Friday, September 26, 2008

subprime saga - by NINAN

The United States is supposed to have not just great markets and great enterprises, but also great regulators. The Federal Reserve and the Securities and Exchange Commission are respected and feared the world over. Those great markets also rely on institutional mechanisms, like the rating agencies — all of which are now American-owned. The amazing thing about this entire pack is that the financial crisis has shown all of them to be as naked as the emperor who strutted out in what he thought were his new clothesWhat, for instance, was the SEC doing when the great investment banks (Bear Stearns, Lehman Brothers, et al) were leveraging their equity 30 and even 40 times? If a company runs $600 billion worth of assets on an equity base of just $26 billion, then if those assets drop in value by just 5 per cent, the company goes bankrupt — which is what has happened. If the SEC wasn’t looking at the problem, what were the rating agencies doing when they gave these firms the best ratings in the book? If the risks are blindingly obvious today, why could the Fed not see them and ask for corrective action from the lawmakers or by the SEC?
It seems obvious now that the whole investment banking model is simply not viable. They made fat profits because they ran risky, over-leveraged businesses; and they were not regulated in the way that traditional banks are, so they did not have any defences in place for when things go wrong. That explains why it is banks like Bank of America which are now gobbling up the investment banks, and why Morgan Stanley is running for cover to Wachovia and others.
When Enron went bust, it was run by a bunch of Harvard MBAs, advised by McKinsey, and its accounts audited by one of the big accounting firms (which imploded). It turned out that the accounting firms were busy getting money from their clients for doing consulting work — which created a conflict of interest when it came to proper auditing. That same problem now affects the rating agencies, which were getting a lot of work and therefore revenue from the investment banks. So did they go soft in their ratings of the investment banks — and mislead the markets? In any case, did the people in the rating agencies actually read and digest the thousands of pages of legalese associated with every complex financial instrument before they gave a rating, for which the fee was relatively modest? You can guess.
In other words, it is not just the investment banking model that is broken, it is the entire system of complex financial instruments that no one fully understood, so that risk was not properly measured — and that is lethal when things start unraveling. The trading practice that makes things unravel even faster in such a situation is called ‘going short’ — a practice long frowned on by Indian regulators for being destructive of value, but advocated by market fundamentalists as being an inalienable part of an efficient market. Now, surprise, the SEC is talking of banning ‘shorting’ because that is causing the selling stampede behind the bankruptcies!
Someone said the other day that the worst is over. Don’t bet on it. All the assets owned by the firms that have gone bust (trillions of dollars worth) have to be sold, and it will be a fire sale at knocked down prices. That means enormous destruction of asset value, and someone has to feel the pain. AIG, for instance, has been given two years to sell down, so it is going to last a while.
Closing thought: It isn’t funny any more to say that the Indian financial regulatory system shines because of its innate caution.

Works at NABARD for poor HH / was Research Affiliate at CDS, Tvm / was Visiting Faculty on microFinance for MBA students NMIMS, Mumbai.