The Hindu Business Line : The US blame game, and beyond

The US housing mess and the Federal Reserve’s efforts to unravel it have lessons for India’s own attempt to solve the agricultural debt problem. For one thing, write-offs and debt waivers lead to complacency on the part of the borrowers and cultivate the culture of “default”.

S. Venkitaramanan

Developments in the US economy have a great deal of influence on what happens in the rest of the world. The happenings in the US financial markets, especially the credit crunch, collapse of various financial institutions and the threatened recession are of immense significance to the Indian economic scene.

The distinguishing characteristic of a vibrant political democracy is the ability and freedom to level allegations against political and economic managers, both past and present.

No wonder the current electoral battles in the US have seen rival candidates trading criticism against each other. The blame game goes on, covering, by legitimate extension, various occupants of public office, such as the Chairman of the Federal Reserve.

Greenspan, Bernanke under spotlight

The tenure of the former Federal Reserve Chairman, Mr Alan Greenspan, has come in for criticism in the recent debate.

Some critics have said that his lowering of rates for a long period to too low levels and encouraging aggressive lending, especially with adjustable rate mortgages, was partly behind the sub-prime crisis. The reality of the case is more complicated and Greenspan has brought out a credible response saying that he was trying to stave off threats of potential deflation.

There is, however, a germ of truth in the statement that monetary policy can be too loose at times. Facing these allegations is, however, an occupational hazard of the post of Chief of Federal Reserve, for both acts of omission and commission. The present occupant of the office, Mr Ben Bernanke himself is becoming the target of criticism. The latest is an attack in a recent issue of The Wall Street Journal, charging that he has been negligent in his duties as Steward of the monetary system of the US.

The Journal, in a recent issue, comments on certain remarks Mr Bernanke made to bankers to increase the pace of voluntary write-downs on the principal of home mortgage loans.

In Mr Bernanke’s words: “Voluntary write-downs are not doing enough to stop foreclosures”. Voluntary write-downs of principal, in American bankers’ language, are equivalent to write-offs in our jargon.

It is surprising that the head of the monetary system is himself pleading for a write-down of the mortgage loans, lest there should be greater delinquencies and foreclosures of housing loans. Can we ever imagine the RBI Governor, Dr Y.V. Reddy, asking for a similar step by our bankers? God forbid!

Lessons for India

The Wall Street Journal, in its issue of March 7-8, 2008, has an editorial entitled “Bernanke’s Principal”. To quote the editorial, “Mr Bernanke and the Fed are charged with protecting the soundness of our financial system. The bulwark of such protection is shareholder’s equity capital, which is used to generate income, by being used to create assets by disbursal of loans.

Yet, the Federal Reserve Chief has advised that, as a matter of public policy, bankers should take a chunk of their capital and “transfer the same to mortgage borrowers”. That is what “debt write-off” in India will also mean to bankers. Banks would be losing a part of their capital to protect defaulters.

The current US housing mess and the Federal Reserve’s efforts to unravel it have lessons for India’s own attempt to solve the agricultural debt problem. For one thing, write-offs and debt waiver lead to complacency on the part of the borrowers, who expect many more such relief to come about.

The fundamental problem of India’s agriculture or US housing has not been solved, leave alone the fact that the write-offs and write-downs affect the banks’ viability. On the contrary, they cultivate the culture of “default”.

Accounting debate

Adding to the confusion in Washington is an arcane accounting debate relating to the convention that financial institutions should mark their assets to market. That is to say, if a bank has, say, $1,000 in assets, whose market value declines to $700, the value of such assets should be marked down to market value or historic cost, whichever is lower.

A debate is now raging as to whether such write-downs themselves are causing markets to fall and lead to a self-perpetuating cycle of decline in markets and further write-downs.

Suppose, for instance, a leading institution incurs a loss as a result of the mark to market convention, the decline in the market prices of the shares of such an institution would itself trigger a further decline in the market prices, which would feed into a continuing decline.

This criticism has been voiced by distinguished experts and financial commentators in various parts of the world. The head of French Insurance Company AXA has been quoted in Financial Times, London, as having criticised this accounting convention as responsible for the market melt-down.

While it is easy to attack the convention of marking to market as a trigger of a melt-down, it is not difficult to see the logic of the convention itself. The point is that if these institutions bring their assets to a sale, they will only realise the market price.

The critics of the convention point out that the convention assumes the institutions have to regard themselves as candidates for liquidation and sale of all assets. The Chief Executive of Merrill Lynch, Mr John Thain, himself has been cited as having argued against this convention.

Mark to markets may not, however, be justified if the institution can assure that the assets will recover in value. When this will happen is precisely the uncertainty, which the accountants have tried to answer through the convention.

Problems of a complex economy

The Wall Street Journal refers to the introduction of this convention in all its force during the time of Mr Richard Breeden, Head of the Securities Exchange Commission, in the 90s. It has mentioned that even then, Mr Walter Wriston, Chief Executive of Citibank at that time, had pointed out that such conventions, together with rigid capital adequacy norms, would lead bankers and institutions trying to escape the rigidity to resort to various securitisation devices.

This is what, in fact, happened. Accounting conventions are not an answer to fundamental problems. But, at least, we should ensure consistency in accounting conventions. Change of accounting conventions to suit a particular problem is equivalent to changing goal-posts when the team is about to lose.

The whole debate in Washington, the origins and solutions of the present financial crisis are illustrative of the various problems that face a complex economy. We in India have much to learn and unlearn from the experience of the US. Hopefully, we will avoid the mistakes and build on the strengths of the US experience.

A recent news report says that the US Federal Reserve has released a lifeline of $200 billion to US banks affected by the liquidity crunch. This shows that in spite of all its faults, the Federal Reserve is quick to act when the need arises. Its move has acted as a saviour of markets around the world, coupled as well as decoupled. All power to Mr Bernanke’s principles!

More Stories on : Financial Markets | RBI & Other Central Banks | Economy | Mortgage

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page