Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (August 2011)
In Crosstown Traffic, Jimi Hendrix sang: " can't you see my signals turn from green to red / And with you I can see a traffic jam straight up ahead." In global financial markets, the signals have changed from green to red.
But rather than a simple traffic jam, a full scale credit crash may be ahead.
Fact 1 -- The European debt crisis has taken a turn for the worse:
There is a serious risk that even the half-baked bailout plan announced on July 21 cannot be implemented.
The sticking point is a demand for collateral for the second bailout package. Finland demanded and got €500-million in cash as security against its €1,400-million share of the second bailout package. Hearing of the ill-advised side deal between Greece and Finland, Austria, the Netherlands and Slovakia also are now demanding collateral, arguing that their banks were less exposed to Greece than their counterparts in Germany and France -- entitling them to special treatment. Of course, Greece, which does not have two euros to rub together, doesn’t have this collateral and would need to borrow it.
The next installment of Greece’s first bailout package is due to be released as at the end of September. Some members of the International Monetary Fund (IMF) are already expressing deep misgivings about further assistance to Greece, in the light of the seeming inability of the country to meet its end of the bargain.
A disorderly unwind of the Greek debt problem cannot be ruled out. Ireland and Portugal remain in difficulty. Spain and Italy also remain embattled with only European Central Bank (ECB) purchases of their bonds keeping their interest rates down. Concern about the effect of these bailouts on France and Germany is also intensifying.
Concerns about U.S. and Japanese government debt are also increasing.
Fact 2 -- Problems with banks have re-emerged:
Banks globally, especially European banks, are seen as increasingly vulnerable to European debt problems. The total exposure of the global banking system to Greece, Ireland, Portugal, Spain and Italy is over $2-trillion. French and Germany banks have very large exposures.
Former French Finance Minsiter and now IMF head Christine Lagarde has called for mandatory recapitalization of European banks. As the sovereigns are increasingly themselves under pressure, their ability to support the banking system is unclear. The pressure is evident in the share prices of French banks; Société Générale’s share price has fallen by nearly 50 per cent in a relatively short period of time. Deutsche Bank shares fell 7.5 per cent on Monday.
In the U.S., concerns about Bank of America (BofA) have emerged, with analysts suggesting that the bank requires significant infusions of capital. BofA's decision to issue $5-billion in preference shares to Warren Buffett's Berkshire Hathaway -- now confirmed as the market's lender of last resort -- at distressed prices was not a statement of strength but weakness. BofA's woes confirm that problems in the banking system exist globally, not only in Europe.
Fact 3 -- Money markets are seizing up
Banks and financial institutions are finding it increasingly difficult to raise funds. Costs have risen sharply.
Spanish and Italian banks have limited access to international commercial funding. Like Greek, Irish and Portuguese banks, they are heavily reliant on funding from local investors and central banks, including the ECB.
Over the last few months, the money market funds have reduced their exposure to European entities, especially Spanish and Italian banks. The funds have also decreased the term of their loans to the European entities that they are willing deal with to as little as 7 days at a time, in an effort to limit risk. European banks are having to pay higher interest rates, if they can attract funds. As a result, non-financial institutions are finding finance less readily available and more expensive.
Fact 4 -- The broader economic environment is deteriorating.
The global economic recovery is stalling. The risk of a recession or minimal growth is significant. Germany and emerging market economies, like China and India, which have contributed the bulk of global growth since 2008, are showing signs of slowing. The effects of the excessive credit expansion in China and India are showing up in bank bad debts.
Then there are pernicious feedback loops. Tighter money market conditions feed into lower growth, increasing the problems of government finances. Falling tax revenues and rising expenditures push up budget deficits, requiring greater borrowing. Lower growth feeds into greater business failures that increase bank bad debts, feeding further tightening in lending conditions and the cost of finance.
The rapid and marked deterioration in economic and financial conditions means that the risk of a serious disruption is now significant.
If market seize up again, then "this time it will be different". There might just not be enough money to bail out everyone and every country that may need rescuing.
Government policy options are severely restricted. Government support is restricted because of excessive debt levels and the reluctance of investors to finance indebted sovereigns. Interest rates in most developed countries are low or zero, restricting the ability to stimulate the economy by cutting borrowing cost. Unconventional monetary strategies -- namely printing money or quantitative easing -- have been tried with limited success. Further doses, while eagerly anticipated by market participants, may not be effective.
The global economy may muddle through, but a second credit crash is now distinctly possible.
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