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Global Banking Crisis: “New Deal” of central banks spells trouble for India

Posted December 26, 2007

"Santa Claus glides mysteriously. Helicopter Ben requires expensive aviation fuel and adds to global warming when he does his rescue act. Whatever the vehicle, the action is the same: Flood the world with more money and pray." — Ajit Dayal

by Ajit Dayal, equitymaster.com

Baltimore — (TFN): A week ago, the central banks of the world united to flood the world with more money. The US, UK, Swiss, European banks let the world know that they exist as a lender of last — and sometimes first — resort. The somber-looking men lent $64 billion to the banking system as a 1-day loan.

But that seems tiny in comparison to what the ECB just did. On December 18th, the ECB — that bastion of anti-inflation, fire fighting daredevils — shocked the financial system by pumping in 348 billion euros ($501 billion) into credit markets. They allowed banks to borrow this huge amount of money for a 2-week period.

To put all this in perspective, when the sub-prime mortgage crisis made global headlines on August 9, the ECB had pumped in 90 billion euros. This recent injection is the equivalent of giving every person in USA and Europe a $1,000 loan for 2 weeks.

Now, we confess we don’t understand what is going on. But the actions of the central banks suggest that the central banks, scarily, don’t really understand the situation either. Imagine, in August a cash injection of 90 billion euros is required to calm things. And then, after many smaller calming actions, the banks need to pump in four times the amount of money to avoid any end-of-year jitters.

What gives?

The International Herald Tribune tries to identify the problem and the challenges facing the banking system. “Central banks have treated the crisis as a shortage of liquidity — the ability to raise short-term cash. But the deeper problem relates to the solvency of banks which might have speculated in securities linked to mortgages given to U.S. borrowers with spotty credit records.”

Interesting. So banks and financial institutions fear that there is a huge loss hidden in the banking system (because all the loans they gave to US home owners are worthless). These banks bought and sold these home loans and now these bad loans are spread all over the world. And no one knows how bad and big the problem really is. When a bank has losses that may be more than what it has as cash in the bank (the Tier I capital, represented by equity) – this is called “insolvency”. A bank with more losses than equity is called “insolvent”.

Like the characters in Agatha Christie’s Death on the Nile everyone is a suspect. No one is to be trusted. Every bank is suspect of being insolvent. Of being a credit risk. Of having that murder weapon, that ticking time-bomb of sub-prime losses somewhere in its balance sheet. Of being at risk of blowing up. So no one wants to lend to anyone. The inter-bank lending market is frozen. When banks and financial institutions refuse to lend money to each other – this is called “illiquidity”.

The central banks cannot risk the economy for coming to a grinding halt. There are real businesses with real needs. We need money to keep our suppliers and customers humming along.

The Tribune goes on to write, “Central banks have so far bet that by providing liquidity, they buy time for other issues, like the creditworthiness of banks and their exposure to sub prime lending in the United States, to work themselves out.”

The central banks are buying time.

Therefore, they don’t really know what is happening. They hope something better happens. They may be right — something better may happen.

They may be wrong – it could get worse.

In the meantime, the central banks are acting as Santa Claus. That is a far superior role than that taken on by Ben Bernanke — the Chairman of the US Federal Reserve. Chairman Bernanke was reported to have said that he was willing to fly in a helicopter to drop money if that was what would help support the US economy.

Santa, as we know, glides mysteriously and also uses a more eco-friendly vehicle. Helicopter Ben – as he is fondly known in the market – needs to buy expensive aviation fuel and adds to global warming when he does his rescue act.Whatever the vehicle, and whether they are compliant with Euro IV emission norms or not is hardly the issue. The action is the same: Flood the world with more money and pray.

Alan Greenspan, by his lenient actions and savior of the big Wall Street firms and banks prompted the phrase “Greenspan put option” — if anything went wrong, make a phone call to Alan and he will bail you out.

“Helicopter Ben” is willing to throw money wherever it is needed and whenever it is needed.The ECB has now given a new lease of life to the avatar of Santa Claus. The difference between these saints, rescuers, and Santa re-borns is that their gifts tend to end up with the folks who caused the mess in the first place. So, the CEO of Merrill Lynch leaves in disgrace with a pay out of $161 million. The Merrill stock is down 40%. The CEO of Lehman gets $30 million in a “record year” when the stock is down 21%.

We have nothing against these 2 firms — they represent the business of money. Actually the jugal-bandi of money and politics. A model that India is trying hard to emulate. While we have had that model in India for decades, there is scope for perfecting it. Politician and businessmen run India’s economy into the ground for a few decades living off the ration mentality of the license raj.

Now they can do it all above board.

With rising market caps and possible pay-backs for favours being given via shares in businesses and real estate projects.Who knows where the world is going? The central banks in the developed world don’t have a clue. The politicians everywhere tend not to focus on issues that matter until it is time for an election – or it is too late.But don’t let this spoil your holiday mood.

Enjoy your holidays. The folks who got their exit pay checks for causing a world-wide financial crisis will certainly enjoy their holiday season.

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