The heat of economic melt down is spreading slowly across the world for the first time since the Great Depression of 1930s. The fall of some of the giant global Banks/FIs of US/European/Asian countries including Lehman Brothers, Merrill Lynch, Bear Sterns, AIG (US), Dexia (Belgium), Origami Bank, Sumo Bank, Bonsai Bank (Japan) etc. unearth the gravity of the situation. Filing for bankruptcy by Banks/FIs across the US / European countries have become quite common and placed the investor confidence at high alert. Even we noticed with surprise the insolvency of Republic of Iceland a consequence of the adverse economic situation. Ben Bernanke, the Head of Federal Reserve, US has admitted the economic slow down in US and expressed that it would take another two three years to set right the economy and make the situation under control. The reported reduction of capacity utilisation, contraction of labour strength, down ward revision of salary structure etc. by major industrial houses engaged in automobiles, textiles, iron and steel, cement, aviation etc. have created much hue and cry among the public.
Indian economy is also not free from this global phenomenon. Though initially the Government of India have vehemently claimed proper insulation of our economy against any global crisis, of late Mr. Man Mohan Singh, our PM has acknowledged that India is also under the clutches of global melt down. The hectic withdrawal by FIIs has resulted in unparallel crash in sensex, heavy depreciation in rupee value against dollar and significant reduction in FEX reserves. To overcome the situation, RBI has opted for various quantitative measures to infuse liquidity in the financial system. In his strategic meeting with leading industrialists of the country, Mr. Singh sought for their assistance to keep away from employee reduction, contraction of productivity and labour retrenchment. Under such a circumstance, it is quite significant to evaluate the scenario behind the global economic crisis and its aftermath.
I. The US Collapse and its Intensity:
The topography of the Wall Street Banks (WSB) changed radically since September 2008. Bear Sterns, founded in 1923, collapsed and was hastily acquired by J.P. Morgan (JPM). The ailing Bank Washington Mutual was also bought into the fold of JPM. Lehman Brothers, founded in 1850, declared bankruptcy, and was taken over by Barclays Bank. Merrill Lynch, founded in 1914, folded alongside Lehman Brothers, to be picked up by Bank of America. A few days later, American International Group (AIG), founded in 1919, the world’s largest insurance company, went down the slope towards bankruptcy, but was fortunately saved at the eleventh hour by an emergency infusion of $ 85 billion by the US Government. A few weeks later, the Federal Reserve provided an additional loan of almost $ 38 billion to strengthen the ailing insurance giant. The Government sponsored mortgage agencies Fannie Mae and Freddie Mac, created in 1968 and 1970 respectively, retreated from their autonomy in to the embrace of Government. In the mid October 2008, Wells Fargo Bank absorbed Wachovia Bank, founded in 1879. JPM, founded in 1879, and Goldman Sachs, founded in 1869, went from being Investment Banks to become Bank Holding Companies. This turbulence has caused a downward slide and slope for major stock markets across the world and the credit market commenced to seize up. The pulse of electricity now began to make inroads into the confidence of those who hire and fire, who make and break. Things are so bad that General Motors released a statement that “Bankruptcy is not an option” for the Company. The Labour Department, US announced that the country lost 1.59 lacs jobs in September, up from 0.73 lacs jobs lost in August 2008. The Wall Street Journal released its survey of 52 economists who pointed out that things can only go negative. The shifts in US from ardent laizzez faire postulates to nationalization concepts are quite a paradox.
II. SPMC – An Overview:
From late 2002 to mid 2005, the US Federal Reserve funds rate stood at levels that implied that when adjusted for inflation, the real interest rate was negative. Easy access to credit at low interest rates triggered a housing boom, which in turn triggered inflation in housing prices and encouraged more housing investments. From the FY 2001 to FY 2007, the real estate value of households and the corporate sector is estimated to have increased by $ 14.5 trillion.
The SPMC is an ongoing economic problem in US and became more visible during 2007. The situation is characterized by contracted liquidity in the credit market and banking system. Sub prime lending is the practice of extending mortgage loans to borrowers with poor credit history. Higher rate of interest is charged to mitigate the risk factors, viz. poor income level, low credit score, unstable employment status etc. Sensing the opportunity coupled with encouraging interest rate environment, the Banks/FIs expanded the borrower base by inducting sub prime ones or borrowers with low credit ratings and high probability of default, viz. the No Income, No Jobs and Assets (NINJAs). Mortgage borrowers attracted these clients by relaxing income criteria and offered sweeteners like lower interest rate for initial period with reset options. The share of such sub-prime loans in all mortgages rose sharply, from 5% in 2001 to more than 20% by 2007. Borrowers chose to use this “opportunity” because they were not properly informed about their commitments. Also, they were over confident about their ability to meet the repayment obligations.
On the supply side, the complex nature of finance centered on the “Originate and Sell” model. The Banks/FIs discounted the risk because they expected to cash in on large profits even while transferring the risk associated with the investments. The mortgage brokers sought out willing borrowers for a fee, turning to sub prime markets in search of volumes. The Mortgage lenders and Banks financed these mortgages because they wanted to buy the interest and amortization flows associated with such lending. Also, they wanted to sell these instruments too less regulated intermediaries such as the Wall Streets Banks. The Banks, who bought these mortgages, opted to expand their business by bundling assets and sold to institutions, investors, hedge funds and portfolio managers. To suit different tastes for risks, they bundled them into tranches with varying probability of default and differential risk weightage/protection against losses.
The associated risk was rated by approved independent agencies which, not knowing the details of the specific borrowers to whom the original credit was sanctioned, use statistical models to determine which kind of tranche could be rated as being of high, medium or low risk. Once certified, these tranches could be absorbed by Banks, Mutual Funds, pension funds and insurance companies, which could create portfolios involving varying degrees of risk and different streams of future cash flows linked to the original mortgage. Whenever necessary, these institutions could insure against default by turning to the insurance companies and entering into arrangements such as CDSs. Even Government Sponsored Enterprises such as Freddie Mac and Fannie Mae, which were not expected to be involved in or exposed to the sub prime market, had to cave in because they feared they were losing business to new rivals who were tiring to cash in on the boom and poaching on the business of these specialists. Because of this complex chain, institutions at every level assumed that they were not carrying any risk or they were properly insured against.
The problems began with defaults on sub prime loans. In some cases, default occurred before interest rates were reset to higher levels and in others, after the resetting of rates. As the proportion of default grew, the structure gives in and all assets turned illiquid. Rising foreclosures pushed down housing prices as more properties were up for sale. On the other hand, the losses suffered by financial institutions were freezing up credit, resulting in a fall on housing demand. As the housing prices collapsed, the housing equity held by many depreciated and they found themselves paying back loan that were much larger that the value of the assets. Default and foreclosures seemed a better option than remaining trapped in this losing deal.
Since mark to market accounting required taking account of prevailing market prices, many financial firms had to write down the values of the assets they had and take the losses into their balance sheets. But since the market value was unknown, many firms took much smaller write down than warranted. But they could not hold out forever. The extend of the problem was partly revealed when leading Wall Street Bank like Bear Sterns declared that investments in two funds it created linked to Mortgaged Backed Securities (MBS) were worthless. This signaled that many financial institutions were near insolvency. Infact, given the financial integration within and across countries, almost all financial firms in the US and abroad were severely affected. Fear forced firms from lending to each other, affecting their ability to continue with their business to meet short-term cash needs. Insolvency began threatening the best and largest firms. The independent Wall Street investment banks, Bear Sterns, Lehman Brother etc, shut shop or merged into bigger banks or converted themselves into bank holding companies that were subject to stricter regulations. This was seemed as the end of an era in which these independent investment banks epitomized the innovation that financial liberalization had unleashed.
III. SPMC- A Search for Causes:
The Securities and Exchange Commission has conceded that self-regulation of Investment Banks contributed to the crisis. The first thing occurred with the withdrawal of the Glass Steagall Act (GSA), which was passed after the Great Depression in 1930s. The GSA separated the investment activities and commercial banking activities. The Act was repealed in 1999 with the Gramm Leach Bliley Act (GLBA) with liberalization in investment and commercial banking activities. Economist Robert Kuttner has criticized that the repeal of GSA has possibly contributed to the sub prime crisis. Coupled with this, the Community Reinvestment Act (CRA) has encouraged lending to untrustworthy/non creditworthy consumers. It has been stated that the amendments to CRA in the mid 1990s, raised the amount of home loans to otherwise unqualified low income borrowers and allowed for the securitisation of CRA regulated loans containing sub prime mortgages. The US Department of Housing and Urban Development’s mortgage policies fuelled the trend towards issuing risky loans.
Before 1970s, the US financial sector was highly regulated and stable in which Banks were dominated, deposit rates were controlled and small and medium deposits were guaranteed. The Bank profits were determined by the difference between deposit and lending rates, and banks were restrained from straying into areas such as securities trading and insurance. Infact, this was the concept of “the lend and hold model”. The Banks extended their activity beyond conventional commercial banking into merchant banking and insurance through a holding company and transform themselves in to universal banking with multiple services. Within banking, there was a gradual shift in focus from generating net interest margins to earning fees and commissions for various financial services. The “Lend and Hold” model gives way to “Originate and Sell” model. While banks did provide credit and create assets that promised a stream income in the future, they did not hold those assets any more. Rather they structured them into pools, “securitised” those pools and sold them for a fee to institutional investors and portfolio managers. Those who bought the risk looked into the returns they would earn in the long term. That Banks were no longer museums, but parking lots that served as temporary holding spaces to bundle up assets and sell them to investors looking for long term instruments. Many of these structure products were complex derivatives and it was difficult to assess the risks associated with them. The role of assessing risk was given to private rating agencies, which failed to estimate the risk associated.
Also, the financial liberalization increased the number of layers in financial system, with varying degrees of regulations across each layers. In areas where regulations were quite light like investment banks, hedge funds and private equity firms, the FIs could borrow huge amounts against smaller own capital and issued leveraged investments to create complex products that were often traded over the counter rather than through exchanges.
Finally, while the many layers of the financial structure were seen as independent and were differentially regulated depending on how and from whom they obtained their capital (such as small depositors, pension funds or high net worth individuals). They were in the final analysis integrated in ways that were not always transparent. Banks that sold credit assets to investment banks, and claimed to have transferred the risk, lent to or invested in these investment banks to earn higher returns from their less regulated activities.
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