The current turmoil in the US financial market and its spilling over to financial markets overseas has made it once more evident that we need to scrutinise the validity and relevance of the neo-liberal theory and policies which brought about this mess.
We try in the following pages, to interpret the crisis: first, by identifying the two special characteristics of the current crisis which also explain its intensity. We also look into the dominant precepts behind, an uncritical acceptance of which has led to policies as can be held responsible for much of the current malaise in the financial sector. These are the mainstream or neo-liberal economic doctrines to achieve what were considered as “efficient” financial markets. Second, we interpret the unfolding of various bankruptcies and bailouts in the US financial sector which have come out in public domain. Finally, we pay attention to the actual and potential threats for a similar crisis as seem to prevail upon India.
What Triggers a Financial Crisis?
To get at the background of the US (and currently the global) financial crisis one needs to address the following two major issues: First, the prevalence of high stakes in the financial markets under uncertainty with risks involved in holding assets often disproportionately high as compared to their realised returns. Such transactions have been identified in the literature as Minskian ‘ponzi’ deals, which, as was pointed out by the post-Keynesian economist, Hyman Minsky in 1986 (1), are both unsustainable and hazardous as compared to acts of simple hedging or even speculation on asset prices in markets.
With ponzi finance, the high returns as are offered to entice the new investors to lend and invest are often not realised in the market by the borrower. To avoid an impending default and an interruption of business, it is not only necessary for new investments as above to continue but also these need to be adequate to compensate the losses as are incurred on previous investments. However, as confidence on these assets is gradually eroded, these transactions come to a grinding halt, leading to big holes in the balance-sheets of the concerned parties. The pattern with ponzi finance as above is very different from hedge finance which to some extent keeps the system going as long as hedging offsets the losses against possible gains. Even speculatory finance, which dwells on more risk than under hedging, can be sustained until it becomes ponzi, when borrowings at high rates no longer generates equivalent returns, a situation which is currently on in the US financial markets.
The second factor which contributed to trigger the recent financial crisis relates to financial innovations in de-regulated financial markets. By generating derivative instruments which aimed to protect asset values in uncertain markets, derivatives also made it possible to invest and acquire assets much more easily. Thus, with ‘futures’, a typical derivative product which arranges a contract towards the sale and purchase of an asset in some future date, the deal can work to the convenience of both the buyers and sellers involved by insuring against the uncertainties in the market, while dispensing with cash transactions at the time of the contract. Thus the buyer contracting a ‘long’ (buying) position deposits only a fraction of the contracted price as ‘margin’, with the exchange trading organisation (usually a security exchange). Innovations and instruments as above in the financial sector have opened up vast potentials for expanding financial market transactions which are no more constrained by availabilities of bank credit. However, transactions as above and the agents involved can remain in business as long as the hedging works to minimise the risk under uncertainty and the risk-adjusted returns offered to those with long (buy) positions are realised by those who hold the short (sell) positions on assets. These may not materialise in a typical ‘ponzi’ situation, as described above.
It now remains to be seen as to how aspects as above are handled in mainstream theory and policy with its advocacy for wide-ranging de-regulations in financial markets. By postulating rational expectations and access to full information for all agents in the market, uncertainty, in terms of these theories, does not get in the way of achieving efficiency when markets are left free. Accordingly, speculation under uncertainty is reduced to arbitrage (in point of space) and hedging (in point of time) and the market is supposed to take care of uncertainty-related concerns by using financial derivatives. From this angle financial markets perform the best when there is no restraint on trading, both in spot markets and in those for derivatives. In case lenders are wary of potential defaults by borrowers which may be due to incomplete or asymmetric information in the market, they resort to credit rationing, as held in the literature. But both borrowers as well as lenders are still viewed as rational beings who decide feely on their lending or borrowing activities in the market.(2) Positions as above, emanating from advanced countries, have continued to dominate policies in financial markets and the financial institutions.
However, the magnitude and the intensity of the latest happenings in the USA and elsewhere seem to have jolted a bit the entrenched positions held by the establishment with efforts to bend the standard rules of monetarism and free markets under capitalism. Otherwise how can one interpret the huge bailout packages from the state in a country (or countries) which always have been strong advocates of free-market capitalism?
Financial Markets – What All have gone Wrong in US Financial Markets?
Back in the 1970s, the US economy was subjected to an unprecedented wave of credit squeeze as the Fed Chairman, Alan Greenspan, launched a series of monetarist strategies to contain inflation. Reacting to above, financial innovations led the way to credit creation beyond the usual banking orbits. Thus a large number of US firms started having access to short-term credit by using, as collaterals, securitised assets like commercial papers.(3) As the wave of securitisation (of assets) caught on, new forms of financial intermediation were provided by investment banks which lent their expertise in re-packaging the securities which were now marketed easily and sold to other banks or non-bank financial units that included the investment banks as well. Since these transactions were outside the orbit of conventional banking channels, the Fed had no regulatory power over these. Instead, these were subject to the jurisdictions of the US Securities and Exchange Commission (SEC). One witnessed, as a consequence, a 50% decline in the proportion of US financial assets as were held by banks between 1950 and 1990. Credit and transactions related to securities were made easy along the non-banking channels, with rates charged at much lower spreads as compared to those along conventional banking channels. Transactions as above facilitated the churning of multiple asset-backed securities (ABS). These were generated on the basis of the original (or underlying) asset, propping up multiple counterparties which held those assets. Leveraging played a major role in the creation of these debt financed assets, which continued as long as there was trust and confidence in the uncertain markets on these newly created financial assets.
Mortgages on property opened up new profit opportunities in the financial sector, by creating a market which targeted the section of US citizens who had so far been financially excluded on grounds of race and/or income, while banks followed credit-rationing which ruled out such loans.(4) Possibilities to securitise the mortgaged assets opened up new channels of investments, for the broker-mortgage firms, the issuers and insurers of asset based securities (ABS), investment banks who readily purchased and repackaged the ABS, and other financial institutions. Each, by acquiring an asset, were able to leverage by obtaining credit against the latter.
As the process continued, a large number of people with low incomes were now endowed with a mortgaged property and a liability to pay monthly instalments, usually to the broker mortgager-cum-bank who organised the deal. These assets were backed by loans which later were discovered as ‘sub-prime’, with the mortgaged collaterals subject to valuation in a sliding market and with little accountability of the borrowing parties, many of whom were not even bankable in terms of conventional practices. The initial euphoria, fed by the rising property prices on the one hand and the eagerness on part of the financial community to profit by using the securitisation route which temporarily shifted the risk to counterparties, did work as long as the former lasted. The business, as led by investment banks, as mentioned earlier, was outside the purview of the Fed, and the SEC did not find any reason to interfere.
To follow the sequence that led to the recent sub-prime crisis of the US we provide below a rough sketch of the possible links in the system:
The above schema of sub-prime loans which prompted the upswing in the asset market failed to work within a few years. High property prices of the mid-1990s made possible the advances against mortgaged houses at interest rates higher than the market rate to low income borrowers who had very little credentials in the financial market. Repackaging of these to back securities (which exchanged hands to generate further assets and sources of credit) finally proved to be an Achilles’ heel by impairing the credentials of the entire financial system in the USA and elsewhere. Use of futures and other derivatives (swaps, options etc.) augmented the scale of operations by making it possible to bid on positions in the security market with small margins of the final transaction until full payment when the contract matured.
To recapitulate the sequence as above, it may be worthwhile to follow the following stages of the upswing in the financial market and the subsequent stages of the reversal:
The Build-up of the Boom
1. Loans advanced by banks, via broker-dealers of mortgages, to borrowers in housing markets at sub-prime rates. Borrowers committed to regular instalments to parties as above.
2. Mortgaged assets get repackaged by issuers of securities as collateralised debt obligations (CDOs) which are the ABSs (or mortgage backed securities) sold to investment banks who sell these to other financial institutions.
3. Market prices of these financial assets determine the returns to the investor.
The Approach to the Crash
1. Drop in property prices, house-owners fail to service debt, announce foreclosure of the mortgage deal.
2. Issuers of ABS and investment banks face losses due to non-payment by borrowers, facing losses which are aggravated by sharp declines in ABS prices in the market.
3. Losses for other FIs who hold such assets as above.
The sequence is also captured by the following formulation:
q= f(A,r) where f’A and f’r are positive as long as ∂A and ∂r are both positive.
Thus dq = r. f’A + A. f’r < 0 when ∂A and ∂r are both negative, which, as mentioned above, is likely in the downturn.
Symbols used include
q : average return on ABS
A: average market value of ABS
r : the initial rate of average down-payments on mortgaged houses
To continue, a major financial crisis in the US first hit the hedge fund Long Term Capital Management (LTCM) in September 1998 when it was rescued by the Fed which injected $3.6 billion to help out its excessive leverage ratio. A sense of doubts and failing trusts continued and intensified over the next decade until it reached a climax by the third quarter of 2008 when two major investment banks (Fannie Fae and Fredie Mac) were taken over by the Treasury and another major investment bank, AIG, was recapitalised by the Treasury with an injection of $85 billion against 80% equity stake with AIG, all happening in the first two weeks of September 2008. The AIG deal was to protect the biggest insurance agency and investment bank in the country which by this time owned a trillion dollar assets spread over 130 countries and a $441 billion exposure to credit default swaps. Loans by the Treasury to AIG were supposed to carry a rate of interest of 11.5%, to be paid back by selling its assets within two years. In between another big investment bank, the Lehman Brothers, went bankrupt on September 12. By September 11, funds injected by the Fed in the financial market were around $900 billion, a sum which has kept on rising by each day as the market fell further. The latest move by the Treasury to pump in a huge sum of $700 billion and its ratification by the US legislators and even the rate cuts by most central banks in OECD is yet to bring about a reversal of the downswing in asset valuations and a general recessionary trend in the global economy. A steep rise in call money rates for inter-bank lending and a sharp fall in yield on US Treasury bonds, considered so long as safe investment, are aspects which speak for themselves. In all, the story reflects a scene of greed and miscalculation as is typical when it ends with a ponzi strategy.
How does it affect the Indian Economy?
As with other developing countries which today are closely integrated with overseas markets, India at the moment faces considerable risk of a severe downturn as a consequence of the global financial crisis. The reasons include at least the following factors which we briefly mention below: First, the free play of FII investors since 1993 when India’s stock markets were thrown open to such investors. Speculatory flows as above have been responsible for phenomenal expansions in the country’s stock markets, with capitalisation as well as P/E ratios moving up to unprecedented levels.(5) Second, the extensive use of derivatives on a legal basis in security exchanges and as OTCs led to rapid increases in their use, especially after 1992, when much of these were legalised. Derivative trading in the futures market has been at least six times the turnovers in spot trading at the National Stock Exchange till the meltdown started in these markets.(6) Third, foreign presence in the capital market has been prominent, especially with FII inflows in the secondary markets for stocks, which not only contributed to the rising turnovers but also to vulnerability in terms of sudden flight of capital. The rising level of official reserves, to the extent propped up by these inflows, are already facing a depletion. These have also affected the exchange rate of the rupee, currently heading a downward spin, despite efforts on part of the monetary authorities to manage the rate. Fourth, with both banks and corporates having a considerable exposure in the global equity market it remains one of the imponderables as to how much the balance-sheet of these financial and industrial units would be damaged by the global financial melt-down.(7) Finally, with the onset of recessionary forces in the real sector of the advanced nations, export markets will be generally hard hit for countries like India. Also the expanding jobs and services, as are related to the outsourcing by foreign companies and the Business Processing Organisations (BPOs) as well as the subsidiaries, would get a jolt.
One ought to feel positive about the economy with the confidence and positive thinking on the part of policy-makers in India, currently devising ways to avoid the contagion effects for the domestic economy. It may not be as simple and easy, however, for the country to come out unscathed in the current global scenario which has been described as financial tsunami! It is even less likely that the world’s financial markets and its economies will be immune to such shocks in future if the prevailing norms of de-regulated finance remain unchanged. After all, even a top billionare like Warren Buffet (8) was convinced to make a statement in 2002 that “…derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal”!
Sunanda Sen is a prominent economist from India, who has extensively worked on issues in development, economic history, international trade and finance. She was a professor at the Centre for Economic Studies and Planning at the Jawaharlal Nehru University (1973 to 2000). She is currently a visiting professor at the Academy of Third World Studies, Jamia Millia Islamia, New Delhi. She is also associated with the Institute for Studies in Industrial Development, New Delhi. Her recent works include, Colonies and the Empire: India, 1890-1914 (Calcutta: Orient Longman, 1992), Financial Fragility, Debt and Economic Reforms (London: Macmillan, 1996), Finance and Development: R C Dutt Lectures in Political Economy (Calcutta: Orient Longman, 1998),Trade and Dependence: Essays on the Indian Economy (Delhi: Sage India, 2000), Global Finance at Risk: On Real Stagnation and Instability (London: Palgrave-Macmillan Publishers, 2003) and Globalisation and Development (Delhi: National Book Trust, 2007).
(1) Hyman P Minsky, Stabilizing an Unstable Economy, Yale University Press, New Haven (1986).
(2) See for an elaboration, Sunanda Sen, Global Finance at Risk: On Real Stagnation and Instability, Palgrave Macmillan (2003) and Oxford University Press (2004).
(3) L. Randall Wray, “Financial Markets Meltdown: What can we learn from Minsky?”, Public Policy Brief No 94, The Levy Economics Institute of Bard College (2008).
(4) Gary Dymski, “Financial Risk and Governance in the Neoliberal Area”, University of California Center Sacramento, mimeo (2008).
(5) See for details, Sunanda Sen, “De-regulated Finance and the Indian Economy”, in Alternative Economic Survey, India 2007-2008: Decline of the Developmental State, Daanish Books (2008).
(7) This aspect has been discussed in Sunanda Sen, “Labour in De-regulated Financial Markets”, in Philip Arestis and Luiz DePaula (ed) Global finance and Emerging Markets, Elgar (2008).
(8) Berkshire Hathaway 2002 Annual Report, p. 15.