The Hindu Business Line : Shut the revolving door between investment banks and Government

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Shut the revolving door between investment banks and Government

A Government bailout means a taxpayer bailout. US taxpayers - whether they were part of this unscrupulous and foolish swindle or not - will foot the bill..

MS LILA RAJIVA, CO-AUTHOR OF, `MOBS, MESSIAHS AND MARKETS'.

This is the time of greatest danger for ordinary people, cautions Ms Lila Rajiva. "Considering the way it has misled the public, the banking industry should be treated with the greatest scepticism," she adds, in an email interaction with Business Line, a day after Lehman Brothers went belly up.

Ms Rajiva is the author of The Language of Empire: Abu Ghraib and the American Media, (Monthly Review Press, December, 2005) and the co-author of Mobs, Messiahs and Markets: Surviving the Public Spectacle in Finance and Politics, (Wiley, September, 2007). "When the higher math and the greater greed come together, watch out below!" cautioned the latter book, "a light-hearted journey through history, politics and finance to show group think at work in an improbable array of instances, from medieval crusades to the architectural follies of hedge-fund managers."

The most important thing, says Ms Rajiva, is to shut the revolving door between the investment banks and Government. "We need to treat bankers as private individuals whose interests are inherently at odds with the interests of the public."

She distrusts "any solution that meant an increase in the scope of Government regulation beyond what is needed to separate the commercial and investment activities of the banks and to make the derivative market more open."

Excerpts from the interview:

In simple terms, what has happened to some of the biggest financial institutions in the US, which till recently seemed almost unshakable?

What you have today is a series of interlinked failures: sub-prime mortgage borrowers defaulting and then a whole series of financial institutions that had tied themselves up with sub-prime debt collapsing.

First, the mortgage lenders were hit - Wells Fargo and Countrywide Financial. Then there was the collapse of the Bear Stearns hedge funds, which were invested in bad debt. Now, two of the biggest investment banks, Lehman Brothers and Merrill Lynch, have collapsed. The monoline insurers, which insure municipal bond issues, are another source of trouble.

Meanwhile, all kinds of private and public rescue packages are rushing to inject billions in capital into the banking system and the whole credit rating system is in disarray, because much of this junk debt was given a thumbs up by the rating agencies. Result: no one wants to lend any more. So you have a liquidity crisis that is threatening all business activity.

Where are the roots of the crisis?

Well, let me agree with Treasury Secretary Paulson on at least one thing - this is the result of the excesses of the past. But these are not excesses caused by an outdated regulatory system as he says. They are excesses actively encouraged by the Treasury itself.

For years interest rates have been set artificially low to encourage borrowing, at the expense of saving. The price of money was made cheaper than the market would have borne, letting people buy more and more for less cash down. So we got a housing boom.

Then, at the height of the boom, Alan Greenspan, the former Treasury Secretary, all but instructed home owners to go out and buy homes with alternative mortgages that needed even less money down, but had ballooning interest payments.

Those alternative mortgages are a major part of the problem we have today, which is the collapse of a very complicated network of financial products that were highly leveraged (that is, based on borrowed money) and tied up with bad housing debt.

Let me explain. You borrow money to buy your home from a bank. Instead of holding the loan on its books, the bank turns around and sells it to someone else as a new kind of debt - a mortgage-backed security. These MBSs are sliced up in complex ways that separate risk from reward. The risk of one loan is bundled up with the risk of another loan.

The riskiest bundle - the so-called sub-prime - gets one sort of credit rating and the safest bundle gets another sort of rating. Then a whole jungle of other financial products based on this flaky scheme springs up. There are even securities that allow you to hedge against the possibility that your securities will fail - CDSs or credit default swaps.

But ultimately all this is built on the back of a rather fragile creature - the American home owner and what we are now finding is that a lot of the original mortgages are worthless. People took them out to speculate on second homes; they put little or no money down and borrowed against whatever equity they had built up in their houses to finance their personal expenses.

So the underlying debt, especially among less creditworthy borrowers, the sub-prime market, is bad. And that bad debt is poisoning everything else. Why? Because the whole bundling process was so complex that even sophisticated bankers couldn't figure out which part of their investments was solid and which wasn't. So now risk has to be re-priced.

Say you borrowed to start a business and your collateral turns out to be junk. Your creditor is going to get very anxious and want his money back immediately. For stock traders, for instance, bad collateral means a margin call. To get hold of cash, people have to sell their assets. That leads to a fall in the prices of assets, like houses. As house prices spiral down, the jobs built on the housing boom evaporate. As wages go down, consumption declines. Sales dwindle and businesses contract. That's what's happening now.

Is a rough estimate possible of the cost of the crisis? And who are all bearing (or will be bearing) the cost?

Well, when the crisis began in July 2007, people said it would cost about $140 billion. The worst case scenario was said to be around $200 billion, which would still be well over the $160 billion hit from the savings and loans crisis in the 1980s.

Now, the IMF - not what you'd call a doomsday monger - has said losses could run to over a trillion dollars. As for the fall guy - well, do you have to ask? A Government bailout means a taxpayer bailout. US taxpayers - whether they were part of this unscrupulous and foolish swindle or not - will foot the bill.

What are the implications for India and Indian businesses? Do you foresee a hit to IT companies that have been servicing the major US financial firms?

It is hard to make a generalised statement. Indian banks are affected for sure. But while emerging markets will continue to be hit, I see some degree of insulation that will help us in the long run. There is real growth in India, wages are really rising, industries are expanding. We will probably see reduced business with the US, but I can foresee more intra-Asian trade.

With the bailing out/intervention by the US Fed and the Government, does the financial system become cleaner or does the situation actually turn worse?

Any bailout will reduce the immediate impact of the financial shock, but it will only postpone and prolong a recession. How can you entrust the solution of a problem to the people that created the problem?

Fannie Mae and Freddie Mac, the two government-sponsored entities (GSEs) that guarantee more than half of all US mortgages, are corrupt semi-private corporations. Their corruption is the direct result of their backing by the government. They took on risks no responsible private lender would.

By nationalising them - and that's what's happened in blunt terms - you are making the taxpayer responsible for market failure. This is the antithesis of a real free market. More management cannot be the response to a failure of management.

To avert crises of such magnitude, are controls/checks and balances possible? More importantly, what happened to the existing controls?

There is regulation. and then there is regulation. Don't forget that IndyMac, which failed earlier this year, is a regulated thrift.

That said, we do need to see a reduction in conflicts of interest. We don't want any more self-regulation from the banks. We can't have commercial and investment activity going on at the same place without firewalls in between. We can't have analysts at a bank pumping investments to the public that the bank is also invested in.

We went through all this after the junk bond mania in the 1980s. But then we went and undid the most useful regulation we had - Glass-Steagall - that kept investment banking and commercial banking apart.

We also let banks consolidate and get so big that they controlled the playing field. To take an example, people ask why Secretary Paulson supported the rescue of Merrill but not of Lehman Brothers. They don't mention that Paulson is a former CEO of Goldman Sachs, the most well-connected bank in the world.

John Thain, the CEO of Merrill, is also formerly of Goldman Sachs. Thain was also the head of the New York Stock Exchange at one time. The chairman of the highly influential New York Federal Reserve - which is usually a part to these bailouts - is also a Goldman Sachs man.

As for the rescue of Merrill, notice that Merrill was trading at $17 a share on Friday, but it was bought out by Bank of America on Monday at a premium, $29. Some bailout. Isn't this a glaring conflict of interest?

AIG, the premier insurance company which has also received government help, was until recently chaired by Maurice Greenberg, a former chairman of the New York Federal Reserve and a friend of former Goldman CEO, John Whitehead.

In short, when the most important investment bank in the US supplies officials at the highest level in Washington DC, who will guard the guardians?

In the face of what is happening, has it become now necessary to think of rewriting some of the older lessons in economics taught to students in colleges?

Economics in the university is dominated by mathematical modelling. Little attention is paid to socio-cultural context and history. But economics is not physics. Models are not going to tell you how things unfold in the real world. The world is far too complex.

I'd like to see more understanding of psychology and history and more variety in what's read. We have an overemphasis on Keynesianism - on demand side economics - although building up capital through savings is the real basis of wealth, not consumption. So, an emphasis on capital formation would be salutary.

But I'd be leery of attempts to paint all this in moral terms..you know, the greedy speculator and the spendthrift consumer. I'm afraid that's exactly how this will be depicted, especially by people who want the credit crisis lead to more Government. We are going to hear cries for the Government to mandate savings, create savings accounts, etc., etc.

We'll get a new GSE to enforce savings and that will be another public trough from which the banks will gorge themselves. And when that leads to even more man-made crises like this one, fingers will wag at the free market, although the market is bound and gagged like a prisoner.

I hope people will remember that the spendthrift consumer is in large part a creation of monetary policy. Recent consumption patterns and speculative activity have been driven by government policy, by banks. So we to need to look closely at fractional banking and the whole federal reserve system and see how they affect us, instead of dismissing such concerns as conspiratorial.

D. MURALI

(Illustration by R. Rajesh)

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