Finance meltdown: Asleep at the wheel

The Republican Party's economic philosophy emphasises free markets, fiscal conservatism and minimal government. The banking bailout package pushed by the Republican administration negates all the Republican beliefs: What it does prove is that the core, market fundamentalist philosophy remains 'private profit, public losses.'

There are those who argue that the government may well make money on the $700 billion worth of 'toxic' securities it will buy from the troubled banks, and that the bankers have also lost: Many employees of Bear Stearns and Lehman now hold worthless stock in these companies.

True: The poor dears are now left with barely hundreds of millions rather than the billions they were entitled to, for having manufactured all those complex derivatives to 'meet investor demand!' (Richard Fuld of Lehman took home $ 480 million in the last few years, only a minor portion remaining in Lehman stock.)

In reality, the aim of complexity is not so much to meet investor demand, as to make pricing and risks non-transparent! The margins were so juicy (Dealbreaker, a blog, estimates that house sales and mortgage securitisation generated $ 2,000 million of fee income in the last few years) that they forgot that 'the gains in our ability to model (and predict) the world may be dwarfed by the increases in its complexity -- implying a greater and greater role for the unpredicted' (Nassim Taleb, The Black Swan).

And, the outsize packages continue. Barclays and Nomura are spending $ 2.5 billion and $ 1 billion respectively to retain erstwhile Lehman employees in businesses they have taken over. Even more complex derivatives will have to be invented to recoup the expenditure.

But this apart, the US package has been quickly followed by many European governments guaranteeing the safety of bank deposits and rescuing more banks. In a concerted move, the central banks in the US, Europe and Japan have cut rates and are pumping money in the system, even buying unsecured paper.

Perhaps the two institutions of the credit market which come out with the least credibility out of the whole crisis are the rating companies and the bank regulators. As for the former, it is obvious that competitive pressures, 'the threat of losing deals,' tempted them to compromise their standards as Bloomberg reported, quoting documents and employees of the rating companies. Without these AAA ratings for junk paper, quite possibly there would have been no crisis!

Coming to banking regulation, the crisis represents a colossal failure to supervise effectively what was happening in the credit market:

Regulatory arbitrage was winked at in a rule-based capital adequacy ratio system. Highly paid lawyers and bankers used all their creativity in circumventing and minimising the capital charge through securitisation and other means. The result: Special investment vehicles managed by banks, which are now coming back to haunt them, and assets-to-equity ratios of 40/50! Did the regulator not know what was happening?

Who was regulating the so-called investment banks (and AIG's financial products unit based in London) despite their egregious gearing, and the obvious systemic risks their derivatives portfolios posed? The SEC probably regulated their activities as brokers but what about the huge trading books? At least after the dividing line between investment and commercial banking was rubbed out, there should have been a regulatory mechanism in place? Now of course all the big investment banks have converted themselves into or merged with commercial banks. The business of taking deposits for lending money remains the most stable form of banking.

In the UK, mutually owned building societies, traditionally solid pillars of the credit markets, were allowed to become commercial banks. After the forced nationalisation of Northern Rock and Bradford & Bingley, none of them now exist.

Did bank regulators review the rating methodologies used for structured finance, particularly CDOs, knowing that banks were exposed to $ 2 trillion of such securities, and were providing capital on the basis of their AAA rating? At least in 2006, when the alarm bells on the subprime mortgages market had started sounding?

The poor logic of regulatory capital ratios: housing finance, which has led to the largest banking crises since 1929, has 50 per cent risk weight! (As a corollary, did the AAA-rated CDOs have a 10 per cent risk weight?) Again, the level of 'trading,' that is, speculative, profits being made by the banks in relation to the reported risk measures, should surely have raised questions about the risk measurement methodologies. The weaknesses of the regulatory models for market risk and credit risk on derivatives have been commented by me in earlier articles. Was nothing learnt about model weaknesses from the LTCM bankruptcy a decade back?

Turning back to the banking bailout plan, given the circumstances, it clearly was necessary. Will it be sufficient? Keep your fingers crossed!