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How the cookie crumbled...finally

What does the current global financial crisis mean? How do we decode it? Is it over? All you wanted to know about the meltdown but were afraid to ask. Read on...

business Updated: Sep 22, 2008 20:54 IST

When Harshad Mehta and Ketan Parekh used money from the debt markets to play up stocks, they took the markets and a few players down with them — tiny games played over two to three years. When large investment banks use money from the wholesale debt markets for nearly a decade, and go belly up when their favourite bets crash, they can bring a whole nation to its knees. If that nation is as big and influential as the US, voyeurs may rejoice, but pragmatists will worry.

The dominance of investment banks in America’s financial system has been hailed as the triumph of markets over men; about how innovation can expand the pie; and about how credit can swell the size of an economy. Their collapse represents a tectonic shift in the way the financial world will work, going forward. All the votaries of free markets and capitalism will know market-led wind down happens. The confusion about choosing between freedom and control will take a while to settle.

Investment Banks
After the crises of 1930s, the Glass Steagall Act was promulgated, separating commercial banks that accepted public deposits from investment banks that specialised in advisory and broking business. Investment banks spearheaded most of what we now know as components of the modern financial system--- capital market funding of businesses, innovative financial products, structures for reviving and expanding businesses, and so on. They also were large brokers and dealers in equity, debt and derivatives.

Competition
In 1999, the Glass-Steagull Act was thrown out. Deposit-taking banks were allowed to indulge in financial advisory and compete with investment banks. Competition cut into the margins of investment banks. Their trading desks became bigger, and their intellectual prowess was used in creating new products and structures and selling them off to clients. The size of their trading books doubled to $15 trillion since 1999.

Funding
Investment banks were experts in raising institutional money. So when they needed money to back their trades, it was not a difficult deal. Wholesale debt markets were only eager to lend to them, for the short term, to fund assets that were routinely churned and traded. The ability of investment banks to create new products and structures only increased the willing lenders and that included banks.

Engineering
The most important condition for the investment bank, when it used borrowed money to buy assets, was that the return from trading the assets was higher than the borrowing rate. Thanks to Alan Greenspan and the incredulously low Fed rates of the early 2000s, funds were easy to come by. But the assets still carried risks. So investment banks bought only those assets that were liquid and easy to sell off in the markets. Where the assets were not liquid, they created liquidity through financial engineering.

Layering
For example, a 15-year home loan made by a bank, is not liquid. But the cash flows due from the loan can be re-packaged and sold off to another entity like mortgaged backed securities. Investment banks would create new structures with these cash flows, re-arranging them into collateralised debt obligations, and sell them off to others. They can also repackage the risks into newer instruments like credit default swaps. The risk on the original home loan is now spread across at least four different balance sheets. This exercise was expected to reduce the risk of the original loan, enabling a fast growth in all the products that were engineered.

Leveraging


Since the interest rate was low, and housing prices were going up, all participants extended themselves. Households borrowed more than they needed, banks lent more than they could, investment banks held and traded too much of the structured products, and investors bought more and more in the hope of profit. This extension created sub-prime loans, where households could borrow even if they had no income, no papers, no credit rating, or payment record. They only needed to use the money to buy a house, whose price went up.

Bubble
As everyone’s books blew out of proportion, the bubble burst. When housing prices crashed, the domino effect came into play. Across the balance sheets that the loans were spread into, all values dropped. And panicky investment banks tried to sell off what they held, and found that the market had become illiquid. When they wanted to borrow to keep the assets, the rates had moved up, and money was not available. They began to sell in panic what they had, and prices only dropped even further.

Bust
Investment banks now faced a situation where the assets they held were worth less than the amount they had borrowed. So, they went around asking for capital. At the peak of the boom, many of them had $40 of borrowings for every dollar of capital. Now, when the value of the assets fell off to say $20 or less, there was no money to repay the borrowings, unless they got equity capital. Equity capital was not forthcoming because the value of the assets was dropping by the day. The result: they simply went belly up.

Bail out
So what did regulators do? They reduced interest rates so that money would be available to borrow and hold up the assets. But markets only tightened from further fears of default. Money was handed out, through a special window opened for investment banks by the US Fed. When that would not do, there was bailout by taking on the bad assets. Now Central banks across countries have come together to create a $247 billion fund to provide credit where it is needed, to stop further failures. (Illustration: more money pumped into toxic assets)

Fear Factor
Since fear of failures grip the markets, credit has dried out. As value of assets held by large players has shrunk, the market itself has shrunk. Money is difficult to get. Loan is the new bad word and no one wants to lend money to fund risky assets. Safe havens like money market funds have begun to lose value, and investors are holding back cash, worsening the liquidity crunch.

What Now?
The US already runs a $3 trillion deficit. Adding billions of dollars of bailout money to this is a sure fire way to trigger a full blown recession. The US recession is also likely to draw others along with it. The weakening of the US dollar may then be inevitable in such a situation. Investors face the double whammy of default and depreciating dollar. The crisis in the credit markets shows all signs of extending into the currency markets.

Plan of Action
Everyone seems to blame regulation now. Since commercial banks are more closely regulated and have strict capital adequacy norms, the clamour is to close down or merge investment banks into commercial banks. That may shrink the size of the financial markets as we now know, significantly. The entire edifice of risk-taking and thus expanding capital markets would crumble and we will return to loan officers from market-driven risk takers.

Before we heave a sigh of relief about how we may not be affected so much, we need to worry about global headwinds that will affect markets across the world. We may still keep our jobs, continue our SIPs and pay our EMIs. But the lessons in this crisis are for macro managers of the economy. If we have to be plan for a longer run, the lessons from this crisis can help us ponder over our policy and institution-building choices.