US Dollar Almighty – Part 1

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US Dollar Almighty – Part 1

By Syed Akbar Ali.

In this Two Part series I would like to talk about three things : i. financial risk and the present financial crisis in the US, Europe and elsewhere ii. the role of the US Dollar and iii. where our own Ringgit should ultimately be heading.

So as not to lose you, dear reader, rest assured that I am a layman. I will try to make this as interesting as possible. It is important and I hope you will benefit from this and, who knows, please go on to save the world and stuff.

This is not an academic thesis on currencies and money. But considering the bloodletting that is presently happening in the world financial markets it is obvious that the ‘non layman’ specialists have seriously botched things up. So the laymen need to participate in this dialogue using our laymen’s understanding and hopefully common sense.

The annual GDP of the United States is over US12.0 Trillion, the largest economy in the world. The US financial system may lose up to US1.1 trillion from the subprime housing loans bubble which burst last year, whose effects are still going around the world like a tsunami. The latest casualties are Europe and even Brazil. One Chinese insurance company has also lost USD2.3 Billion from investments in the Fortis Financial Group of Belgium.

But what do they mean by saying ‘lose US1.1 trillion’ ? Did someone flush all that money down the toilet, never to be recovered? Not exactly. The money is still there somewhere but in someone else’s pockets. The US economy has not shrunk by US1.1 trillion either. In fact it is still growing. Ford is still manufacturing the Mustang, Boeing is still making planes and Coke is still being consumed by the millions of litres.

What I am saying is there is no need to lose our heads over this. We just need to take some rational steps. We do not have Wall Street style derivatives trading or ‘Liar Loans’ asset securitisation here yet. No matter how great the temptation or the arm twisting, we should make sure that these Wall Street genies are kept safely locked up inside the bottle. If we let them out in Malaysia, it will be deja vu for us too.

Risk is directly proportional to the distance between the transaction and its underlying basis

The problem in the US has arisen from putting too much distance between a transaction and the underlying basis of the transaction. It is very simple. Before fiat money (paper currencies, bank notes, cowry shells, beads, metal coins, traders bills of exchange etc) was invented, human beings traded by barter. So many goats for a cow, a chicken for some firewood and so on. This was the ‘safest’ and least risky ‘exchange’ system. The buying and the selling (the transaction) was often done with the cows and goats (the underlying basis for the transaction) standing right next to you. You could see them before your eyes.

But barter trade was good for small scale exchange. It was not too efficient. So the humans invented fiat money. Cowry shells, metal coins, paper money and so on. But this increased the exchange risk because now you had to give up your cow in exchange for a piece of paper, a shell or a piece of copper with a king’s head stamped on it. As long as there was a king or an emperor still in charge, the shells, paper and copper had some exchangeable value. What if the king died, war broke out or your kingdom ceased to exist? Or the coins were easily counterfeited? So with the advent of paper currencies, coins and such, the distance and hence the risk increased between the transaction and the goods transacted increased.

But even this was not enough. As human activity grew, we invented Banks. The Banks then promoted cheques, banker’s drafts and so on. This telescoped further the distances between the transactions and the physical goods transacted. Now you did not even need paper money. You had other pieces of paper (cheques) claiming to represent other pieces of paper (paper money) which could finally be exchanged for a cow (the tangible goods).

The risk has actually multiplied manyfold. (Anyone who has been unfortunate enough to receive a ‘rubber’ cheque from someone will understand what I am saying). First of all you suffered the risk of the cheque bouncing, ie the writer of the paper cheque did not have enough paper money in his account.

Then you also suffer the risk whether the Bank will still open for business. Please do not take this lightly because this is EXACTLY what is happening now on a gargantuan scale in the US and Europe – Lehman Brothers, Washington Mutual Bank, Wachovia Bank, Hypo Real Estate Bank in Germany, Fortis Financial Group in Belgium and others technically went bust. If they were not bailed out, their cheques and other instruments would have bounced.

Worse they would just not open for business anymore at 9:30 am on weekdays. Try to imagine going to your favourite bank in Kuala Lumpur tomorrow morning and finding it padlocked! Please do not think that it cannot happen here. It is happening, as you are reading this, in the US and Europe.

Then you also suffer the national currency risk. What if the cheque did not bounce, the Bank still remained open for business but the currency was quite valueless – like what happened in Iraq in the 90s. Because of the economic embargo against Iraq, the value of the Iraqi dinar decreased by the day. In contrast please note that despite the banking turmoil in the US, the US Dollar strengthened yesterday (Mon 6th Oct ’08) against all major world currencies except the Japanese Yen. We will discuss this further in Part 2.

So the greater the distance between the ‘monetary’ transaction and the underlying goods involved in that transaction, the greater are the financial risks involved.

In the US, another genie that jumped out of the bottle was derivatives trading. But before that, the devil that uncorked the genie’s bottle was the US Banks’ action to outsource their housing loan applications to brokers and commission agents. To increase market share, save on staff salaries etc US Banks hired loan brokers to source clients for their housing loans. Because they were commission based, these middlemen started bringing in all sorts of low quality loan applications.

(I would like to point out that some Malaysian banks also outsource their loan sourcing, perhaps not to the extent of the US Banks but it is also practised here).

Soon things got out of hand in the US. People without steady incomes and jobs could just say ‘I promise I will pay’ without even having to swear on the Quran or in the mosque and still get a housing loan to buy a house. (Only now after the fiasco, they have started calling these the ‘Liar Loans’). When these loans started defaulting in large numbers, everything else came crashing down. This is not unlike our credit card companies handing out pre-approved credit cards at shopping complexes to anyone with two arms and legs.

But in the US it was even worse. Poor quality borrowers were even given 100% financing to buy a house (no need deposit) because “house values were going up and up all the time so in a few months the financing will become less than 100% anyway!”

The US Banks were very happy to make all these new loans. Soon they even ran out of money to lend. So they needed more money to make more loans. This is where securitisation comes in. (Dear reader please do not get bored yet because our Banks in Malaysia also do loan securitisation.)

To generate quick cash the US Banks took all these ‘Liar Loan’ agreements and i) sold them to other Banks, insurance companies and such for cash or ii) used them as collateral or cagaran to borrow more money from other Banks.

They need not physically hand over each and every Loan Agreement. They create other pieces of paper which represents the Loan Agreements. These papers may be called Trust Deeds, Promissory Notes etc. More pieces of paper. Or they may issue Bonds to represent the Loan Agreements. This is called asset securitisation.

Now these Trust Deeds, Promissory Notes and Bonds in turn become tradeable. People can buy and sell these pieces of paper. And how is their value determined? It is determined by the value of the same ‘Liar Loans’ which become the collateral or cagaran for these pieces of paper. As long as all the house buyers keep paying their monthly instalments, this house of paper cards will hold up.

Other than banks in the US, insurance companies, pension funds, municipal funds (tabung dewan bandaraya) and just about anyone with money in Europe, Japan, China, Singapore and elsewhere could buy these pieces of American paper. China’s largest insurance company Ping An just lost USD2.3 billion from their investment in Fortis Group in Belgium. That is how the US crisis is spreading around the world.

I repeat : ‘risk is directly proportional to the distance between the transaction and its underlying basis’

Now lets measure the distance between Joe the defaulting house buyer in suburban Middletown, USA and say the Ping An insurance company in China. Joe the housebuyer was a poor quality loan. He defaulted on his housing loan. He missed his monthly instalments. His bank in Middletown, USA which had securitised his housing loan now is short of funds to service its own loans which it raised from a Wall Street bank by using Joe’s loan papers as collateral. So now the Wall Street bank is also short of funds. The Wall Street bank in turn may have issued bonds which in turn were raised based on the banks ‘good quality loan assets’ – which may have included promissory notes or deeds from Joe’s Middletown bank. Some of these bonds issued by the Wall Street bank were bought as a ‘sound investment’ by the Fortis banking group in Belgium, in which China’s Ping An insurance company had bought a stake. Fortis went bust and Ping An had to write down US2.3 Billion in the value of its shareholding in Fortis.

The American genie has flown out of the bottle, but the genie has not reached warp speed yet. The genie reaches warp speed when the derivatives traders get into the act.

The bonds and trust deeds pay interest – usually a fixed rate. No matter what is the prevailing interest rate in Tokyo, KL or Belgium these American bonds pay a fixed rate of interest. This also affects the market prices of these bonds. Based on their “gut feel” about interest rate movements, the derivatives traders place bets worth billions of US Dollars on the future prices of the bonds. I call it gambling. Its purely main tikam.

And here is the interesting part – no one really knows how the derivatives market really moves. (Can anyone recall Nick Leeson and the Barings Bank in Singapore? In 1995 Leeson singlehandedly bankrupted the 100 year old bank through USD1.3 Billion losses from derivatives transactions).

And the whole deck of cards stands on the premise that Joe the housebuyer in Middletown, USA will keep making his monthly instalments. The moment Joe defaulted, everything else collapses. Derivatives traders who do not jump out the window may end up selling hot dogs.

The US Federal Reserve estimates the US housing loan market at USD11 trillion. They say that 10% of these are poor quality sub prime loans that have now defaulted. This is USD1.1 trillion. Even for a USD12.0 trillion GDP economy its a lot of money.

Coming Next – Part 2 of US Dollar Almighty – Where Should Our Ringgit Be?



1 Komen

  1. Nice article… thanks for sharing.. keep it up ^^

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