One of the most fascinating aspects of a financial meltdown built on excess credit – except that I am unfortunately living through the accelerating pain – is this basic observation: when folks overvalue assets and borrow heavily against them, somehow the creditors usually wind up with those assets. When a company files for Chapter 11 reorganization under U.S. bankruptcy law, except for a rare (a very, very, rare) exception, the holders of the equity (the common shareholders) generally lose it all, and the creditors (unpaid vendors, lenders based on their seniority on the debt scale) tend to take over as the new owners of the reorganized company.
So what happens when whole countries borrow heavily from other countries? Aside from the obvious relative shift in currency values over time? Here’s a seriously pessimistic view – Harvard Professor, Niall Ferguson (quoted in the February 23nd www.theglobeandmail.com): “The world divides in two, the debtors and the creditors. The debtors … (U.S., Europe) ... are going to have to sell off their assets. Call it the global foreclosure. They're going to be selling their assets cheaply to those who have the surpluses. This is not going to be like the Chinese buying Blackstone [a large private equity firm that is famous for mega-deals] at the top of the market… It's revenge of the sovereign wealth funds [money stored by governments from economic surpluses – like oil-rich sheikdoms or massive exporting economies]. They got burned. And this time, no more Mr. Nice Guy.”
Ferguson’s core theory is that government economists have spent way too much time looking at currency inflation and very little time looking at “asset inflation,” which he claims is at the bottom of this entire meltdown. It’s hard to argue with the reality that companies have been trading at increasing multiples of the same levels of earnings – investors were literally bidding up the price of assets merely because they could borrow money very inexpensively and needed a place to put that cheap money. Too many buyers with too much money drove stock prices through the roof. Whole new economic movements – hedge funds and private equity – grew to take advantage in this shift in valuation.
The same thing happened in the real estate market. Cheap money was offered to unqualified borrowers to buy houses – supply and demand – more buyers in the marketplace for a relatively smaller universe of homes pushed real estate prices through the stratosphere. Until the subprime mortgage meltdown shoved those buyers out the door… and demand for real estate dropped, home prices plummeted, and the lenders who bought into the inflated prices died.
Simply put, it’s time to pay the piper. Assets are being looked from an entirely new perspective, and there are many economic professionals who see (i) a permanent downward adjustment in stocks and real estate values, and (ii) a whole lot of shifting of assets from Europe and the U.S. to Middle Eastern and Asian powers. If it’s any consolation, Europe is more highly leveraged than the U.S., and the very existence of the European Union is at stake.
But what we are facing as Americans is horribly worse than most of us, including the President, might have thought. The February 28th New York Times: “A sense of disconnect between the projections by the White House and the grim realities of everyday American life was enhanced on [February 27th], as the Commerce Department gave a harsher assessment for the last three months of 2008. In place of an initial estimate that the economy contracted at an annualized rate of 3.8 percent — already abysmal — the government said that the pace of decline was actually 6.2 percent, making it the worst quarter since 1982.”
Is there hope? The countervailing balance: oil exporters (like Saudi Arabia – and yes, unlike Iran, Russia or Venezuela, they still have massive wealth) and manufacturing exporters (like China) have much to lose if they nations have been their customers for decades suddenly are unable to buy their products. In short, they have a stake in supporting the Western borrowers.
But the temptation to create “buy American” programs or the equivalent “protectionist” sentiments we see in Europe (like in the automaker sector) will bring fierce retaliation from the nations we owe so much money too already. As civil disobedience turns into riots and even civil war among and within the debtor nations (we only seen a taste of what can happen), it will be interesting – in a bad way – to see whether those violent efforts are sufficient to destroy the stabilizing influence of the otherwise strong relations (call it co-dependency) between debtor and creditor nations in a global trade cabal. If that co-dependency dies, you ain’t seen nothin’ yet!
I’m Peter Dekom, and I approve this message.