Finance and the fear of flying

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SummaryAnother financial crisis; another ritual orgy of breast-beating and ululatory lament: what went wrong? Why? Who is to blame? Why is private folly being bailed out at public expense?

Another financial crisis; another ritual orgy of breast-beating and ululatory lament: what went wrong? Why? Who is to blame? Why is private folly being bailed out at public expense? Don’t we need tougher regulation to strangle banks, non-banks, exchanges, brokers, and financial firms? Isn’t financial sophistication just camouflage for pyramiding? Isn’t financial capitalism fundamentally flawed? Aren’t financial derivatives dangerous instruments of mass financial destruction? And so on, ad nauseam. Every crisis triggers this litany of retrospective recrimination, implosive introspection, elliptical expatiation, and perambular pontification. The current crisis is, alas, no different. These questions have been asked after all the crises of the last half-century. Each time the answers have failed to predict or prevent the next crisis.

The modern era of financial crises began in 1971 when the US unilaterally abandoned the fixed redemption price of $35 per ounce of gold. Since then, we’ve had the debt crises of 1982-87, the Tequila crisis of 1994, the Asian financial crisis of 1997-99 and a number of country crises in between. Now, it’s “déjà vu all over again”. The 2007 crisis has the same roots as in 1971. What—despite the angst and Q&As—have we learnt over the last 40 years?

Not much, apparently! What is different this time? Well, size, shape, geography and impact. Starting out as a subprime crisis in the mortgage market of the US in late 2007, we now have a global financial debacle in 2008. We do not know its full dimensions yet. We have no idea how long it will last. Underlying macro-meso-micro causes are similar to previous crises: that is, government failure, regulatory failure, market failure, and induced institutional failure in financial services. It has also been management and risk-management failure; compounded by a compensation culture in the financial world that generates perverse incentives and is now past its sell-by date.

Does all this mean that modern finance is to blame for this mess? That would be an otiose conclusion to reach when there are so many other variables in operation. Excess dollar liquidity—created since 2000 by the US administration and the Federal Reserve—inflated global property, asset and commodity prices from 2002 to 2007. The Fed’s bubble-blowing capacity raises fundamental questions for the rest of the world. Might we all have been better-off if it had only an “inflation-fighting cum financial stability” mandate like the Bank of England? If it were not responsible for ensuring growth and employment in the US, would the Fed have primed the pump to this degree? But that key question is being obscured; especially in India, where we must ask the same question of the RBI.

The dollar bubble of 2000-05 created systemic pressures to increase speculative, risky lending. That was partly in response to erroneous signals—sent by governments and regulators. This time, dubious lending was directed to low-income, uncreditworthy US homebuyers. They were persuaded to buy cheap homes they could not afford through aggressive mortgage pricing made possible by a 1.25% Fed rate regime. First, the Fed reduced rates to unprecedented levels. Then, it jacked them up mechanically to five times the low rate over 21 months. It would be like RBI raising rates to 30% in the next two years and not expecting trouble to arise! That sharp reversal of tack heightened risks across the US financial system. The subprime crisis unfolded with a vengeance as mortgage payments spiralled. It is spilling over into prime credits as well. The whole US property market is imploding with devastating implications. Value-loss is now spiralling well beyond limits that any properly functioning market should be signalling.

Confidence is collapsing across the board in: (a) the quality, content and probity of national, regional and global financial regulation; (b) monetary and academic judgements of central bankers whose concerns seem to be at odds with what their priorities should be; (c) reactions of OECD treasuries which seem to be too knee-jerk to be thoughtful; (d) mark-to-market valuations of financial securities, with stressed-out asset markets emitting price signals that are not worth relying on at all for the time being; (e) the credibility and probity of ratings and rating agencies; (f) a seeming inability on the part of financial operators, authorities and commentators, to differentiate systemic problems and effects of aggregation, from firm-level problems and consequences; and (g) the collective impact this is having on perceptions about the fundamental creditworthiness, solvency and liquidity of all borrowers.

That is resulting in situations like HSBC not lending to Citibank in national or global interbank markets, because neither knows what the other is worth, or whether it has any free net capital at all! Trading desks are being asked at a moment’s notice not to do business with any outfit about which a rumour is circulating. And there is financial trade in rumours! With all this happening, a number of commentators are indulging in heavy-duty, sanctimonious huffing and puffing about how rotten things are in the land of Nod. They are going overboard with criticisms of financial markets and striking a chord with Joe-Public.

But they have no experience of finance, nor do they have any practical idea of financial decision-making in firms, banks, central banks or treasuries. Their knowledge of theoretical economics may be sound but their knowledge of finance is suspect. We will learn some lessons to be sure; but not all that can be learnt even from past mistakes. For example, despite serial crises in its savings and loan system (regulated at state level) the US has still not found a way to regulate origination quality in a market as elementary as home mortgages. The Fed and SEC failed in not highlighting risks that non-transparently bundled collateralised debt obligations (CDOs) with hidden subprime risk entailed. So did the FSA and BoE. Nor has the US found a way of curbing its own systemic macro-excesses. None of these are financial firm or market failures. They are failures of governments and regulators. They need to be looked at with greater scrutiny than the behaviour of financial markets and firms responding to the signals sent. But since governments and regulators are also the investigators, they are unlikely to criticise themselves in the way they should. And India, which is congratulating itself and RBI for the wrong reasons, is not exempt from that observation.

(To be continued)

Percy S Mistry, economist and corporate finance expert, chaired the committee on making Mumbai an international financial centre

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