how the us saw its dominoes begin their tumble

The US economy typically goes through cycles of upturn and downturn. In every downturn since the Great Depression of the 1930s, the US financial system has been sufficiently resilient to withstand the adverse environment.

But in the latest downturn, the US financial system is teetering on the edge of a complete breakdown, and life support is being administered by the Federal Reserve and the federal government.

Most people are now blaming capitalism or deregulation as the culprits behind the collapse, but there is nothing wrong with either US capital or deregulation. The problem has more to do with a failure in the US to interpret macroeconomic issues and manage microeconomics; in other words, misunderstanding the wider issues and failing to look after the smaller details.

Thai Securities and Exchange Commission secretary-general Thirachai Phuvanatnaranubala believes mismanagement at both the macroeconomic and the microeconomic levels have brought about the US financial crisis. At the macroeconomic level, the US government has been stuck in an overconsumption mode for a couple of decades, ever since the Ronald Reagan years.

Macroeconomic misreading

Reaganomics - the principles of which are still being espoused by hard-core Republicans - prescribes across-the-board tax cuts to put spending power in the hands of corporations and families. Once the private sector spends this money for investment and consumption, this helps drive the economy. In turn, the government is supposed to pick up more tax than the revenue it lost by making the original cuts.

However, the virtuous cycle of Reaganomics has never been realised. As a result, the federal government has been running budget deficits for years, because it cannot collect enough tax to meet its spending obligations. It has therefore been pushed into an overconsumption mode, spending future money beyond its tax-collection ability.

At the same time, there has been enormous overconsumption on the part of US consumers.

Thirachai says the emergence of China has exerted an enormous and unprecedented impact on the global economy. China has become the world's manufacturing base by virtue of the sheer size of its economies of scale.

"The opening up of China's economy has had a once-in-100-years effect, similar to the US impact on the world's economy in the 19th century," he says.

Most US economists and policy-makers have underestimated the "China factor", which has been flooding the world's markets with cheap manufactured goods and products. After being a closed economy for many decades, China only began to open up in 1979. With a population of more than 1 billion, many of them living below the poverty line, it was able to keep wages low for a sustained period because there was new labour flowing into the market all the time.

US retail and department stores are full of Made in China products, and this has caused a huge black hole in the US trade balance.

Since Chinese products are cheap, they help keep global - and US - inflation artificially low. Former Federal Reserve chairman Alan Greenspan attributed low US inflation to higher US productivity when in fact it was the China factor that was artificially containing US inflation. Greenspan went on to engineer a low-interest-rate environment despite bubbles in the hi-tech and housing industries.

US consumers went into top spending gear, made possible by the availability of cheap credit, at a time when housing prices had been rising sharply for more than a decade. About six years ago, Nobel laureate Paul Krugman said on a visit to Thailand that the US housing industry was facing a bubble.

"It's going to burst one day, but I don't know when," he said.

US financial institutions started to become complacent about easy credit. They became overleveraged, and the financial bubble began to build.

Eventually, with a combination of overconsumption by both the federal government and US consumers and overleveraging by US financial institutions, the world witnessed a "superbubble" the likes of which had never been seen before.

Lax management

As well as the macroeconomic misreading, the US is suffering badly from the mismanagement of financial institutions.

The problem stems from poorly regulated mortgages that eventually spilled over into the financial system. There are now about 20 million homes in the US facing mortgage-repayment problems.

First, borrowers were entitled to 100-per-cent mortgages on new houses without having to make any down payments.

Second, lending institutions introduced "teasing rates" to attract borrowers, who were charged very low interest rates in the first few years of a mortgage, but the rates were later increased. Many found they could not meet their repayments when their mortgage deal began to reflect market rates.

Third, there was no due diligence. Borrowers' financial backgrounds were not cross-checked by lending institutions, which allowed the borrowers a free hand in declaring their assets and income.

Fourth, home-builders were also extending loans. This was a conflict of interest. Since they built the homes, they were more inclined to sell and agree to mortgages quickly.

All of these factors happened when housing prices had been rising sharply for more than a decade. This created a "feel-good factor" among borrowers, lenders, investment bankers and credit-rating agencies, for even if borrowers were unable to repay their mortgages, the houses could be foreclosed at higher prices.

Investment banks, the likes of Lehman Brothers, stepped in to make money in a crazy fashion. They bundled housing loans into mortgage-backed securities to help carve out the risk to the mortgage lenders. From mortgage-backed securities came collateralised debt obligations (CDOs), which are complex financial products designed as a structure on top of a structure. They became very popular over the past four years, because they were offered with a rating of AAA and a higher yield than other AAA products. The CDOs appealed to banks and investment funds.

The mortgage-backed securities were originally assigned different ratings, from AAA to AAA, A and BBB. There was also an equity feature. Then they were bundled together with features of notes, cash, interest and principal into CDO tranches. These tranches come with ratings of class A, class B, class C, class D, class E and equity (not rated).

US investment banks sold the CDOs worldwide, while credit-rating agencies mixed the ratings of these instruments similar to the ratings of US Treasury bonds. The selling point was that high-grade CDOs faced a lesser risk of defaults than lower-grade CDOs, because they were structured like a condominium: if a fire started, it would burn the basement first before damaging the higher floors.

When investors or banks lacked confidence in the risks involved with CDOs, institutions like the American International Group came up with credit-default swaps, which guaranteed the complex instruments against default. Most European banks now have high exposure to credit-default swaps, whose volume totals about US$55 trillion (Bt1.9 quadrillion). The European banks have had to be rescued by their respective governments, because of their exposure to the failed Lehman Brothers and also to the credit-default swaps.

With the economic downturn, most US borrowers are now finding their debts are higher than their equity, meaning even if they sell their homes, they will not make enough money to pay off their mortgages.

The defaults of the home borrowers have brought about the collapse of the entire financial house of cards, and all of the credit ratings mean nothing.

The US investment banks had been overleveraged. Normally, banks can leverage only 12 times against their capital, but the US investment banks were leveraging more than 30 times. They made filthy money in the good times and paid top bonuses to their executives. But when the markets turned the other way, the leveraged  institutions fell like dominoes.

Pongsak Hoontrakul, a senior research fellow at Chulalongkorn University's Sasin Graduate Institute of Business Administration, warns of a credit risk created by the vulnerability of global financial institutions facing forced sales. This could lead to stock-market falls, tighter credit markets and recession.

"Although Thai banks do not have significant exposure to US financial instruments, we also stand to get hit, as some banks have already started to tighten their lending. We need to stimulate domestic growth to keep the economy afloat while the world is going through the financial storm," he said.

Asian banks are less vulnerable to the global financial crisis, because they have less exposure to the toxic financial products sold by US investment banks. Japanese banks in particular have adopted Basel II banking regulations, making them cautious about risking their capital with US financial instruments. European banks have yet to move to Basel II banking regulations, and that is why they are now at their most vulnerable, with daily news of government intervention.