions
were accused not only of permitting high levels of debt, but also of
turning a blind eye to a vast system of secretive financial records
that kept the problem concealed from any public scrutiny. One-third of all Korean listed
companies did not generate enough operating profit to service their
debt, and dozens of blue-chips sported debt-to-equity ratios above
1,000%. Fraudulent financial
statements were widely tolerated; the Daewoo Group reported debts of
$20 billion, when the reality was that they were $80 billion in the
hole.
Today, American financial institutions are
steering trillions of dollars, even pension money, into hedge funds,
and all of this money is leveraged to the max, with the result being
that the market cap of all the stock markets in the world is more
owned on margin than at any time since the Crash of 1929. Moreover, many of these funds
invest in: arcane, secretive “black box” investment schemes
(frequently based on the assumption the market will go up forever);
so-called synthetics; or illiquid securities which the manager values
arbitrarily each month. If
there were a strong stock market correction in tandem with a sudden
inflationary spike, we could see an avalanche of margin calls and
snowballing market plunge. The
market is already correcting and the central banks are flooding world
markets with liquidity. That’s
like lighting up a Marlboro in an oxygen tent. This is what your Econ 101
professor called a “Minsky Moment”.
So, in hindsight, Korea’s
great transgressions ten years ago are not a lot different that what
is going on in the U.S.
today. I suppose a few retired
MOFE officials and bank loan officers might be tempted to gloat right
about now. Unfortunately, they
probably have a lot of personal money tied up in the Korean stock
market, and thus have been hammered by its continuing correlation to
the U.S.
stock market.
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