The financial markets turned turtle and the tremors are felt all over the world. After the Great Depression following the crash of ‘29 and the many crises of the past two decades, the drama unfolding for the past 15 odd months is sending panic waves across the globe. This time around, the financial denizens of Wall Street are gasping for life and looking for life-support from the US government. The US financial system needs more than an overhaul to get back on its feet - it needs to be completely re-engineered. Professor Marti Subrahmanyam - Charles E Merrill Professor of Finance, Economics and International Business, Stern School of Business, New York University and a think tank for global financial bodies, enlightens Matrix readers on the emerging situation, which remained unresolved as we went to press.
Sanmar thanks Prof Marti Subrahmanyam for his invaluable insights even in a highly volatile situation where a string of events continued to play out day after day.
As we go to print, the US government announced a $ 700 billion bailout but the Pandora’s box continues to spring new surprises.
Ex-President Bill Clinton rightly put it – it is no longer about Wall Street versus Main Street but it is about the interest of the people. In the past, remedial packages post the Depression, the loan to Mexico, etc., helped bring stability and have worked out well for the Government. The bailout will not be a bad buy forever. When the situation called for action, a lot of things that had to be done were, perhaps, not done. What is important now is to learn from internal circumstances and do the right thing.
From the Indian context, while we harp on so many things going awry, we have to pride ourselves on the regulatory framework and controls present in our financial systems and markets. The fact of the matter is, there are good times and there are not-so-good times.
What exactly are the after-shocks worldwide, of the double whammy - the housing market bubble-burst and the crash of the mortgage bond markets? In the case of sub-prime mortgages, despite bad debts, wouldn’t things bottom out if the property markets picked up?
At the outset, one must make a distinction between the prices of real assets, in this case mainly real estate, and those of the financial assets that are used to finance them, often sliced and diced in different ways. The main difference between the present crisis and those in previous periods when real estate values declined substantially (for example in the early 90s worldwide, or in the aftermath of the 1997 Asian financial crisis) is the sheer volume of the financial claims issued against these assets. If we were in the old world, circa 1960s in the US in an environment of stable interest rates, where banks made mortgage loans to buyers of real estate and held on to these assets, a decline in the value of real estate would not have a devastating long-term effect, especially if asset values recovered over time. Of course, there would be some defaults, repossessions and asset sales under distress. But, the capital of most financial institutions would buffer these shocks. In the present instance, the loans were sold to intermediaries that pooled them into portfolios and sliced them into tranches in a complex fashion, and sold off to other investors. This created a huge distance between the original holder of the real estate asset and the ultimate holders of these complex securities known as collateralized debt obligations (CDOs). This created a further incentive for the loan originators to issue more loans to replace the ones that were sold off and since they did not intend to keep the new loans either, to become lax in their evaluation of the credit quality of the borrowers. Instead of asking if the borrower could repay the loan, the banks started asking, “Can we make the loan and pass it on like a ‘hot potato,’ making a buck in the process?” To make matters worse, very few institutions understood or had the capacity to price and hedge these complex securities. Of course, when the music stopped, the banks, which also retained some of these complex securities, were left with a lot of hot potatoes that were unsaleable. Even if real estate markets recover, the value of many of the complex securities is under water, and naturally, the financial institutions that hold them are sitting on huge losses. Most estimates of the potential losses in the financial system – as opposed to the real economy – are upwards of one trillion dollars, with some going as high as two trillion dollars.These numbers essentially wipe out a significant proportion of the capital of the world’s largest banks and an orderly restructuring of their capital structures is a daunting task that will take many years.
What are the various ‘Off-balance-sheet, structured investment vehicles’ that American banks have relied upon? What went wrong?
Banks had various types of off-balance sheet entities related to their mortgage loans. First, they had the “special-purpose vehicles” that structured the CDOs. These entities were sometimes on - but often off-balance sheet and were used by both investment and commercial banks. More importantly, commercial banks created entities known as conduits, structured investment vehicles (SIVs) and SIV-lite structures. There are technical differences between these entities, but the basic idea is that the banks shifted their mortgage assets to these structures, financing them with short-term commercial paper (asset-backed commercial paper or ABCP). In other words, these off-balance sheet entities were financing long-term risky assets with short-term borrowing. The only reason why investors were willing to buy the commercial paper is that they were explicitly or implicitly guaranteed by the banks themselves. If investors were to stop financing the conduits/ SIVs the banks were obliged to step in and provide the liquidity. This is exactly what happened in the fall of 2007 and continued on into early 2008, straining the liquidity of major international banks such as Citigroup and other major banks in the US and Europe. The banks quickly ran out of liquidity for their other lending activities.
All through the boom, banks have slept with their eyes wide open. Were there no lessons learnt from the past? Is there a governance angle to this? Is it possible that gross mis-selling brought about the banking crisis?
There is a governance issue which has not been highlighted in the public debate so far. What were the boards of the major banks doing? What were the risk and audit committees doing? Was it not their job to ask questions about the risks the banks were taking in the mortgage-backed market and the off-balance sheet risks that were being taken? What about the auditors and their professional bodies? How did they permit the funny accounting that was involved? Most importantly, what about the regulators, at the federal and state levels, who were asleep at the switch? These are all questions that demand to be answered in the months ahead. There will no doubt be a witch-hunt, with many a witch, some guilty and others innocent, being burnt at the stake.
In addition to these issues, there was mis-selling and sometimes even outright fraud in the creation of these mortgages and the marketing of the mortgage-backed securities. For example, people lied about the information they furnished to the banks and the bankers accepted this with a wink and a nod. The packaged securities were also sold to gullible investors with false assurances about their attendant risks. It goes without saying that many of these cases will be pursued vigorously in the courts.
Were the past lessons ignored? There is no doubt that they were. In the past, the complexity of structures and transactions hid a lot of the shenanigans at Enron before it was eventually brought down. The parallel today is that the complexity of the financial products and their sheer volumes brought about the crisis, with credit rating agencies, accounting firms and regulators asleep at the switch.
Many in the US did not learn from the experience in Japan during the 1990s and during the Asian financial crisis in the late 1990s, dismissing them as problems of immature markets. Little did they realise that the very same malaise would afflict the US and UK a decade later. As George Santayana said, “Those who cannot learn from history are doomed to repeat it.”
The present credit crunch and the reactionary reining-in of lending by banks will further dampen economic growth. Is it going to be a Hobson’s choice of addressing inflation and crippling credit that would in turn fuel recession?
That is indeed the quandary. The central banks – the Fed, the European Central Bank, and the Bank of England – cannot afford to continue the easy money policy that in part allowed the flood of liquidity that caused the real estate bubble in the first place from the early part of this millennium. Inflationary pressures are rampant in every sector of the economy, in part sparked by energy and commodity prices. On the other hand, keeping interest rates high will dampen growth for several quarters to come. That is indeed a Hobson’s choice that the central bankers face and they have to tread carefully. This is, of course, not being helped by the huge budget and trade deficits in the United States and the massive savings deficit that goes along with it. The cost of the bail outs of the major mortgage refinance companies – the so-called Government -Sponsored Enterprises, Fannie Mae and Freddie Mac, investment banks and quasi financial bodies, is bound to add to the bill. The $700 billion bailout package that has just been passed by the US Congress will add to the bill, although the US taxpayer may well come out ahead in the years to come.
In the face of the ‘great bail out’ by the government and its accompanied underwriting, how would the markets play out? Is there a possibility of it correcting itself?
The bail out consists of the government setting up a fund to buy the securities at a price. The question is the price at which the securities may be bought. In the days to come one can expect a lot of arm- wrestling on the appropriate pricing of the bad assets. This calls for a structure to be put in place, a whole new bureaucracy has to be set up. The interesting thing is that the legislative process is rolling and is moving towards writing the new law. It will probably get done by this week. If that happens there will be a boost of confidence. Presently a lot of debate on setting regulatory caps, even setting limits to executive compensation is on, reminiscent of what we had in India.
In a nutshell, if Congress is able to flash the signal that they mean business, things might turn around. Markets are confused and if Congress dilly-dallies and imposes caveats and puts riders in, things might backtrack.
As for the possibility of markets correcting themselves, the real estate price has to ultimately go up, although that may take a few years, this time around. On an average, real estate prices crashed by 20-25%, and that value is basically gone, at least for a few years. The issue at hand is whether the loans against these real estate assets have lost much of their value. The answer is that some of it has gone, some not, some borne by the borrower and some by the lender. The price has to be paid by someone in the interim, while waiting for the markets to recover. The amounts involved are so large that no one in the world other than the US government has the resources to bail out the global financial markets. Hopefully, the bail out package will provide the electric shock that would help revive the almost dead credit markets.
Where does that leave the industry?
The financial industry in the US and parts of Europe is going to be semi nationalised and negotiations are on at present. The industry wants the government to buy their bad assets, at a reasonable price so they can go back to their business as usual. But Congress will want to have a say in the conduct of the company. My forecast is that they will have to settle somewhere in the middle. It is highly unlikely that the US Congress will just dole out the money and leave the industry alone. They will demand and get a lot of concessions - from curbs on executive pay to part of the equity of the financial institutions. We are in for a prolonged period of regulation with the pendulum swinging in the opposite direction from the past decade.
Till such time economic activity would just have to wait, ride out the recession?
That is an exaggeration. Economic activity is affected but it is not as though it is at a standstill. Many sectors of the economy are doing fine. For instance, technology companies are not seeing much of a fall-off in economic activity. Many companies such as Microsoft have announced huge buy backs of their stocks betting against the bearish sentiment in the markets as a whole.
So far, down the line, the economy may have entered a recession or just coming out of a recession. The worst forecast is that recession might last 4-5 quarters or longer. The US economy probably entered into a recession in the first or second quarter of 2008, and may last for about a year. By middle of 2009 it could be over and the stock markets should recover before then. Right now, every one is way too pessimistic. As with any precipitous decline, most people are unable to think beyond today’s reality. Therein lies the opportunity for those with long horizons like Warren Buffet.
Can corporate India buying overseas hope for funding from the West?
Yes, corporate India has been on an overseas buying binge for the past two years. Hitherto, much of the funding came from international banks. The sheer magnitude of a Corus or Land Rover/ Jaguar acquisition is way beyond the resources or risk appetite of even the largest of the Indian banks. While Indian banks can provide some of the credit expertise and be part of the syndicate, only international banks can provide the bulk of the long-term funding.
We are in the midst of a major liquidity squeeze internationally as a result of the jamming of the credit markets. The major banks have experienced huge losses and need additional capital to make their capital adequacy ratios, just as a massive deleveraging is happening in global markets. The international banks do not have many degrees of freedom at the moment. They will naturally be much more selective to fund any projects from India, and not just these mega acquisitions. Indian companies will have to pay much higher credit spreads. Of course, if Indian companies have genuine projects with good economic prospects, I am sure Indian and international banks would consider them. The slight advantage that the best Indian companies have is that even in this depressed economic scenario, the growth prospects in India and China and maybe Brazil, are too good to ignore even in the medium term. My advice to my international banking clients would be, “You should focus on the positive about India. Think about where you would like to be in the next five years and place your bets accordingly.”
Where does that leave mid-sized Indian companies?
My advice to them would be to take a deep breath and sit tight. Put your international acquisitions on hold for some time. My view is that even with a positive economic scenario in India, they will have a more difficult time raising money internationally. Many of them are highly leveraged and if the funding dries up, the going will get tougher. This is the time for caution and the time to wipe off some of the hubris of corporate India.
What is the way out?
They cannot be aggressive in acquisitions. Companies without deep pockets have gone the leverage route and if there is a more severe downturn, they are going to face a challenging market situation. Some of them may even have to fight for their survival. My advice to them would be to consolidate their existing businesses and mitigate the risks already present rather than take on more uncertain international exposures.
What does Mr Subba Rao, our new Reserve Bank governor have to do to fix the problem?
There is not much the RBI governor can do about the price of credit in a global sense. After all, India is a small player in the global market. Many of our liquidity issues are only tenuously connected with the global scenario, if at all. These are qualitatively different issues and have been there even before the present crisis. There has been tremendous growth in the Indian consumer sector over the last few years. Since a year ago, banks started to slow down their credit growth - you simply cannot continue with those scorching growth rates. The Reserve Bank has to make sure that inflation does not get out of control. I think the previous and the present governor are totally focused on this issue and I applaud them for that. They have signalled that they are willing to jack up rates as high as necessary, although they are under tremendous pressure not to do that. One positive sign is that the Indian central bank has been a lot more independent than many people in India give it credit for, especially given a highly charged political climate.
What changes are required to get the economy on track again and level the ground?
No five-year period in recorded human history has seen the whole global economy grow at a rate of over 5%, as we had during the 2002-2007 period. This growth has been phenomenal, a lot of it driven by China, and to some extent, India. This cannot continue for ever. It is inevitable that our growth expectations should come down somewhat.
To expect 9% growth for India for ever is not realistic. The growth rate forecast at 7.5 % is a bit lower than in the past couple of years, but not that bad. In the 80s and 90s we would have been ecstatic with this rate of growth. After tasting almost double-digit growth, our expectations have shot up a bit; they need to be scaled down. Corporate India drank too much of the “India shining” potion and was overcome with hubris.
The next few years are going to be more sobering.
Which are the industries that would weather the storm and keep going?
Infrastructure industries should be doing fine, since whatever calculations justified by them are largely in place. The demand may slow down a bit but even with the reduction, the impact may not be too large. In fact, in most cases we have actually ran out of capacity, whether in our roads, airports, power generation or our ports. The marginal investments are bound to yield high returns over time.
In all this, has the US dollar been given a run for its money?
The euro has appreciated significantly in the last few years and continues to do so. The maturing of the euro as a reserve currency is now in place. The dollar has lost some of the monopoly it enjoyed as a reserve currency and consequently the seigneurage it enjoyed. More and more people are moving out of the dollar and towards the euro and the shift will continue, proportionately. Indian exports are also moving slowly from the dollar as the default invoicing currency and this is a natural hedge for the economy, even as the volatility of the rupee against the dollar and the euro has gone up. Once you are part of the global market economy, you are in for the ride. I can make a safe forecast, which is Volatility - whether it is in interest rates, exchange rates or stock prices, it is here to stay.