Wednesday, July 15, 2009

Financial assets are debt

Credit economy includes both borrowers and lenders. The growing value of financial assets is just another side of coin which is the growing amount of debt. Financial assets are debt.

The growth of assets needs to equal interest payment and the growth of debt. When interest payments are in default, the whole system fall apart. When creditors discover that borrowers won't have the ability to pay back interest and maturing debt, they will pull back the credit extended to borrowers.

In real world, the situation is a little more complicated with the role of financial intermediaries. The same creditor might at the same time be the borrower. For example, when pension funds invest in mortgage-backed securities, the beneficiaries of pension funds could equally possible take out mortgage loans from one of the major banks in the country. The bank then might pool large number of mortgage loans together, package them into mortgage-backed securities and sell them to pension funds.

Another example is government debt. Pensions and mutual funds invest nearly 30 percent in government debts. The government uses borrowed money to cover its revenue shortfall and spend on health care, education, social security etc. for the interest of its people. The beneficiaries of pension fund can at the same time be the borrowers.

When creditors pull back their investments, the cost of borrowing goes up and it will be more difficult for borrowers to pay back their interest and roll over their debts. The taxpayers are now both borrowers and creditors. Now the same taxpayers are suffering from both sides. The value of their investments are going down and debts are blooming.

I am not arguing that we as a society should not have the financial intermediaries to share the pie of real economic output. In fact, they are absolutely necessary to lubricate the real economic activities in complex world. The more extra savings they can turn into investment, the more people will get employed to produce something. The real argument is that how big share this financial sector should be in the whole economic pie and how large the debt level should be in terms of not threatening the borrowers' ability to pay back their interest and maturing debt.

The key to run a successful credit economy is to have a sufficient large real productive economy. That means borrowers' real income from wages has to grow at least equally with the growth of interest payment. In most developed world, the staggering real income growth came from both the lower productivity growth and greater income inequality for the last three decades. There is no short solution for quick recovery in terms of real economy.

Monday, July 13, 2009

Credit expansion and economy

Financial firms are not only one of the major sectors in the whole economy. They are in a strategic position that propel the direction of economy through its influence on credit. Today, financial intermediaries not only finance business investment but also consumption. That means the pullback of credit or loans from financial sector will have double effects on economy.

In old days, banks used to be careful in watching the creditworthiness of industrial and business firms to make sure that they will pay back their loans. In modern finance world, banks need not to worry about the underlying financial strength of firms too much. They underwrite businesses and sell stocks, bonds and all kinds of different financial instruments directly back to creditors while extracting fees by servicing as intermediaries. Now they are in true sense of being intermediaries that the only goal is to achieve higher rate of return for its own shareholders. As they underwrite more and more businesses, they also use their retail channels to help the business sectors to sell these financial securities. In return, they extract fees from servicing both borrowers and lenders.

Financial firms and even the financial branch of big corporations has also been emerged to be major players in providing consumer credit during the last decades. The underlying consumption is that banks can diversify the credit risk of individuals by underwriting a huge pools of loans. They underwrite these pools of consumer debts into financial instruments and sell them back to the creditors who are willing to hold these securities. If banks or financial institutions are successful in marketing these securities and get ride of these loans and securities from their balance sheet, they will successfully transmit risk from borrowers to creditors. The only concern is that when the financial market are in turmoil, the financial intermediaries' fee business will be significantly reduced due to the lack of demand from both borrowers and creditors.

Financial instruments are in essence debts. We live in a society saturated with all different kinds of securities which assumes to meet the different needs of individual investors. However, the essence of all these securities are the same. Stocks and bonds are essentially the claims to firms' future streams of income and they vary in terms of priorities and forms of payment.We are a nation that saturated with financial advisers or investment advises that helps to manage your money. In reality, what they really want to sell are loads of debt to you. Whether you will earn the rate of return expected from these securities depends on the underlying business or consumers' ability to generate enough cash flow to pay back their debt obligations. The return of securities depends on the expected future profitability of business and expected future wage income of consumers.

There is an over-grown financial instruments (in other words debts) comparing to real productive economy. If the growth of financial products is greater than the growth of GDP (real economy), it is usually a sign of accelerating built up of debt . Productivity growth has been snagging for the last two decades. The return on securities including both stocks and bonds has been far greater than the growth of productivity and the growth of GDP. The assets of the economy including pension funds, mutual funds has been increased dramatically during the last decades while all the assets are in essence debts from other side of coin. Modern finance makes money circulates faster than ever and creates money ever faster than before out of control of banking regulatory system. In credit boom situations, accelerating amount of assets has been invested in securities which drives the rate of return higher than real productivity gain of the whole economy. Gradually, the optimistic outlook acts as a self-confirming evidence and takes on the life of its own to reach an even higher level of indebtedness for both business and consumers.

The credit boom circuit will break when it's time for consumers and business to pay back its interest and principle obligations. Some time it may starts as self-fulfilling prophecy that more and more investors start to worry about debt level. Some time it starts with the failure of business and individuals to pay back their loans. When pessimistic sentiments penetrate the market, the two forces reinforce each other and start a strong momentum to drive economy downward. That's what we saw during the last two years. Creditors pull back their investments quickly. Without reducing credit, business and consumers has been squeezed and the economy went nosedive.

Globalization also adds up complications to existing problems. Export of US financial assets has been one of the most important businesses that global financial institutions did. US has run trade deficit with the rest of the world for decades. The sales of financial instruments has been increased dramatically during the last five years.

Source: CFR

The same argument can be made to domestic market as well. Financial securities has been greatly oversold which created the credit driven boom economy for a very long period of time. It's going to take a long long time to wait for consumers to build up savings for consumption if we want to reduce instabilities built in by financial institutions today.

Credit-led consumption has a long way from recovery

Overcapacity of production is one of the main phenomenon of recession. One of the key determinants is wages. On individual level, corporations has the incentive to cut wages and layoff workers to survive in competitive market. On aggregate level, wages are the largest social purchasing demand for industrial production. When consumption is down, the whole economy will slow down and more jobs will be lost. Over the last twenty decades, wages has been trending slowly downward comparing to the total output produced. In order to keep consumption level high, government and financial institutions introduced credit-led consumptions such as consumer loans, credit card, mortgage loans and other various types of credit and loans. The overall effects are that consumers can consume products or services first before saving enough money to purchase it. This simultaneous process of credit expansion on consumption is blew up first in sub-prime mortgage securities and now spread to all other credit-led consumption loans and securities.

The result of this credit-led consumption is that individuals, states and government are loaded with debt after decades of build-up of debts. Debts are not only the obligations for entities to pay at the debt mature date. Debt is also the future steams of income that has to be assigned to pay back for the current consumption. That means that most consumers, state and government has been spending the incomes which they might generate in the future to cover current level of consumption. We are mortgaging our future into current spending.

Suppose that government force banks and other financial institutions to continue to support the credit expansion directed at increasing consumption while wages continue to keep at suppressed level, wages earners still won't be able to pay back their loans with expected interest payment with the constraint of their limited income. Over time, creditors will lose confidence in borrowers' ability to pay back both interest and principle and they will cut the credit line eventually. If the government doesn't step in to provide credit to consumers or direct banks to do so, the consumers and wage earners will pull back their consumption and full blowup economic recession is going to take a long time to recover while consumers are saving their money to spend.

Overall, there is no short-term solution for the dilemma of whether to extend consumer credit. The root problem is income disparity which the politicians are reluctant to touch upon.

Thursday, July 2, 2009

Debt Dillema

The relationship between lender and borrower can be analyzed by Greek philosophy. This idea was first originated by Economist Henry CK Liu. Hegelian dialectic, usually presented in a three-fold manner, comprising three dialectical stages of development: a thesis, giving rise to its reaction, an antithesis, which contradicts or negates the thesis, and the tension between the two being resolved by means of a synthesis. For example, British Columbia government total gross debt reached 31 billion at the end of 2008.

Source:Government of British Columbia Website

As we see from the picture, most of the funding sources are from Canadian public and private sector. Among the, CPP and other pension funds takes 16 percent. Canadians financed 82 percent of its total debt.

Let's take a quick look at the biggest pension fund management firm at BC and check its asset allocation.

Source: bcIMC

From the chart, we see bond takes 27%. It's a little big surprising that mortgage-backed securities takes only 4%. ( Two years ago, the number was 30 percent or so I believe). It seems that they dramatically increased equity stakes recently comparing to the past.

We live a dilemma. On the one hand, individuals and governments are loaded with debt burden which could not possibly be increased especially in recession while all sources of revenues are shrinking. On the other hand, pension funds and private investors reply on the income from debt securities to maintain their asset value and fund the standard living of all employees.

Ironically, Canadian public and private sector has pulled the plug and abandoned debt securities during the financial stress. Housing prices were falling while funding sources were drying up. The government steped in to reduce interest rate and mortgage rate. As if only we go back to the previous debt level and fund all debts, our economy will go back on track again. The government's answer is to keep the party going. By going into more fiscal deficit, the government hopes to spend money out of recession. This recipe seemed to work pretty well in the part, so they hope it's going to work well this time. Unfortunately, the crisis is "the mother of all crisis" (Paul Volcker) and we are "at the end of credit bubble that has lasted for nearly fifty years" (George Soros). The recipe to carry on more debt may not work this time.

The synthesis perhaps is to reduce the debt level orderly over time and let the real productivity growth to take charge of its economy.