What made the stockmarket crash

Updated on Jan 26, 2008 10:56 PM IST

I ’ve been trying to find out how bad loans by banks in the US led to a crash in our stock markets, writes Manas Chakravarty.

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I ’ve been trying to find out how bad loans by banks in the US led to a crash in our stock markets. Here’s what I’ve gleaned: The first thing to remember is that there are a lot of social workers in the US who are also mortgage salesmen. Naturally when they see a dirt-poor out-of-work financially challenged person who can’t afford a home, their first instinct is to recommend his name for a housing loan. As you know, such loans are safe as houses. The other motivation for these mortgage salesmen is the pat on the back they get from the bankers when they bring in a new client. The bankers, acting on the same philanthropic considerations, immediately sanction the loan and then desperately look for a way to sell it to somebody else. That’s not because they think the loan is dicey but because they want to get the money to make more loans to even more underprivileged persons.

Trouble is, some investors don’t share that social conscience and they’re worried the money will go down the drain. So the bankers had to cut up the loans into slices and package them and get the rating agencies to label some of them AAA, AA, A and so on. Rating agencies have a very rosy view of human nature that makes them feel, deep down, that nobody would be such a cad as to really default on a loan. So they merrily handed out the AAAs and investors lapped them up in the belief that three As are better than one. Banks sold the loans at a profit to investors who in turn sold them to other banks who sold them to other investors and so on, always at a profit. That left bankers who didn’t have loans to sell somewhat peeved, until someone came up with the brilliant idea of selling something that wasn’t really a loan but whose value was based on the loan packages sold by other banks. It was called, not a pseudo-loan, but a credit derivative.

Where did all these investors get the money to buy these loans? They borrowed it from the banks, of course. Policy makers felt it their duty to spread the prosperity, so they kept interest rates low so that people could borrow more and more. And people made such a lot of money that they invested in stocks and real estate and the wave of money spilled over into countries like ours and made our stocks go up. First, the stocks of companies that made profits went up, then people started bidding up the stocks of companies that would earn profits in the future and then people who called themselves investors ran after stocks of companies whose promoters promised they would soon be setting up very profitable businesses. Indian investors are a patriotic lot and they seized upon this opportunity of doing their bit to expand the economy.

For some unaccountable reason, however, those poor out-of-work people who had been given loans started to default, the loan packages and fancy derivatives suddenly became worthless and investors who had borrowed to invest in them had no option but to sell stocks all over the world to raise money. It’s just one of those unfortunate events that nobody could have foreseen.

But don’t worry — help is at hand. It would be terrible if these bankers and market operators and investors have to face the consequences of their actions —after all, none of them acted out of greed. That is why the US central bank, under the able leadership of Ben Bernanke, has lost no time in preparing plans to bail out the banks and insurance companies and has slashed interest rates. So people can borrow more to buy stocks and other assets, which will increase in price and can then be pledged as collateral to borrow even more and the money used to buy more stocks, which could lead to more borrowing and so on till everybody becomes immensely rich and lives happily ever after.

Manas Chakravarty is Consulting Editor, Mint

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  • ABOUT THE AUTHOR

    The PM’s speech in Toronto contained the analogy that while India and Canada growing separately would be a2 + b2, when joined together in friendship they would be (a+b)2 which equals a2 +2ab+b2, with the synergy giving an extra 2ab.

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