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Wall Street: Hoist With Its Own Petard

Before the shocks and reverberations of the subprime mortgage crisis turn into a great disaster, the present regulatory structure in the United States, especially that relating to large financial conglomerates, has to be overhauled.

COMMENTARYseptember 27, 2008 EPW Economic & Political Weekly10Wall Street: Hoist With Its Own PetardD N GhoshD N Ghosh (dnghosh1@dataone.in) is the chairman of ICRA.Before the shocks and reverberations of the subprime mortgage crisis turn into a great disaster, the present regulatory structure in the United States, especially that relating to large financialconglomerates, has to be overhauled.Experience, they say, is a great teacher. Not for Wall Street. It refuses to learn. Over the past 25 years, one major financial crisis or the other has been hitting Wall Street once every five years or so. On each occasion, we have seen the regulating authorities step in and with some swift makeshift arrangements stave off the threat to the stability of the system. Each of the crises has had its origin in some kind of unacceptable behaviour on the part of the market participants, but they have conti-nued to behave with hauteur, impervious to any wise counsel. Once the regulator has cleaned up the mess, the players have got back to their old game.What is the game that has now landed us in the present crisis? Everyone seems to know the answer; “subprime crisis” is the phrase on every lip. It is as if a kind of meteor from outside has all of a sudden hit the banking system. Nothing of that sort! In plain language, what underlies the term “subprime” is irresponsible lending; lend-ing to borrowers who do not fulfil any con-ventional or standard credit criteria.Any first year student in a commerce school knows that the basic principle of banking requires that the quality of the collateral be evaluated before public funds, of which the banks are the custodi-ans, are committed. It is this textbook principle that the major banks have been merrily violating for several years now. Massive house mortgage loans have been extended to non-creditworthy persons, those who do not have the inherent capa-bility to honour the repayment commit-ments they have taken upon themselves. Why should poor borrowers, hungry for loans and eager to own a house, bother at all when the normally reluctant lenders are so obliging? The lenders are happy to lend; they have the innovative genius to back up the loan with collateral – that is, the hope that property prices would always ride a rising curve. It is this highly unrealistic assumption that makes the loans ab initio risky. Having knowingly created these risky assets, the banks then do the smart thing by moving fast to shake these off from their balance sheets. And lo, these risky assets, which none would have normally touched with a bargepole, are magically transformed into market-able assets in neat and attractive “securi-tised” packages! The dynamic and innova-tive investment bankers now step in and market these securitised packages with their stamp on it to investors across the globe. A brilliant piece of innovative bank-ing, a win-win for all! The banks are spared the requirement of having to set aside additional capital for these risk assets while the investment banks make a killing from the distribution and sale of these packaged products, sanctified by the global rating agencies.What Were the Regulators Doing?The simple questions that any novice would ask are: Why is it that the commer-cial banks were allowed, in the first place, to get away with such irresponsible lend-ing? When all this lending was going on at a breakneck speed and the housing mar-ket was riding a terrific boom, propelled largely by the easy lending, what were the regulators doing? If the banks were get-ting more and more involved in risky lend-ing, should not the regulators have inter-vened? Knowing pretty well that once these bundles of risky assets were securi-tised and sold off, they would scatter themselves all across the globe like the radioactive ashes from a thermonuclear detonation? These “unknowns here are unknowable”. The American regulators, who are at the nerve centre of the global economy, should have intervened much earlier, at the stage when these risky assets were being generated all over, and halted the mad rush that was going on.Here let me digress a bit and refer to a recent report in theWall Street Journal that exposes the casualness of one arm of the regulator, the Federal Deposit Insur-ance Corporation (FDIC). Since 2001,FDIC has been managing Superior Bank, a failed bank that it took over that year.
COMMENTARYEconomic & Political Weekly EPW september 27, 200811However, even withFDIC supervising Superior Bank’s day-to-day operations, the latter funded more than 6,700 sub-prime loans worth over $ 550 million.FDIC then sold a big chunk of these loans to another bank, knowing fully well that the loan pool was inherently risky, afflicted by serious deficiencies such as lending to unqualified borrowers, inflated appraisals and poor verification of borrowers’ income and all that. If an institution managed by an arm of the regulator can continue with such lending, why should one blame the “innovative” bankers? (‘Running Failed Bank, US Regulator Waded Deeper into the Mortgage Mess’,Wall Street Journal, July 22, 2008.)Now many experts are dishing out gems of analysis among hapless television viewers: for instance, it is to the slowdown in the growth of the world economy that we must attribute this crisis. I would no longer be surprised to see many an econo-mist indulging in a clever and abstruse analysis of supposed factors, exogenous and endogenous, that have seemingly con-spired to precipitate the present crisis. Recall the kind of debate that had gone on for decades about whether the failure of the Bank of the United States in 1930 was caused by factors exogenous or endog-enous, factors that had hit a fragile system like a meteor, wiping it out needlessly, or endogenous, that were part of the prob-lem. The core issue as to what is behind the current credit crisis is not very compli-cated, unless we choose to make it so. The scourge lies, as I have tried to explain, in the heart of the American banking system. It has to go back to school to learn the basics of banking, and the regulator must learn when and how to intervene. In this short commentary, I focus on two basic issues, behaviour of market forces and their regulation, so that market distortions like the one we are now witnessing may be avoided. First, what has happened is not the collapse of a market economy. That would be a mistaken conclusion to draw. We must recognise that it is the market that exposed the unethical and unsustainable opera-tions of the market players. Recently, Paul Volcker, the giant among central bankers, had this to say about the present crisis: “Simply stated, the bright new financial system – for all its talented participants, for all its rich rewards – has failed the test of the marketplace” (Financial Times, May7, 2008). If Wall Street has been stripped of, the credit goes to the market, not the state or the regulating authorities. Second, while this is so, one must not fall for the prescription of the market fun-damentalists: let the market participants bear the consequences of their actions; let the financial markets live and die by the laws of competitive markets; if they fail, let them go down, with all their share-holders, customers and employees. That would be a dangerous approach to follow, one that would bring untold hardships, directly or indirectly, to millions across the globe. Thus, given the circumstances, going against market principles to bail out the monoliths of the system is certainly the right and the most appropriate policy to follow. True, in the process, it is not unlikely that the Federal Reserve and its associated institutions would themselves turn into huge monoliths, owning several commercial banks, investment banks and what not. From being the greatest advo-cate of a deregulated banking system, the Fed may well turn out to be the largest holding company of banks. And the list of institutions acquired is certain to get longer. Even as I write these lines, Gold-man Sachs and Merrill Lynch are being battered down in the stock market. We have not seen the end yet; remember, the dimension of the credit default swap mar-ket is about $ 62 trillion.Supervising the Big Financial ConglomeratesWhat boils down as the central stability issue for the world’s largest financial sys-tem is this: it must find a way as to how its regulators should supervise the big finan-cial conglomerates that dominate many key areas of trading, underwriting and investment management. Many command an overwhelming position in derivatives and in many of the esoteric financial instruments that are revolutionising the marketplace. In a recent column, Joseph Stiglitz, the Nobel laureate, had this to say on the bailout: “Defenders of the bailout argue that the institutions are too big to be allowed to fail. If that is the case, the government had a responsibility to regulate them so that they would not fail [emphasis added]. No insurance company would provide fire insurance without demanding adequate sprinklers; none would leave it to ‘self-regulation’... Even if they are too big to fail, they are not too big to be re-organised” (Financial Times, July 25, 2008.)Interestingly, a year ago, in a column in Wall Street Journal (November 24, 2007), Henry Kaufman, that doyen among invest-ment bankers, came out with the follow-ing suggestion: “What is urgently needed is a new kind of institution that I will pro-visionally call the Federal Financial Over-sight Authority. The regulatory body would oversee only the largest US-based financial institutions – the giant conglom-erates engaged in a broad range of on- and off-balance sheet activities – assessing the adequacy of their capital, the sound-ness of their trading practices, their vulnerability to conflicts of interest, and othermeasuresof their stability and their competitiveness.” The moot point is that there has to be a way for regulators to intervene in the functioning of any large conglomerate whenever they take the view that the way the conglomerate is functioning in the marketplace may jeopardise the stability of the system. A balance must be struck between market discipline and regulatory intervention, and the present regulatory structure in the US has to be overhauled. If they do not apply themselves to this task, the shocks and reverberations of the subprime mortgage crisis will be a mere prelude to a greater disaster. Fine, all that would be in the future. Meanwhile, what do we, the economies lying on the periphery, do now? Nothing in particular, I guess, maybe just watch the reality show as it unfolds.EPW Blog The new EPW blog feature on the web site facilitates quick comments by readers on a selection of the week's articles. Four topical articles from the current issue are posted on the EPW blog every week. All visitors to the site are encouraged to offer their com-ments and engage in a debate.Please visit the blog section on our web site (www.epw.in).

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