Friday, August 10, 2007

Naked Uncle Sam

Economic Nobel laureate (1999) Mundell effectively said that Dollar reign will last for another 100 years because of the sophistication of American Financial System. Mortals and layperson like me are expected not to challenge these high priests unless we want to exhibit our foolishness again. But the turn of events in last two weeks in Global Finance make one wonder whether Prof. Mundell was indeed wrong.

It all started when Fed absolved itself from the responsibility of controlling what type of ‘mortgage loans’ were issued in the first place. Why in the world Fed could not see that with record low interest rates and extremely lenient qualification norms (no equity, no tax returns, etc.); the problem was brewing in the first place? Further, the past Fed Chief on top of it exhorted Americans to go for ARM type loans. Wow! One can judge the cluelessness of the Fed when it sirens all is well but on the second day an European Bank blows the whistle because of failure to ‘price’ CDOs.

Next, Congress got busy itself in reducing taxes for rich people. Congress has been so immoral that it would tax hard earned wages of poor people at higher percentage than the Capital Gains of rich people. May be, America is truly Capitalist country… While busy in crafting these tax cuts and preserving these tax cuts; Congress forgot to put any legislation to control non-bank mortgage players when these players were at their creative peak in creating CDOs out of these low quality mortgage loans.

Finally, we have the ‘toll collectors’ of Finance – Wall Street Investment bankers. These investment bankers and brokers put all sorts of fancy wrappers on these low quality CDOs and sold those CDOs all over the world at fat fees. Rating agencies (S&P and Moodys of the world) as usual played the dubious key role in blessing these loans with higher status than warranted. The collective ‘greed’ prevented Wall Street in correctly characterizing these shoddy papers and these Wall Street firms failed once again in applying any standards while selling these sub quality merchandise to everyone.

Given all this collective failure who in the world can call American Financial System as the ‘sophisticated one’? The system results in cheating of those who bought these CDOs. It generates contempt and loss of credibility for all instruments denominated in Dollars which are not directly backed by Treasury or Uncle Sam. The goal of a sophisticated financial system is non-governmental players are also observing rules and standards which produce a creditable, uniform, honest and above all ‘liquid’ market for transacting various financial instruments. American Financial System failed those criteria here.

As if it is not enough to destroy America’s political credibility and national security (otherwise which fool will fight Iraq war when Bin Laden in free?); Bush Administration does not show any leadership in preserving America’s financial credibility. The Administration, for example, could take initiative in making special arrangements in assisting home owners who can repay the loan over an extended period. For example, Fannie Mae and Freddie Mac can offer special loans for these distressed home owners. The Administration can work with Wall Street Firms in creating a fund which will help to generate market for these frozen instruments. Reduction in interest rates may help, but one will have to be careful there otherwise the ‘inflation’ monster would arise as well as asset bubble can get re-ignited in a different manner.

The goal is collectively American Financial System honors the implicit commitments behind CDOs bought by rest of the world. Otherwise, no amount of reforms can restore the ‘financial leadership’ for Wall Street in already intense Global competition for financial markets. Dollar would also come under renewed attack when the perception gets settled that Wall Street sells ‘cheap papers’ and Uncle Sam does not honor it in the end. (Chinese ‘Nuke Attack’ of selling Trillion dollar reserves?) Any solution for this credibility challenge will have to involve those very home owners from where the whole charade started. One can not have Conservative instinct in restricting participation of these original players. Being vindictive for those players (did they not have sense while taking those loans in the first place?) will not solve the problem, but rather will help to bring the whole ‘financial house’ down. Unfortunately, all that this Administration is doing is precisely following such vindictive route, not showing courage in persuading Wall Street rich guys in owning their responsibilities and in general wasting all the political capital in preserving those ‘damn tax cuts’ for rich even while the carnage is spreading. What a shame. Looks like America needs episodes like Great Depression from time to time to live on. But this time America very likely will loose the leadership in Financial Industry unless it corrects itself or Congress wakes up.

Umesh Patil
Cupertino, CA 95014
August 10, 2007.

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