AN INGREDIENT FOR DISASTER

With hardly a glimmer of hope in sight, it seems that amidst all this aura of gloom and disappointment by many an economic entity, there is perhaps one individual who would be all smiles as the mayhem unfolded – none other than Mr. Bin Laden!!! For what he could not achieve through the 9/11 attacks, the US of A with its well-prided “cream of financial intellectuals” has most “successfully” executed the ECONOMY-SUICIDE Attack.

Well, to put things in perspective, WHO or What exactly murdered Wall Street and is now on a rampage across every other Street? The Answers may be endless, but all essentially boiling down to one aspect, which put across in refined parlance would mean Lack of Discipline or crudely put - Greed.

By whatever term you may call it, this emotion which is probably as old as the human race is at the very heart of the crises. And the irony is that while everybody knows it intuitively, nobody wishes to acknowledge it.

Way Back in 1995 when the hedge funds industry begun assuming tremendous footing in the financial world, leverage caught on as the fanciest means to make Big money quickly. All was well until Long Term Capital Management collapsed in 1998 – a Hedge Fund which at its peak commanded around $ 4bn in assets. And what aided this was the fact that the fund was able to take on infinite leverage or unlimited risk in practically every other asset class-commodities, stocks, currencies and bonds. What’s worse is that LTCM conducted and published much of the research, validating the risks of the trade for the rest of the industry. It was easy for LTCM to convince and impress investors for 2 reasons-one, it employed strategies so complex that no lay investor could probably trust his/her own head with and two, it had 2 Nobel laureates in its payrolls.

As huge bets paid off initially, no-one felt the need to question the source of the profits. It suited banks and other commercial lending institutions not to take the procedural due diligence too seriously. For ultimately the loans they lent yielded huge returns; End of day, targets were met which raked in huge bonuses.

Surprising isn’t it?? Exactly a decade later, the world find’s itself mired in a crisis that’s probably LTCM raised to the power of…. Anybody’s guess! From an endless pursuit of Return ON Capital, it’s now virtually a question of Return OF Capital that is seen driving sentiment across financial markets.

The crisis as we know it today all began sometime back through a seemingly innocuous financial innovation which was aimed at including millions of otherwise excluded families to fall under the “home-owners” category. Real competition was introduced in the mortgage lending business by allowing non-banks to offer mortgages. It didn’t stop there. Mortgages were allowed to be pooled together to be further used as collateral to issue securities. They were then sold to yield-hungry investors (and speculators!) alike and mortgage payments, consisting of interest and principal, were passed through the chain, from the mortgage servicer to the bondholder. The final icing on the cake was to call reputed rating agencies to certify that the “less risky” of these mortgage-backed securities were indeed “safe enough”. All this was not bad after-all or so it was believed to be…..as another mechanism to tackle defaults was created- the Credit Default Swaps market which later became an instrument of speculation instead of insurance.

It seemed like nothing short of a Dream product that America could showcase to the entire financial world. Sadly however, it stands today helplessly owning a crisis that would probably make the Asian financial crisis of 1998 or the dot com burst of 2000 seem like dwarfs.


Leverage yet again proved to be the culprit. Greed sent risk taking to dizzy heights, the effect of which is seen today as the cascading influence of panic and fear play out. Even as the wounds of such a meltdown remain raw, it pays to note that much of the risk taking, apart from being permitted was infact encouraged or better said-INCENTIVISED.

Closer home, the derivative debacle that occurred some months ago points to a fact that in essence, is no different - except of course for the magnitude of the problem. Here again, it originated with unrealistic targets set out by some of the managements of the banking sector to their treasury departments, which drove many a treasury official to aggressively market such products to corporates .Nothing really mattered to the treasury sales team – not even if it suited the risk profile and intrinsic business structure of the corporate. And quite a number of corporates fell for the bait of quick returns, as it came on the back of a sales gimmick – “x currency has never hit a particular level in the past 10 years and thus will not in the future”. Even though it sounds as baseless as saying, “I haven’t met with death in the past x years and therefore, I will not perish in the next y years”, the lure for overnight riches can send even the most “conservative” or rational/level headed firm or individual to assume risks beyond its capacity.

Risk per-se is nothing wrong for without it there is no business and most importantly no return. There is one common thread that runs across most cases, be it the large investment bank which went under the weight of its exposure to the mortgaged backed securities or the small scale retail investor in the equity markets – each of them were presented with a reasonable timeframe of positive payoffs. So Risk did payoff. It’s just that they didn’t choose to book their profits and exit their profitable positions.

The importance of managing risk can be summed up in the words of the great John Maynard Keynes who said, “Markets can remain irrational longer than you can remain solvent “. A thought worth its weight in gold!

AN AVALANCHE THAT WAS….

As the whole world suddenly awakens to the ruthless face of Free market economics and its nasty verdict, it is indeed ironic that the world’s largest proponent of laizze faire should have found itself falling prey to the “invisible hand” , better known as “efficient” market forces .

The historic Bear Stern’s takeover (bailout) by JP Morgan early this year virtually tricked many, if not all into believing that the worst of the crisis had come and gone, when in effect it only foreshadowed the fate of many that were to follow.

It was a week that underscored the alarming intensity of the credit crisis to an extent that it brought back haunting memories of the Great Depression to the world of Banking and Finance.

It appeared as though the whole financial cave-in was just waiting for the slightest trigger. And well, the honors were done by none other than the Fannie-Freddie combine, who effectively communicated a short but strict “THE GAME IS UP, Folks……..!! “ message to the over-glorified, over rated investment behemoths who ruled Wall Street for decades, packaging almost anything under the sun in the name of exotic “high-yield” products.

With Lehman filing in for chapter 11 bankruptcy and Merrill Lynch selling itself in less than 24 hours to Bank of America - fearing to face a similar ruling like Lehman if it had to face the markets on the first trading day of the week, the cascade had set in motion. An interesting point to note is that Lehman had survived two world wars, the Depression, a currency crisis and the Sept. 11, 2001 terrorist attacks that destroyed its former headquarters in New York. It was even acclaimed just a year ago, as being one of Wall Street's best-managed firms .

Even as the world watched, visibly stunned at the Fed/Treasury’s conscious decision to stay off and let the 158 year old company become history, America’s biggest insurer AIG sheepishly lined in next, seeking for a rescue.

Despite the dirty turn of events, the FOMC decided to keep its benchmark rate unchanged at its regular meeting slated that day, much against expectations. However, in the next couple of hours decided to do what no central bank had ever done before, namely insuring the Insurer by loaning out $85 billion to be repaid over the next 2 years.

As panic and fear spread across, the apparently safe money market funds came under strain, losing its foremost characteristic of being highly liquid. Reserve Management Corporation said that due to the Lehman bankruptcy, the value of its sponsored Money Market Fund shares had fallen below par, which in turn triggered redemptions, worsening the liquidity-starved interbank market.

As investors pulled out of money market funds, they quickly sought cover in the T-bill markets, which saw 3-month rates drop to a record low of 1 basis point. This prompted central Banks all over the world to inject dollar liquidity worth $180 billion into their systems in an attempt to kick start the critical working of the money markets. Apart from this, the Fed also came up with temporary guarantee program for US MM mutual funds, by which it insures for one year the holding of any public offered eligible money market mutual fund, retail and institutional.

The slew of measures didn’t quite restore the needed confidence as it only meant a stop-gap solution aimed at addressing the liquidity crunch in the system. The precedent set by the FED clearly saw the system crying for something more – of the kind which addresses the very root of the problem, namely the junk asset/mortgage backed securities (now, not even worth the paper on which it is written on!!! ), which is all over the balance sheets of Wall Street.

Even as the “ingenious” (?) $700 bn rescue plan hangs in balance; there is one very interesting and vital lesson to take home. That if the “invincible” Wall Street is today, more or less razed to the ground, then that is the power which the Market mechanism possesses-one that does not discriminate between how big or small you are. Doesn’t really care for how long you’ve been in existence. It can be the most rewarding force and yet be merciless, simply because it operates not with a heart but a mind, which understands only one language-the language of efficiency and discipline. And therefore, any excesses in the form of too much greed or over-leveraging or excessive-spending or for that matter absolutely anything beyond what is to be, the MARKET will most certainly bring back into equilibrium, even if it means much pain and elimination.

While pushing through a rescue to the tune of $700 bn may just about help ward off an immediate collapse of the system, the cost however would be manifold

- the Fed risks setting a precedent, which implicitly encourages sub-efficient processes/systems/products to continue unchecked.
- Reckless policies to continue without any accountability and lastly
- push the US economy into a predicament of even greater proportions as it would then need to attract an approx $30 bn per month (approx $ 10 bn pm on the Iraq war is spent) for the next 2 years to fund the same. This is wholly apart from existing deficit it runs on virtually all its accounts(fiscal, trade and current)


Mr. Paulson and Mr. Ben Bernanke would do well to consider the many implications and respect the House’s verdict on the rescue plan coz if the INVISIBLE HAND could whip Wall Street, then the so called Sovereign, Risk-free US Treasuries may not be far behind as it may become the most riskiest asset around eventually……


……………..Makes sense, coz logically who would come forward to bail out the Federal Reserve??!!