Posted by: Pradeep | October 1, 2008

Global financial problem – still long way to go

World is going through the most serious global financial crisis since the Great Depression. It is centred in the United States, but its implications are worldwide. The nationalisation of Bradford & Bingley in the UK and financial support for Fortis in Europe highlight the dangers of contagion.
Only concerted action by governments and monetary authorities, particularly those of the US, can prevent a global disaster. The crisis is as much real as it is based on the fear in the minds of participants in the financial system. That is why the $700 billion Troubled Asset Recovery Plan proposed by US treasury secretary Paulson and rejected by US House of Representatives is so important. The US government must commit large amounts of taxpayer funds and show firm determination to solve the problem.
There were four main factors behind this crisis. One, the US had long and continuous economic expansion with low inflation over the last 15 years, making financial markets and regulators complacent. They forgot that there is a “business cycle”. Only 18 months ago, regulators, particularly the US Federal Reserve, were focused on dealing with the so-called ‘liquidity glut’. In the process, they missed noticing the emerging risk due to asset price inflation, particularly in real estate.
Two, during these good times financial institutions (FIs), particularly investment banks, grew very large. They took big risks and made huge profits. In recent years, FIs contributed nearly 40%, as against the normal 10%, of total US corporate profits. They paid huge salaries to recruit the best and the brightest from top business schools, who, in turn, helped create and sell complex financial products, credit derivatives and other securities whose risks were not understood by either investors or the top managements of investment banks.
Three: The good times encouraged banks to take higher risks. Highly leveraged transactions with “life covenants” became the norm. Investment banks themselves, became highly leveraged: 32:1 for Lehman Brothers before it failed, as against 8:1 for a conservative bank. Investment banks did not have sufficient capital to support the risks on their balance sheets.
Four, there was major failure of leadership at most FIs. Dealmakers took charge and risk managers were completely sidelined. Credit was mispriced so much that there was only small difference in the yield between junk bonds and US treasuries.
The very first inkling of the crisis came in February 2007 when Bobby Mehta, chief executive of HSBC, North America and another executive of HSBC, USA were sacked for catastrophic forays into high-risk US mortgage securities. These two bankers had received $40 million in bonuses the previous two years. The bank was forced to issue the first profit warning in its 142 years history but the timely action to recognise and deal with this problem has served HSBC well. Few market participants picked up the implications of this market signal.
Since early 2008, treasury secretary Henry Paulson and Federal Reserve chairman Ben Bernanke have been spearheading the fight against the financial crisis. Their challenge is to prevent systemic failure and recession, without creating a moral hazard, which would encourage people to act irresponsibly in the future.
They orchestrated Bear Stearns’ merger with JP Morgan to stabilise the markets in March. Last month, they took over Fannie Mae and Freddie Mac, virtually government enterprises believed to have “the full faith and credit of the US government” behind them. They let Lehman Brothers file for bankruptcy as it did not represent a systemic risk. By this action, they also gave a salutary warning to shareholders and creditors of FIs that the US government would not always bail them out.
Merrill Lynch’s merger with Bank of America, nudged on by the regulators, was a smart move. It addressed a problem before it became serious. AIG had to be rescued. Its normal insurance business continues to be sound, but it has assembled a huge portfolio of structured securities and credit default swaps that posed a risk to the entire financial system. Washington Mutual’s takeover by JP Morgan, and Wachovia’s acquisition by Citigroup underline the current fragility of US banking system.
Depending upon how effective the US government and other monetary authorities are in dealing with the current crisis, it would take at least a year, possibly more, for the credit markets to get back to normal. In the medium term, we will see US lawmakers impose fresh, perhaps, too many, regulations, on the financial system. The structure of the financial industry will undergo a major change. After the Great Depression, the Glass-Steagall Act separated commercial banks and securities firms. Ironically, the current financial crisis has led to combination of the two. There will be other changes. Insurers will have to stick to their basic business and not take on huge risks on unrelated ventures. There is likely to be more regulations on hedge funds and other unregulated financial entities. Capital requirements for most FIs will be further enhanced. There would be an overhaul of executive compensation, and strengthening of risk management. Most derivatives such as Credit Default Swaps would become exchange-traded to eliminate counter party risk. Rating agencies will completely revise their approach to rating of mortgage and other complex securities.
This crisis will have some impact on India as well — we are not decoupled from the global financial systems. We have already seen the Indian stock market move in tandem with global markets. Capital flows into India will, the in short term, slow down. The rupee will depreciate.
On the other hand, our domestic financial system is robust and well capitalised. The Reserve Bank has already initiated sound measures to control inflation and excesses in the property sector.
There is an additional concern and an opportunity. Indian corporates who made large acquisitions overseas in recent years, with significant leverage, will be challenged. At the same time, asset prices are very depressed, particularly in the US and Europe, presenting Indian companies with interesting acquisition opportunities.

Originally written by Mr. Arun Duggal, TOI


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