The markets are as uncertain as they have ever been. Pessimism is the order of the day and there is a fear of uncertainty. This being a headline everywhere, and when we have views expressed on either side whether, positive or negative, by those so called “experts” on the markets, is not very helpful, as their views are often myopic and has conflicts of interest. Coming from the industry, people call people like us as well (sometimes) and I always end up saying that I do not know. That is true simply because it is too complex and is uncertain.
Background
There is no clear answer to the extent of the problem and where we are headed. However looking back, it is clear that at the start of the crisis in the fall of 2007, no body had predicted such challenges await us ahead and also that we are witnessing the negative result of the various excesses of the boom era which is unwinding today and we would have to go through the pain before we have some sanity. Still it is very hard to predict the extent and the limit of this unwinding. We are in the midst of times which are witnessing unforeseen events unfolding and are continuing to unravel through the system and with time.
Where we are headed and is there any clarity?
Whenever we have strong volatility, one cannot be sure since that is the very reason for the underlying volatility. Volatility has been historically high since the fateful September and it has not abated since then despite historical steps taken by various governments and their central banks. The steps are mostly reactionary and ad-hoc due to any perceivable visibility. There have been coordinated rate cuts by various Central Banks including Federal Reserve, ECB and RBI but they have not been nearly enough at least that is what it seems today.
Also, the other factor which is the result of the crisis is that structural breakdown of international credit markets. The credit markets saw historical growth, both in volumes and innovation during the boom period between 2003 and 2007 when the credit was cheap with risk premiums were down historically. This led to opaque financial instruments being invented by the banks and financial intermediaries to trade the underlying risks. Thereby the very premise on which the financial transaction should take place broke. The risks were not in line with the expected returns. Financial Markets had not seen any thing like that before hence there was no precedence on how they could be regulated and priced. These instruments panned across the markets and hence there was a transnational web of problems which was being created. Volumes grew and with time, it became almost too complex to cope up with.
There had been warnings before as well when it was suggested to get the financial contracts documented and system being put into place to cope up with the tremendous growth but obviously not enough was done when the going was smooth. The other evils of a boom market like leverage, lack of due diligence were also causing the boom but when it did bust, which started with the underlying risks going bad due to real estate prices in the US housing markets going down, slowly but surely asset classes across the spectrum had to be unfolded and they are still unfolding. The outstanding CDS contracts at the end of 2007 was USD 62 Trillion which is in multiples of entire GDP of USD, this has gone down to $ 54. 6 trillion on June 30, 2008 (compared to $ 900 billion in 2000) but that remains a mountain. We had gone too far and the fall will also be equally painful.
These led to many instruments defaulting and we have had several bail outs (Freddie Mac, Fannie Mae, AIG almost failing), write downs (USD 750 bio and still counting), Investment banks either going bankrupt, becoming a bank or being acquired. The events eventually unraveled in Sep 08 so fast that it left every one stunned. Lehman, which followed the rescue of Fannie Mae and Freddie Mac and then AIG shook the banks so much the underlying confidence just disappeared and that is still to be restored. The damage has been so severe that the confidence on their counterparts broke down and it spiraled into a financial crisis and is now having a catastrophic impact on the other real sectors of the economy.
What is likely to happen can only be best predicted when we have some clarity which is only when the volatility goes down and credit markets have been restored somewhat.
Impacts
There are a few impacts which are clear if we are not to repeat the same mistakes again.
There would be a better framework on the cross border regulations which will emerge, the effectiveness will have to robust to bring about transparency into the systems in terms of underlying risks and pricing.
The markets for complicated products is over for a long time to come it will be important that a better framework of disclosures, monitoring and ratings be devised as a lot of risk sharing which happens is due to securitization, and when it gets too complicated causes the problems which we are facing today,
Historically, the reversal of reasoning
Leveraged model of banking and financial underwriting which is nothing but Investment Banking will be more serene and will be accountable. However, given what has happened, it is difficult to see how they will be relevant again in the current scenario. They cannot be completely ruled out since it was only about 75 years ago, that we had effectively the beginning of Investment Banking. US - Post depression, The Glass-Steagall Act (GS Act) passed in 1933 in USA created a wall between commercial banking and investment banking. The underlying reason, which resulted in promulgation of the Act, was the thinking that the risky business of investing in stocks is definitely not the area meant for banks that should rather stick to conservative commercial lending. In 1999 Gramm - Leach- Bliley Act (GLBA, 1999) was passed which repealed the restrictions on banks affiliating with securities firms & banks in US can now declare themselves as ‘financial holding companies’ and engage in a broader spectrum of activities including operation in insurance and securities market.
It sounds ironic that we have come a full circle in less than a century of banking and the cause and effect of one crisis has proved to be completely the opposite of the current crisis.
Since we do not have a perfect model and likely we will never have one, these debates will always be there but its only the excesses which highlights the frailties of a system, and till the time we work within a acceptable limit, it is likely to work else we land up in a crisis.
Note: A few inputs are taken from an article I contributed in 2002, when I was a Student of SIIB. It can be accessed at http://www.indiabschools.com/finance_007.htm
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