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!