It all hasn’t happened so quickly as hyped and discussed but over 2-3 years. We are left with the benefit of hindsight, but the price we have to pay is the astronomical financial loss.
We were residing in low point of the economic cycle and the interest rates were cut steeply to bring economy out of the recession. This encouraged people to borrow beyond means. Economy also reacted positively with bubbling liquidity, expanding businesses, lowering unemployment levels and rising income levels. However, the cycle had to take a turn and it started to reverse with fed increasing interest rates. During 2004-07, upward spiral in interest rates put pressure on asset prices and on speculative bets taken by banks resulting in colossal losses.
Who should be held responsible for the financial catastrophe that we are experiencing today? Is it irrational i-bankers or profit hungry commercial banks or credit rating agencies or homeowners borrowing beyond means or regulators?
The recent meltdown showcases that the entire financial services ecosystem is at risk. A closer examination reveals that the banks were lending subprime loans as they could securitize and trade it with investment banks. Investment banks were trying to mitigate risk by using CDS (Credit Default Swaps) with their peers and insurance companies. These equations seemed to be in balance but they went beyond control as the economic variables were not aligning to the financial bets taken earlier.
I believe, we have just now started seeing the impact of the entire financial mess around the Wall Street. People have to look beyond subprime mortgages into subprime auto and personal loans and even subprime cards. More banks are expected to go bust, especially regional banks. If the US government starts assuming the bad debts and losses of these institutions it will run into trillions of dollars. However, US government is trying to calm the situation by proposing a $700b bail-out package, which will be significantly deficient to handle the toxic!
In the coming months,
- We will see banks orchestrating more stake sales, and trimming down balance sheet.
- Equity markets haven’t bottomed-out yet. Fundamentally markets should find its bottom aligning with business cycle i.e. corporate earnings should reach lows
- Central banks across the world will continue pumping money into the market to ease the pressure and build investor confidence
- Oil prices will stabilize around $100 mark.
Some unanswered questions
- Will top echelons compensation be rationalized and NOT incentivize them to take undue risks?
- Will the soft treatment to Wall Street firms by bailing them out set precedence to take riskier bets in future also?
- Were credit rating agencies unable to sense the impending danger earlier? OR Were they not independent on their opinions and ratings?
- How well the corporate governance of the institutions measure up? Lehman in their last reported quarterly results were cautious but reassuring to handle the situation!
Hope we sail through the tougher time ahead.
September 29, 2008 at 11:44 am
machan one thing i ouldnt understand.. MBS and CDO are cited to be the main reasons behind the subprime crisis. This leads to the question of why the subprime borrowers started defaulting. Did they start defaulting due to reduced cash flow arising from increased rates or due to the decreasing property value? If its the former, isnt the Fed responsible for this crisis as they increased rates?
I feel all this comes down to oil. As inflation started to climb on the back of rising oil prices, Fed hiked rates to control it. Does data support this theory?
Also, we need to understand how the value of property starts decreasing. We are starting to see the same issues here in India, with property prices coming to a standstill and interest rate rising drastically. The high inflation has induced rate hikes in India also..
Will India have its own version of subprime, with our banks and NBFC’s bearing the brunt of defaults?
Only time will tell.
September 29, 2008 at 11:44 am
If we are to get out of this financial mess and ensure that nobody tinkers and plays around with the fundamentals… we need to bring order to “Wall Street” and in that respect.. two players in Wall Street… who directly / indirectly influence earnings…. a) Analysts b) Credit Rating Agencies
I am a strong believer that Analysts & Credit rating agencies are bumbling idiots and nincompoops who push companies to generate better earnings. The enormous influence these analysts have in influencing stock price forces executives to flog themselves to appease Wall Street. This is the route cause of economic turmoil! Anything byond the ordinary.. will decay faster.. sustenance will be tough.
Analysts seek protection under the disclaimer statements.. but what I fail to understand is… why is always on the last page?? Why can’t it be in the initial pages?
Credit Rating agencies are jokers.. I simply cant understand how somebody becomes a sector expert by going through excel spreadhseets instead of being out there in the market and facing the music! You need to be in the shoes of the salesman to guage the pulse of the marketplace.
Credit rating agencies measure the worth of a financial instrument and assign a risk.. fine.. but then why do they complicate issues so much that they lose common sense??
When executives of corporations are punished for committing offences… I believe Analysts / Credit Rating agencies should also be punished if they give buy recommendation. They should also be imprisoned, fines levied and their PF contribution cancelled and transferred to Investor Protection fund. This will teach these analysts to be more genuine in their calls to investors and give more “correct” analysis.
I also feel Business Schools need to start becoming more responsible in the teachings they impart and stop making students greedy and money minded. The greed to outstmart and be the best in the business is not what an educational institution should be doing. Education is all about teaching value creation.. not value destruction!
September 29, 2008 at 2:56 pm
“Will top echelons compensation be rationalized and NOT incentivize them to take undue risks?”
In an ideal scenario, the top bosses should get paid only for generating revenue and profits for the company. If their risk paid off, they should be compensated but if the company is in a mess, they should bear the loss of compensations.
A classical example is the case of Adam Applegarth, the erstwhile CEO of Northern Rock which was taken over by the UK government in the wake of the insolvency. He is reported to have received a compensation of £760,000. An avid cricketer, it is reported that he even had in his contract a clause for an annual sponsorship / donation by the bank to his cricket club.
“Will the soft treatment to Wall Street firms by bailing them out set precedence to take riskier bets in future also?”
Yes. It has set a precedence. The national governments cannot afford to allow these institutions go bust. Taxpayers’ deposits, Investor confidence, Speculation, Elections etc etc have a say in this. The taxpayer is the ultimate sufferer in either case. If the companies do well, a certain section gets all the rewards. If companies fail, their money is used to bail them out.
It is high time that these money making institutions retrospect on their approach. While risk has to be rewarded, it also has to punished if it fails.
September 29, 2008 at 4:04 pm
vk, heard that some other bank in the uk, bingley or something is also being taken over? pathetic situation.. as you rightly put, failure of risk has to be punished.
September 29, 2008 at 4:53 pm
Scudie, yes. Bradford & Bingley has been nationalized. Makkal are so kadi here because it is their money that is used to bail these banks out. Aana inevitable situation for the governments da. Lot of people will lose their deposit if these banks are not saved.
Hope nothing happens to Citibank where I hold my deposit
September 29, 2008 at 5:09 pm
Europe seems to be more vulnerable now. Fortis has partially become nationalised! Eurpoean banks leveraging are alarming and higher than US peers. I also read in an article about their liabilities. Deutsche Bank has liabilities worth 80% of Germany’s GDP and Barclays has it almost equal to UK GDP. So even entire country cannot bail-out these bank if they go down.