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Harish Damodaran

Wall Street tail wagging Main Street dog. Financial Engineering taking precedence over Real Engineering.

Speculation riding roughshod over Enterprise. These are some of the familiar epithets ascribed to the US economy that many see as fundamental to the current meltdown threatening to engulf markets worldwide.

How appropriate are these portrayals — of a financial system that has ‘over-leveraged’ and ‘innovated’ beyond limits? The accompanying data, culled from the US Federal Reserve’s latest Flow of Funds Accounts of the United States (released on September 18), captures the volume of debt built up by various sectors of the world’s No. 1 economy.

As on end-June 2008, outstanding debt contracted by US entities from both domestic and overseas sources stood at roughly $49 trillion — a near eleven-fold jump since 1980. Relatively speaking, total debt was 3.46 times the country’s GDP in 2007, whereas it was 1.62 times in 1980, 2.32 times in 1990 and 2.68 times in 2000.

But more than the overall increases, it is the changed sectoral composition of the debt that has relevance to the immediate context.

In 1980, the most indebted sector was business, which encompasses corporates, non-corporate firms and farms. This was followed by households. Then came government (at the federal as well as State and local levels) and, only finally, the financial sector comprising banks, insurance companies, credit unions, brokers, and so on.

The above pattern persisted right up to 1990. The early 1990s, however, saw households emerging as the most leveraged segment. By the middle and latter part of the decade, business had conceded its primacy not only to households but also to finance.

It is the present decade though that has witnessed a real explosion of financial sector leverage.

A phenomenon wherein finance, rather than being a vital lubricant greasing the wheels of commerce, becomes an activity in and for itself, an engine endowed with a motion and logic of its own.

The financial sector accounted for over a third of the accumulated stock of American debt as on June 2008, while being a mere 12.75 per cent in 1980.

The picture is starker when viewed in terms of flow magnitudes. Of the aggregate net borrowings of $4,268.8 billion by US entities during 2007, financial firms raised $1,753.4 billion or 41 per cent, compared to $1,211.6 billion, $880.6 billion and $423.2 billion by (non-financial) businesses, households and government respectively.

The financial sector was predictably also the biggest lender, at $2,979.6 billion of the total $4,394.9 billion (the second-largest share of $1,012.3 billion incidentally belonged to ‘rest of the world’, meaning overseas investors and governments that have invested in US bonds, treasuries and other debt securities).

It all adds up, then, to an overwhelming dominance of the US economy by finance — a far cry from the conventional ‘handmaiden-to-the-real sector’ role assigned to it. But the story does not stop there.

Who are the main constituents of the financial sector? In the classical framework, it would be banks and maybe insurance firms. Again, it is not so in this case.

Of the $1,753.4 billion credit market borrowings of the US financial sector in 2007, a major chunk of $626.3 billion was by agency — and government sponsored enterprises (GSE)-backed mortgage pools, followed by other asset-backed securities (ABS) issuers ($332.1 billion) and GSEs themselves ($282.4 billion).

The latter include Fannie Mae, Freddie Mac and similar federally-supported secondary mortgage firms.

On the other hand, commercial banks per se borrowed only $263.2 billion and their net lending of $750.8 billion, too, worked out lower than the combined $1,202.2 billion of agency — and GSE-backed mortgage pools, ABS issuers and GSEs.

What these trends signify is the way American finance has evolved in recent times. In the old days — as it is still in India — a home loan was essentially a matter between the lending bank and the borrowing buyer.

The bank held the loan until maturity and at most foreclosed on the property in the event of default. But today, there are the Fannie Maes and Freddie Macs that buy up individual home loan mortgages from banks, consolidate them into big packages, and then chop these into smaller pieces or ‘pools’ that serve as collateral for the issuance of tradable mortgage-backed securities (MBS).

Further to these are ‘giant’ or ‘mega’ pools built on combinations of existing MBS pools, thereby generating larger securities with underlying assets covering wider geographical areas.

In short, the humble home mortgage forms the basis for a whole layer of securities and disappears into the ether of financial derivatives.

Since 2000, the market for MBS has overtaken even those for US treasury notes and bonds. Likewise, there are markets for ABS and derived synthetic instruments — whose cash flows are secured by the principal and interest payments made on everything from student and auto loans to credit card receivables.

Credit is, thus, allowed to proliferate and finance begets finance to the extent of the proverbial smoke rendering the bottle invisible.

It is precisely this credit proliferation and leveraging of assets several times their value over that is unravelling now.

So long as property prices kept going up, it was attractive for households to buy and bankers to lend — not on the basis of the borrower’s cash flow stream but against the expected (rising) value of the collateral. The outstanding value of US home mortgages, in fact, more than doubled between 2000 and 2008.

These loans were then the starting points for the creation of a web of securitised claims between the original mortgage titles and the chain of derivatives based on those mortgages — all in the name of diluting and spreading risk.

The downside of this is, of course, what is currently being felt in the context of tumbling asset prices and multiple claims turning into multiple liabilities.

The same smart derivative products designed to spread risks have ended up spilling red ink on the balance sheets of firms across and beyond Wall Street, interconnected by the slender thread of virtual finance.

Where all this ‘de-leveraging’ would eventually lead to is anyone’s guess; what is inevitable perhaps is a contraction of the financial sector to more ‘real’ levels.

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