Even as the global credit crisis has reached a crescendo and central banks around the world (India included) try to thwart it, I raise the most pertinent question: did regulators in the US mess up big time? The answer is yes, but what is more important is that even after several months into the crisis, the Fed is completely unsure of what to do. Going a step further, I foresee that some of the steps that the Fed has taken or is contemplating are either inadequate or may trigger a possible contagion in the long term.
Americans filed an average of around 1.5 million bankruptcies every year between 1998-2005, before these declined in 2006 and 2007. In 2008, the bankruptcy filings have increased significantly and likely to cross at least 1 million. This clearly establishes that in the midst of the 1996-2006 housing boom, there was already the undercurrent of a huge crisis building up. Interestingly, using bankruptcy data, recent studies in the US have concluded that homeowners were using this route as a potential home-saving device. For example, ?even five to six years after their bankruptcy filing, 72.1% of families still owned their homes, with only the remaining 27.9% having lost their houses.? Even among homeowners who entered the foreclosure process and did not file bankruptcy, 57% avoided foreclosure. Meanwhile, the Fed actually accentuated the problem by first pursuing an expansionary monetary policy, and then following it up with a contractionary one.
Every time a financial crisis has broken out in the US, the Fed has arranged a hasty rescue without looking to strengthen the domestic financial architecture, giving the Savings & Loan Scandal of 1985 a $150 bn bailout and shelling out $3.75 bn for the Long-Term Capital Management Disaster/LTCM of 1998. In the latter case, Fed officials later testified in Congress that had they not intervened, the outstanding trades of LTCM?a completely unknown firm and employing only a few hundred people?could well have posed a serious threat to the markets. As for further similarities to the ongoing crisis, LTCM was a hedge fund that raised $1.01 billion in 1994 and ended up with derivative positions of about $1.25 trillion, built purely on leverage, before the derivative bets turned bad and lenders started asking for their money. The now defunct Lehman Brothers had an astonishingly high debt equity ratio of 10.6 at the time of its collapse, compared to 6.2 at the time of the LTCM collapse.
In between the crises, the Fed did nothing noteworthy to put together a comprehensive plan to regulate hedge funds or even markets like the one for credit default swaps. This encouraged financial services players to take excessive risks, with the understanding that the Fed?s decade-old bailout culture would protect them from the worst eventualities, at taxpayers? costs.
As for current interventions, one of the Fed?s first mistakes was initially refusing to take equity ownership in the ailing banks. When Sweden was afflicted with a similar crisis in 1992, the banking sector became practically insolvent at the end of a real estate bloom, the Swiss Government not only took over the bad debts but also extracted equity from bank shareholders. This strategy kept the banks on tenterhooks but returned profits to the taxpayers.
The Fed has also been changing the accounting rules, which may end up having destabilising consequences. For instance, the new rules will allow beleaguered financial companies like Citigroup to transfer goodwill capital from their parent body to less regulated and more risky affiliates. This proposed change will make some of the faltering banks more attractive to suitors, but increase the cost of the bailout in the long term. In a similar vein, the Securities and Exchange Commission has issued statements that will allow companies to use more flexibility when valuing securities in a market that has dried up. Clearly, the whole plan is a complete smoke screen for the banking industry.
The author is an economist and is with Tata AIG Life. These are his personal views