Independant
De Soto: 'We must find the financial WMDs'
If one bad bit in the system explodes, causing a bank run, then the rest could come tumbling down
By Margareta Pagano
Sunday, 5 April 2009
Hernando De Soto is someone we should listen to. While the Peruvian economist applauds the latest attempts by the G20 leaders to rebuild the financial system, he warns that they are still not dealing with the poisonous paper in the $600trn derivatives time-bomb hidden in the balance sheets of our financial institutions. Until the world's leaders get these derivatives recorded, he claims, they won't get the world's banking system functioning again.
As De Soto told me from New York last week, the G20 leaders have got to learn from the Iraq War and find where the weapons of mass destruction are before going into financial battle; it's not enough just to guess. As he put it: "Anything else they are doing is merely cosmetic, tinkering at the edges of the crisis, a bit like giving a blood transfusion to a patient ahead of a critical operation. The transfusion is important, but the patient's life will only be saved if you remove the bad bits."
And it's the bad bits we have to get our hands on. This is difficult because no one knows which bank has got what, or where; or how big the shadow economy actually is. No one has a clue. To some extent, the size doesn't matter, but De Soto's point is that we should at least know what and where the paper instruments are, so that they have a value and can then be traded. This means the CDOs, CDSs and CLOs – derivative contracts – must be recorded and documented. In themselves, they are not dangerous, but if one of them should go wrong, then the domino effect could bring down the entire system. In reality, the bad bits are tiny – from $2trn to $4trn – but if one explodes, causing a bank run, then the rest may come tumbling down.
Imagine, says De Soto, going to Barclays and asking for a mortgage for your house. "The banker asks you for the address of your house. But you refuse to tell him where it is or how much it is worth. You wouldn't get a mortgage, would you? That's why credit isn't moving in, and it won't until you have the address written down." Only when you have a recorded piece of paper can you have value and then an asset.
The Obama administration can only restore trust in credit – which is not money, but paper – when the paper is documented. To be fair, the US Treasury Secretary, Tim Geithner, is working on the toxic paper, but De Soto would like to see the process accelerated. He reckons that one of the reasons policymakers are so reluctant to tackle the issue is that they can't face the fact that this crisis is down to something as prosaic as a poor paperwork.
Analysing derivatives is new to De Soto. But what is curious is that the answer he has come up with to solve it is the same as the one he discovered while working in emerging markets such as Peru and Tanzania. The poor stay poor, he says, because they are denied any formal property rights and are thus locked out of the formal, legal economy. They are credit-starved, with no means to get out of the spiral of despair. That's why Wall Street's financiers have so much in common with the slum-dwellers of Cairo or Mumbai. They don't have any assets to use as collateral either, and that's why we should listen to this brave economist.
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Independant
West has to deal with toxic debt to end recession
By Margareta Pagano, Business Editor
Sunday, 5 April 2009
Attempts by the G20 leaders to halt the global recession are doomed unless they get to grips with the "toxic" debt hidden in the shadow economy, warned to Hernando De Soto, the prize-winning Peruvian economist.
Mr De Soto said: "This toxic debt is the elephant in the room and solving the problem is the missing link to getting the world economy moving again. Until we know what proportion of the estimated $600trn [£400trn] of derivative contracts is toxic, then credit markets will remain in a state of chronic paralysis."
He added: "No amount of fiscal stimulus or new international regulation will get the banking system fixed until we know how much poisonous paper there is on the balance sheets of the banks. The G20 leaders have given the world economy a blood transfusion but now they need to get on with the operation if they are to save the patient's life."
Mr De Soto welcomed the efforts of the US Treasury Secretary, Tim Geithner, to put pressure on institutions to establish how much toxic debt they hold. "But there must be more focus on forcing all the financial institutions and banks to face up to the bad debt hidden away in the shadow economy. Lawyers and bankers must now work on bringing these contracts out of the shadows so they can be given a value and be traded."
The economist also claimed that it was fear which forced Mr Geithner's predecessor, Hank Paulson, not to go ahead with his original $780bn rescue plan to ring-fence toxic paper: "I'm told that the bankers told him they didn't know where it was hiding." Mr Paulson's U-turn over toxic debt – switching instead to recapitalising the banks – was never fully explained. "My sources told me they were terrified that they couldn't find out where all the contracts were lodged and that's why Paulson dropped the plan," he said.
An adviser to presidents around the world, Mr De Soto runs the Institute of Liberty and Democracy in Lima, and advises emerging economies on how to alleviate poverty by giving the poor property and other legal rights. "The problems are similar," he said. "US and European authorities find it difficult to believe that the fundamental cause of a recession could be a badly documented legal system. But this is what this crisis comes down to and will only be alleviated when that paper is documented, has a value and can be traded."
Mr De Soto reckons there are only a few hundred billion dollars of toxic paper: "Until we acknowledge this toxic debt then this crisis could get even worse. Let's learn the lessons of Iraq and find out if these derivatives are the financial equivalent of weapons of mass destruction or not, and if so, get them documented."
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