Sunday, September 28

Say, which country is the U.S. Treasury going to bail out? The U.S. or China?


Bernanke: I think we're supposed to first separate the blue and yellow wires.

Paulson: No, no! Don't touch the blue and yellow wires!

Bernanke: Are you sure?

Paulson: Yes I'm sure. What we need to do is cut the red or green wire.

Bernanke: I'm pretty sure we first need to separate the blue and yellow wires.

Paulson: Will you forget the goddamn blue and yellow wires and help me figure out whether we cut the red or green wire?
I understand the lights can go out any minute if we don't get the credit crisis resolved, but Pundita is such a skinflint I'd rather live by a candlelight for a few weeks if it means saving a trillion or so dollars in taxpayer money.

There is an aspect to the financial crisis that is just starting to come to public light, and which only struck me this morning when I got around to reading a Sept 26 analysis by Gillian Tett of the Financial Times titled Putting dodgy assets in deep freeze will not remove the rot. (H/T John Batchelor Show website) Tett mentions that "there appears to have been widespread fraud in the mortgage brokerage world in the latter stage of the credit boom."

Tette's remark reminded me that the FBI announced four days ago that they were adding Lehman Brothers and AIG to the list of companies (including Fannie and Freddie) they were investigating for fraud relating to the mortgage loan crisis.

AIG is an American company in name only, so to speak; it's a truly globalized corporation set up in Shanghai in 1919, and which always had deep roots in the Asian financial markets. It became the 18th largest corporation in the world. AIG owns 19.8% of People's Insurance Company of China through direct and indirect holdings. PICC is China's largest insurer of casualty insurance.

And as we recall, little more than 10 days ago AIG received the largest government bailout in U.S. history for a private company.

This is not the first time that AIG has been investigated for monkey business. Around the middle of this decade AIG was the target of a series of fraud investigations conducted by the Securities and Exchange Commission, the U.S. Justice Department, and New York State Attorney General's Office.

According to Wikipedia, CEO Hank Greenberg was ousted amid an accounting scandal in February 2005. The New York Attorney General's investigation led to a $1.6 billion fine for AIG and criminal charges for some of its executives.

Something else was going on around the time that AIG was under investigation, which was the staggering accumulation of bad loans in China.

By the spring of 2006, a conservative guess put the amount of those bad loans at $1.18 trillion; it could only be a guess because China's government-run banking system is opaque. Yet everybody knew there was a lot of bad debt backing up in China and that someday, something would cause the tower of bad paper to collapse from sheer weight. The bets were that a big jump in the price of oil would be the final straw but when the big jump happened, nothing happened. China continued more-or-less merrily along while carrying a huge amount of U.S. debt.

But over in the U.S., something did happen. An accumulation of bad paper set off a crisis in the mortgage brokerage industry.

Before you chuck your "Made in China" chachkas out the window, I am only guessing about a situation. And even if my guess is right, we're all adults here; we know that we can't allow China's economy to collapse because the economies of the U.S. and China are entwined. But maybe not so entwined that the U.S. should be the only country to dig China out from a crushing mountain of debt.

In any case, once you start talking about wide-scale fraud in globalized financial instruments, this not a problem that Americans should try to solve on their own. This is a task for the Lords of the Craps Table, who oversee (to the extent it can be overseen) what I term "The Casino" -- the international monetary system.

Ben Bernanke has as much stated that the $700+ billion rescue plan is an experiment.(1) I would prefer a workable solution. That would require a clear definition of the central problem, which has seemed lacking because details of how the credit crisis snowballed are sketchy.

That doesn't necessarily mean the details are suppressed; it could just mean that there hasn't been time to gather and integrate enough data to provide a clear picture.

However, there is a shortcut to getting to the bottom of matters. For this, representatives from the Bank for International Settlements, the International Monetary Fund, the central banks from the G-8 countries, the European Central Bank and China's central bank, need to gather in a room and have a frank discussion.

(In a perfect world I would like to see a few other central banks sitting in, including Singapore's and five Eurozone banks in addition to the ones I mentioned. I would also like to see representatives of Hong Kong's major commercial banks in attendance and -- well, the Lords of the Craps Table would know which banks they'd want at a summit.)

Should Henry Paulson attend the meeting? Not to be rude but I don't think that would be a good idea. Mr Paulson has a long and close association with China's communist government; in fact, he's known as China's Armand Hammer. Hammer was the fellow who did huge business with the Soviets during the Cold War.

And indeed Goldman Sachs, which has been having its own financial problems, is very deeply involved with China's banking sector, and this was so during Mr Paulson's tenure as the company's CEO. We return to the 2005-2006 period:
[...] In late January 2006, Goldman Sachs purchased a stake in the Industrial and Commercial Bank of China (ICBC), China’s biggest bank, for $2.58 billion. According to press reports, Mr. Paulson’s personal stake in this transaction was $25 million. [...]

[T]he PRC seems simply to be dressing-up what were, until recently, insolvent banks in the hope that international capital markets will contribute to bailing them out. This process involves the off-loading of non-performing loans onto asset management companies in a fashion very reminiscent of the U.S. savings and loan crisis. Indeed, the PRC appears, in fact, to have modeled its strategy on the American experience.[...]
Those comments and many more on the same theme from Frank Gaffney at the time of Paulson's 2006 confirmation hearing for the role of Treasury Secretary, and which summarize Gaffney's testimony before the U.S.-China Economic and Security Review Commission.

I think that's enough detail to convey that a group discussion with China's central bank and the Federal Reserve might be more relaxed without an ex-CEO of Goldman Sachs in attendance.

Depending on what the meeting turns up, we might expect a plan that spreads among several national governments the true cost of unfreezing the credit markets and the most efficient way to go about this.

At the least, such a cooperative effort would spread the blame and responsibility if the worst comes to pass; i.e., a total collapse of the world economy.

Can such a meeting take place? If my guess is near the mark it could be that the Federal Reserve already knows much of the story, and wouldn't want to have a meeting that telegraphed by China's presence the bottom line. If that is the case, it could explain the big rush to fix a plan in place without a thorough public review.

In any event, I think the kind of summit I propose will have to happen at some point down the line. So the question is whether to bite the bullet and meet now, or wait until the U.S. taxpayers are a trillion dollars in the hole before everyone realizes that thrashing around in the dark isn't working.

Often it happens that solving a problem first requires solving another, or at least getting a clear picture of the other problem.

The 'other problem' in this case is that China's financial affairs are inextricably entwined with those of America's, and that for at least five years running up to America's financial crisis, China's central bank was in a losing battle with a snowballing accumulation of bad loans that is so huge it may have no precedent in dollar figures for one nation.

The IMF and other financial institutions, including the World Bank, spent years in futile attempts to pressure China's government into revealing the extent of the bad loans, and they tried to help the government manage the worst effects of the ongoing crisis.

So before the U.S. government grabs blindfolded for a solution that is termed an "experiment," we need to get a handle on just what happened with China's crisis of bad paper. That knowledge may throw much light on how best to proceed with handling America's crisis of bad paper.

1) Sept 25 via Yahoo News:
[...] With the bursting of the U.S. housing bubble, mortgage-related securities are caught in a vicious downward cycle, commanding only "fire sale" prices, Bernanke says. The government purchases, through a series of novel auction mechanisms, will help the market value these assets, he says. And this could be the spark needed to get markets working and the economy’s engine turning over again.

This explanation is very different from the "bailout" imagery that surrounds the debate. And the great challenge for both sides has been to find some path in between these two poles — able to satisfy the anger voters feel for Wall Street but also leaving enough room for Bernanke's experiment to function.

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