The Hindu Business Line : Market keeps profits, exits losses

There is little sympathy and help forthcoming for the little man buffeted by negative equity in his mortgage and uncertain job and income prospects.

S.Balakrishnan

Is the financial sector a derivative of the real economy? Or is it the other way round?

Like mythological characters and those in science fiction devouring their own creators, the financial sector now threatens to derail the global economy.

An activity – intermediation – which sprung up to channel savings into investments in the most efficient and low cost manner possible has grown far beyond its original function and acquired a gigantic profile and role of its own.

It has generated millions of jobs in front and back-end services in Wall Street, London’s City, Tokyo, Hong Kong, Singapore, Shanghai and Mumbai.

This does not count the “Bangaloreing” of software jobs to India. International banks and financial institutions are the biggest customers of our software companies. So the present US crisis is having a noticeable impact on their business volumes and new contracts.

The problem is that financial intermediaries have vastly diversified from their basic intent. They have become financial engineers, covering a wide array of activities such as securitisation, originating and trading derivatives and risk transfer and management, in addition to their traditional role of lending.

Commodities have also become financial products thanks to futures markets. The spectrum and cross-section of equities, bonds, currencies, commodities and their derivatives is truly amazing and mind-boggling.

A Wall Street doyen, Mr Henry Kaufman, called securitisation one of the greatest inventions of finance. The prospect of laying off credit risk through this device coupled with the house price boom became the basis for reckless lending and investment.

Systemic risk

Enter, at this point, systemic risk. Once house prices collapsed, the game was up. All the fancy products conjured up by banks – CDOs, CDOs², credit default swaps, etc. – turned out to be sand castles. But so overwhelming had they become in the portfolios of banks that once the skeletons tumbled out of the cupboard, the inter-bank credit market ground to a halt.

The US Fed Chairman, Mr Ben Bernanke, was smart enough to realise the seriousness of the situation.

After all, he had won his doctoral spurs studying the causes of the Great Depression and the Fed’s failure to lower interest rates and ease liquidity at a time of extreme economic and financial distress.

Recurrent crises

What must worry Governments and central banks are the recurrent financial crises because of the excesses in financial markets, necessitating expensive bail-outs of big market players such as Bear Stearns (and LTCM in 1987). Wall Street keeps the profits, but passes on the losses when they become big.

There is little sympathy and help forthcoming for the little man buffeted by negative equity in his mortgage after the crash in house prices and uncertain job and income prospects amidst the severe economic downturn.

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