mfc distressing reality 20090316

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Market ForceMarket Force

A View Of Distressing Reality

MARKET FORCE

June 2007

16 March 2009


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Market Force

Copyright 2001-2009, Market Force Company, All Rights Reserved.

Real Economy

Housing

Consumers Workers

Information

TourismLarge

Companies

Retail

HOUSEHOLDS

SERVICES FACTORIES

Medium

Companies

Small

Companies

Children

Assets

Construction

Cars

Education

Culture

Medical

Utilities

Manufacturing

The Real Economy is

driven by consumers

spending money on theirbasic and discretionary

needs, and purchasing

tangible and intangible

assets that serve their

current and future

purposes

The goods and services

that meet these needs

are supplied bymanufacturers and

service suppliers, who

also function as the

employment providers

for the household wage-

earners


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Real Economy

The interaction between

these three dynamics is

the primary source ofvalue creation (GDP) in

the economy, and must

be the core focus of any

economic progress

This model has existed

in one form or another

throughout history


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Real Economy + Financial Sector

Assets Liabilities

Risk

Capital

Customer

Deposits

Consumer

Loans

Corporate

Loans

Mortgage

Loans

Cash

TRADITIONAL BANKING

Traditional banking is a relatively new phenomenon that has developed in a supporting role to serve valuable

functions that support the Real Economy :

! Storage of money as a unit of exchange (Customer Deposits = Savings)! Transaction services that simplify the payment for goods and services! Providing of loans to finance the purchase of assets, goods and services

These functions are provided almost entirely by using Other Peoples Money (OPM)


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Economic and Financial Interaction

TRADITIONAL BANKING

Traditional Banking surrounds much of the real economy, which has come to depend vitally on its

smooth functioning


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TRADITIONAL BANKING

One of the key functions of Traditional Banking is to recycle the funds generated by the Real

Economy, providing liquidity and the opportunity for value creation (GDP)


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TRADITIONAL BANKING

However, it is important to remember that Finance is not the Real Economy

It is a derivative of the real economy

Without the real economy, Finance has no reason to exist


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TRADITIONAL BANKING

PRIVATE EQUITY

In principle, Private Equity can represent direct investment into companies and services, and in

this model it therefore directly supports the growth of the real economy - but it is also a

derivative function, and not a direct creator of GDP itself


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TRADITIONAL BANKING

PRIVATE EQUITY

LISTED EQUITY

Listed Equity provides capital to the real economy when companies actually sell their shares to

the market, but most of the time it only serves as a trading and valuing platform removed from

and derived from the real economy, and is not in itself a primary source of GDP


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Market Force



TRADITIONAL BANKING

PRIVATE EQUITY

LISTED EQUITY

INVESTMENT BANKING

Likewise, Investment Banking is a derivative function assisting the allocation of capital (OPM) to

various financing or investing activities


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TRADITIONAL BANKING

PRIVATE EQUITY

LISTED EQUITY

INVESTMENT BANKING

TRADINGMost Trading is fundamentally

removed from the real

economy, and representstransactions with

no direct effect on

consumption


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Market Force



TRADITIONAL BANKING

PRIVATE EQUITY

LISTED EQUITY

INVESTMENT BANKING

TRADING

DERIVATIVES

And Derivatives are actually . . .

derivatives of derivatives . . .

of derivatives . . .of derivatives

. . . furthest removed

from contributing to

real economic activity


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Assets Liabilities

Risk

Capital

Customer

Deposits

Consumer

Loans

Corporate

Loans

Mortgage

Loans

Cash

CORRUPTED BANKING

Bonds

Borrowed

Money

Derivatives

Over the last several decades, as the financial sector has

become more sophisticated, the Traditional Banking model

has gradually become deeply corrupted :

Borrowed Money (especially short-term wholesalefinancing) has increased bank liability risks

Market instruments like Bonds and Derivatives have

changed the nature of the bank balance sheet


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TRADITIONAL BANKING


These new embedded risks

were not immediately

obvious for thedanger they

created . . .


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TRADITIONAL BANKING


. . . until failures elsewhere in

the financial system

created destructionof derivatives . . .

. . . that in principle

should not have spilled

over into Traditional Banking


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TRADITIONAL BANKING

A major consequence has been that Traditional Banking

has ceased to perform its vital function of recycling the

funds generated by the Real Economy, providingliquidity and the opportunity for value creation (GDP) . . .

. . . and in fact by causing a reversal of flows,

has instead been removing liquidity from the market

and destroying the activities of value creation (GDP)


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Assets Liabilities

Risk

Capital

Customer

Deposits

Consumer

Loans

Corporate

Loans

Mortgage

Loans

Cash

CORRUPTED BANKING

Bonds

Borrowed

Money

Derivatives

INITIAL RESPONSES TO

Initial responses to the financial crisis were to try and protect the

banks . . . not the real economy :

Customer Deposits received government guarantees to

try and keep cash in the banks

Bank risk capital was refilled


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Assets Liabilities

Risk

Capital

Customer

Deposits

Consumer

Loans

Corporate

Loans

Mortgage

Loans

Cash

CORRUPTED BANKING

Bonds

Borrowed

Money

Derivatives

SECOND-ROUND EFFECTS OF

But these actions did not address the real problems of banks :

Borrowed Money was not guaranteed and

wanted to flee

Bonds and Derivatives continued to collapse

in value

And little was done to maintain the primary Lending function


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Assets Liabilities

Risk

Capital

Customer

Deposits

Consumer

Loans

Corporate

Loans

MortgageLoans

Cash

TRADITIONAL BANKING

OBSERVATIONS :

1. It has become obvious that governments are effectively obliged to guarantee bank deposits

2. This obligation will not go away in the future


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OBSERVATIONS (continued) :

3. Huge injections of liquidity into the financial sector have not

translated into liquidity for the real economy4. Banks are actively disintermediating themselves from the

real economy in natural response to their balance sheet stress

5. Instead, they are focusing on absorbing the consequences of past errors

We need to "endure" a period of cyclical correction and capital consolidation

before real investment and lending activity can begin anew Banker viewpoint, 15 December 2008

Assets Liabilities

Risk

Capital

Customer

Deposits

Consumer

Loans

Corporate

Loans

Mortgage

Loans

Cash

CORRUPTED BANKING

Bonds

Borrowed

Money

Derivatives


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Assets Liabilities

Risk

Capital

Customer

Deposits

Consumer

Loans

Corporate

Loans

MortgageLoans

Cash

TRADITIONAL BANKING

OBSERVATIONS (continued) :

6. Contraction of real-economy lending has become the cause of the economic contraction, not the consequence

7. The distressing reality is that without direct intervention, the real economy will be obliged to continue contracting

8. Economic contraction will create business failures, unemployment, and individual bankruptcies

9. Continuation of this process is a Death Spiral, feeding on itself with no clear benefit


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Assets Liabilities

Consumer

Loans

Corporate

Loans

MortgageLoans

Cash

INTERVENTION BANKING ?

CONCLUSIONS :

1. The government already effectively owns the liability for Customer Deposits, which is the real money of the economy

2. With banks removing themselves from the market, it seems inevitable that the government must involve in real lending

3. This lending can be funded with the same Customer Deposits that the government has now taken responsibility for

4. And this lending should be structured with a suitable Risk Reserve that covers the practical default risks

Risk

Reserves

Customer

Deposits


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Assets Liabilities

Consumer

Loans

Corporate

Loans

MortgageLoans

Cash


CONCLUSIONS (continued) :

5. This Back-To-Basics approach appears to have become inevitable regardless how you choose to dress it up

6. This is not a Korean problem it is a global and systemic problem manifesting in countries all over the world

7. Other countries are implicitly already starting to do this for example, U.S. and UK auto industry bailout attempts

8. The key issue is to ensure continued access to ordinary borrowing for consumers and small and medium businesses

Risk

Reserves

Customer

Deposits

UNAVOIDABLE SHIFT TO A NEW PARADIGM BASED ON OLD TRUTHS


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Assets Liabilities

Consumer

Loans

Corporate

Loans

MortgageLoans

Cash


IMMEDIATE OPPORTUNITIES FOR KOREA :

1. Silver Bullet Credit Cards

2. Time Bomb Mortgages

3. Too-Short Corporate Loans

4. Working Capital Credit Lines

" Convert immediately to revolving credits / 5% minimum monthly payment" Convert immediately to 30-year monthly amortizing" Encourage conversion to 5~10-year monthly amortizing" Activate immediately for revolving financing of A/R at 80% advance rate

Risk

Reserves

Customer

Deposits

" REDUCE MATURITY RISKS (LIQUIDITY SHRINKAGE) FOR REAL ECONOMY PARTICIPANTS" INCREASE EXISTING LIQUIDITY FOR REAL ECONOMY PARTICIPANTS

5. Chaebol Squeeze Bill Payments " Activate Credit Central to buy chaebol notes and control issuance


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Key Issues - 1

TRADITIONAL BANKING

How to get the liquidity recycling machine working again at levels that match recent economic activity, even

while the financial sector is being restructured ?

Will it become necessary for governments to effectively direct financial lending ? That is what is alreadyhappening in the U.S., UK, France, Germany ?, China, Korea, and elsewhere . . .

Can Traditional Banking be expected to function effectively without the complete removal of the sources of

corruption ?

The implications of this would clearly be to require deposit-taking financial institutions to be completelyseparated from market-participating institutions, and NOT the other way round as the U.S. Government has

recently been encouraging with mergers of investment banks into bank holding companies

Because deposit-taking financial institutions must effectively be guaranteed by governments, and perhaps

directed by governments, what will be the relevance of their shareholders ?


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Market Force


Key Issues - 2

TRADITIONAL BANKING

Is there a need for the creation of new financial intermediation models that will be more reliable providers of

capital and liquidity to the Real Economy, and that can be less prone to amplifying cyclical downturns by

withdrawing liquidity from the market when it is most needed ?

What implications does all this have for the emergence or continued growth of newer intermediaries in the

financial system, including the Islamic Finance model ?

What implications does all this have for other layers of the financial system ?

Is there a valuable role for private capital in Business Development Funds (10 - 20 years time horizon) as

distinct from the current role of private equity in short-term leveraged buyout funds (3 - 5 years time horizon) ?


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Market ForceMarket Force

June 2007

1 August 2008

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