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   08-31-2007 11:45

Debt Crisis – Ten Years Later


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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