The Relevance Of Velocity Of Money & Confidence

The story below is meant to be a funny story, but it also helps to explain the importance of velocity of money and confidence. Confidence in markets, financial well bring and job security have a great impact on the economy. To restore financial health, it is important for people and governments to spend and not just save. All fiscal stimulus are there to help with spending, especially when the public refuses to spend. Thats mainly the reason why Japan is still in the doldrums since the early 90s till even today, because Japanese save and save. South Korea attacked the Asian financial crisis by spending ferociously, not just the government but the general public took on the advice to spend with gusto and hauled itself out of recession faster than the rest. As irresponsible as it may sound, to continue to spend is a patriotic duty.

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It is August. In a small town on the South Coast of France, holiday season is in full swing, but it is raining so there is not too much business happening. Everyone is heavily in debt.

Luckily, a rich Russian tourist arrives in the foyer of the small local hotel. He asks for a room and puts a Euro100 note on the reception counter, takes a key and goes to inspect the room located up the stairs on the third floor.

The hotel owner takes the banknote in a hurry and rushes to his meat supplier to whom he owes E100. The butcher takes the money and races to his supplier to pay his debt. The wholesaler rushes to the farmer to pay E100 for pigs he purchased some time ago.

The farmer triumphantly gives the E100 note to a local prostitute who gave him her services on credit. The prostitute goes quickly to the hotel, as she was owing the hotel for her hourly room use to entertain clients.

At that moment, the rich Russian is coming down to reception and informs the hotel owner that the proposed room is unsatisfactory and takes his E100 back and departs.

There was no profit or income. But everyone no longer has any debt and the small town's people look optimistically towards their future.

p/s photos: Chen Kuang Yi

Lehman Brothers, The Rosetta Stone

The 'Rosetta Stone' is an Ancient Egyptian artifact (حجر رشيد in Arabic) which was instrumental in advancing modern understanding of hieroglyphic writing.

Lehman Brothers' demise probably caused the "banking crisis of confidence", which brought about the present state of financial markets. The massive deleveraging by funds of all kinds, the downgrading of emerging markets' debts and currencies, the flight to USD and yen, the numerous injection of liquidity into the system by central banks, the guaranteeing of deposits to prevent bank runs, the notion that nothing has real value anymore... may all be traced to Lehman Brothers' bankruptcy, or rather Paulson's refusal to save the company. Lehman Brothers may be the Rosetta Stone which helps us better understand why things are the way they are now.

Though Lehman was the smallest investment bank when it failed — and regulators decided it was not too big to fail — its demise set off tremors throughout the financial system that reverberate to this day. The uncertainty surrounding its billions of dollars of transactions with banks and hedge funds exacerbated a crisis of confidence. That contributed to the freezing of credit markets that has forced governments around the globe to take steps to try to calm panicked markets, including guaranteeing bank deposits.
The list of creditors with material exposure to Lehman Brothers is long. There will be dozens of holders of senior notes, sub debt and junior sub debt, so you can’t make too much of the fact that it looks as though the Japanese banks were laid out. We’d need to see the signatories to the Trust Indentures of the three sets of Notes to see just how many financial institutions and debt funds were exposed to Lehman’s various debt pieces:

• $138 billion of senior notes, which have Citibank and BONY listed as indenture trustees
• $12 billion of subordinated debt, with BONY listed as indenture trustee
• $5 billion of junior subordinated debt, also with BONY as indenture trustee
• $463 million of bank debt provided by Japan’s AOZORA
• $289 billion of bank debt provided by Japan’s Mizuho Corporate Bank
• $275 million of bank debt provided by Citibank N.A.’s Hong Kong Branch
• $250 million of bank debt provided by BNP Paribas
• $231 million of bank debt provided by Japan’s Shinsei Bank
• $185 million of bank debt provided by Japan’s UFJ Bank
• $177 million of bank debt provided by Japan’s Sumitomo Mitsubishi
• $140 million L/C provided by Svenska Handelsbanken
• $93 million of bank debt provided by Japan’s Mizuho
• $93 million of bank debt provided by Canada’s ScotiaBank branch in Singapore via NYC
• $75 million of bank debt provided by Lloyds Bank

Paulson obviously did not appreciate Lehman's involvement. Lehman is a leveraged brokerage shop that was the counterparty to trades sized in billions, including interest rate swaps, commodity futures, corporate bonds, international equities and real estate loans, currency swaps, and private equities. The counterparty risk created fear and triggered domino selling. Banks refused to lend to one another fearing the other end to be infested with Lehman's positions. Insiders claim that it could take over a decade to fully unwind Lehman's positions.The scary bit is that Citigroup and Bank of NY may not be out of the woods yet as things stand.

What's more, Lehman was one of the largest prime brokers to international hedge funds. Lehman's bankruptcy immediately caused wholesale panic within the hedge fund industry as funds tried to close/transfer/pull their money out of their Lehman custodian. Today over $60 billion is still locked up in Lehman's London brokerage unit. Given the leveraging nature of hedge funds, the effect on global equity markets was catastrophic as trillions of dollars were wiped off global equity markets. If you were to leverage the $60 billion twenty times (about right) it comes to $1,200 billion worth of positions that needed to be unwound.

Maybe now we can get a better grip on why so many injections of liquidity and bailouts still failed to calm the markets. The injection of capital is more than sufficient, its just that those with fresh capital are not really lending, except to very solid names. Maybe Paulson would be better off addressing the root, i.e. unwind those institutions and creditors affected by Lehman's failure. The escalating domino effect from Lehman's failure is already cascading across the globe. I hope its not too late for Paulson and the global financial leaders to stem the tide.

p/s photos: Jiang Yu Chen