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Jaimini Bhagwati: Deregulate and perish?-I

Jaimini Bhagwati  |  Belgium 

since it decreased costs through increased competition and raised efficiency.

In the last few years commentators often pointed out that the persistent global economic imbalances were unsustainable. However, few would have predicted that the Western financial sector and global stock markets would be close to a meltdown by October 2008. Governments have been forced into taking action to prevent the financial system from shutting down. Therefore, taxpayers have ended up recapitalising wayward financial firms. In this context, it would be useful to review recent events with a historical perspective to better understand how some of the best-known names in banking and insurance descended into bankruptcy so abruptly.

In the 1840s several US states defaulted on loans received from European creditors and the prevented foreign creditors from obtaining repayment by petitioning US courts. Over time some of these loans were repaid since US borrowers did not want to lose their access to European credit. It was around the late 19th century that financiers such as John Piermont Morgan garnered sufficient capital to act as financial intermediaries between Europe and the US. The two World Wars devastated Europe and US-based firms were able to establish themselves as the dominant international financial houses. As capital was scarce at that time, financial firms had a stranglehold over the corporate sector.

Till about the 1970s bankers in Western countries continued to have exclusive relationships with corporate clients, and investment banks underwrote debt and equity issuance at highly profitable terms for themselves. US companies grew, along with the economic ascendancy of the US, and were able to set up triple A-rated financial subsidiaries. Consequently, in the 1980s, as underwriting margins decreased, firms such as Salomon Brothers moved away from traditional investment banking to focus on proprietary trading of stocks, bonds and later options. Salomon Brothers was perhaps the first to create mortgage-backed securities (MBS). Michael Lewis documents in Liar’s Poker that as deregulation continued in the 1980s, and savings and loans managers were allowed to sell mortgages as bonds, unscrupulous Wall Street traders made huge fortunes. Michael Milken emerged as the junk bond king and finally went to jail in 1989 for “racketeering and securities fraud”. In 1990, Drexel Burnham Lambert was driven to bankruptcy for its involvement in junk bonds.

The 1933 Glass-Steagall Act, which set up the Federal Deposit Insurance Corporation and separated commercial from investment banking since the Great Depression in the US, was repealed in 1999. This meant that deposit-taking commercial banks like Citibank could underwrite and trade instruments such as MBS and collateralised debt obligations (CDOs), and set up structured investment vehicles (SIVs). In 2000, the elite investment bank J P Morgan which was reeling from an erosion of its traditional high margin investment banking business consolidated with Chase Bank.

Hedge funds are relatively lightly-regulated on the grounds that these special investment vehicles cater only to high net worth individuals or institutions. These funds have proliferated since the late 1960s when they were first set up. They engage in complex trading strategies including algorithmic or automated trading and are usually highly-leveraged. However, it is not just hedge funds which have high leverage ratios and use automated trading, banks engage in similar practices. It is estimated that in G7 countries, at least half of all stock trades are executed per automated instructions.

It is amusing that hedge funds and asset management firms advertise themselves as having consistently beaten the market rate of return. To do this, they have to adopt higher-risk strategies. And, riskier asset portfolios face sharp corrections in value from time to time. Hedge fund managers and institutional investors profess that they can time their investment decisions optimally. This is seductive logic. However, since hedge funds take varied positions, their collective investments are a sub-set of the market and it is not credible that they can regularly outperform the average market return.

The US housing mortgage market is valued at about $14 trillion and the sub-prime component is around 10 per cent of that amount. The recent financial firm bankruptcies and credit freeze were clearly triggered by housing loan defaults. However, the root causes of the current crisis are more varied than just the repackaging and selling of “toxic” sub-prime mortgage securities by getting the rating agencies to classify them as triple A. For example, AIG was inadequately capitalised to sell high volumes of credit default swaps (CDSs) on CDOs linked to MBS. At a more fundamental level, elementary principles of risk management were abandoned by regulators. For instance, in 2004 five US investment banks, namely Goldman, Lehman, Merrill, Bear-Stearns and Morgan Stanley prevailed upon the Securities and Exchange Commission (SEC) to allow them to increase their leverage. The SEC relaxed its three-decade-old rule, which restricted debt to net capital ratios to 12:1 and allowed these five banks to increase their leverage ratios to 30 and even 40:1. If leverage is around 30:1, a reduction in the value of a bank’s assets by a little over 3 per cent will wipe out its entire equity capital.

The US has invariably been at the forefront of financial sector deregulation and innovation. At the same time, in the last ten years or so, any weakening of consumer confidence or stock market sentiment was met by increased federal spending and interest rate cuts. This was possible because some Asian and fossil fuel-exporting countries had accumulated large trade surpluses and lent back the dollars to the US through investments in US government paper. Excessively generous housing loans to non-creditworthy borrowers led to a sharp increase in demand which, in turn, resulted in a housing market bubble. MBS were repackaged such that the underlying risk was less obvious and for a time the rise in real estate prices fuelled consumer spending. Less nimble financial institutions were left holding the risk on their books and some of the firms which provided CDS cover did not have adequate risk capital.

To summarise, is it deregulation which is at the root of the financial sector’s current problems? Deregulation cannot be blamed since it decreased costs through increased competition and also raised efficiency levels. The financial meltdown was due to an abdication of regulatory responsibility, conflicts of interest leading to irresponsible behaviour on the part of rating agencies, and excessively leveraged bets taken by financial institutions combined with loose monetary policy, the last of which was made possible by global trade imbalances.

The writer is the Ambassador of India to Belgium, Luxembourg and the European Union. Views expressed are personal. Contact: j.bhagwati@gmail.com.

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Jaimini Bhagwati: Deregulate and perish?-I

Deregulation cannot be blamed since it decreased costs through increased competition and raised efficiency.

since it decreased costs through increased competition and raised efficiency.

In the last few years commentators often pointed out that the persistent global economic imbalances were unsustainable. However, few would have predicted that the Western financial sector and global stock markets would be close to a meltdown by October 2008. Governments have been forced into taking action to prevent the financial system from shutting down. Therefore, taxpayers have ended up recapitalising wayward financial firms. In this context, it would be useful to review recent events with a historical perspective to better understand how some of the best-known names in banking and insurance descended into bankruptcy so abruptly.

In the 1840s several US states defaulted on loans received from European creditors and the prevented foreign creditors from obtaining repayment by petitioning US courts. Over time some of these loans were repaid since US borrowers did not want to lose their access to European credit. It was around the late 19th century that financiers such as John Piermont Morgan garnered sufficient capital to act as financial intermediaries between Europe and the US. The two World Wars devastated Europe and US-based firms were able to establish themselves as the dominant international financial houses. As capital was scarce at that time, financial firms had a stranglehold over the corporate sector.

Till about the 1970s bankers in Western countries continued to have exclusive relationships with corporate clients, and investment banks underwrote debt and equity issuance at highly profitable terms for themselves. US companies grew, along with the economic ascendancy of the US, and were able to set up triple A-rated financial subsidiaries. Consequently, in the 1980s, as underwriting margins decreased, firms such as Salomon Brothers moved away from traditional investment banking to focus on proprietary trading of stocks, bonds and later options. Salomon Brothers was perhaps the first to create mortgage-backed securities (MBS). Michael Lewis documents in Liar’s Poker that as deregulation continued in the 1980s, and savings and loans managers were allowed to sell mortgages as bonds, unscrupulous Wall Street traders made huge fortunes. Michael Milken emerged as the junk bond king and finally went to jail in 1989 for “racketeering and securities fraud”. In 1990, Drexel Burnham Lambert was driven to bankruptcy for its involvement in junk bonds.

The 1933 Glass-Steagall Act, which set up the Federal Deposit Insurance Corporation and separated commercial from investment banking since the Great Depression in the US, was repealed in 1999. This meant that deposit-taking commercial banks like Citibank could underwrite and trade instruments such as MBS and collateralised debt obligations (CDOs), and set up structured investment vehicles (SIVs). In 2000, the elite investment bank J P Morgan which was reeling from an erosion of its traditional high margin investment banking business consolidated with Chase Bank.

Hedge funds are relatively lightly-regulated on the grounds that these special investment vehicles cater only to high net worth individuals or institutions. These funds have proliferated since the late 1960s when they were first set up. They engage in complex trading strategies including algorithmic or automated trading and are usually highly-leveraged. However, it is not just hedge funds which have high leverage ratios and use automated trading, banks engage in similar practices. It is estimated that in G7 countries, at least half of all stock trades are executed per automated instructions.

It is amusing that hedge funds and asset management firms advertise themselves as having consistently beaten the market rate of return. To do this, they have to adopt higher-risk strategies. And, riskier asset portfolios face sharp corrections in value from time to time. Hedge fund managers and institutional investors profess that they can time their investment decisions optimally. This is seductive logic. However, since hedge funds take varied positions, their collective investments are a sub-set of the market and it is not credible that they can regularly outperform the average market return.

The US housing mortgage market is valued at about $14 trillion and the sub-prime component is around 10 per cent of that amount. The recent financial firm bankruptcies and credit freeze were clearly triggered by housing loan defaults. However, the root causes of the current crisis are more varied than just the repackaging and selling of “toxic” sub-prime mortgage securities by getting the rating agencies to classify them as triple A. For example, AIG was inadequately capitalised to sell high volumes of credit default swaps (CDSs) on CDOs linked to MBS. At a more fundamental level, elementary principles of risk management were abandoned by regulators. For instance, in 2004 five US investment banks, namely Goldman, Lehman, Merrill, Bear-Stearns and Morgan Stanley prevailed upon the Securities and Exchange Commission (SEC) to allow them to increase their leverage. The SEC relaxed its three-decade-old rule, which restricted debt to net capital ratios to 12:1 and allowed these five banks to increase their leverage ratios to 30 and even 40:1. If leverage is around 30:1, a reduction in the value of a bank’s assets by a little over 3 per cent will wipe out its entire equity capital.

The US has invariably been at the forefront of financial sector deregulation and innovation. At the same time, in the last ten years or so, any weakening of consumer confidence or stock market sentiment was met by increased federal spending and interest rate cuts. This was possible because some Asian and fossil fuel-exporting countries had accumulated large trade surpluses and lent back the dollars to the US through investments in US government paper. Excessively generous housing loans to non-creditworthy borrowers led to a sharp increase in demand which, in turn, resulted in a housing market bubble. MBS were repackaged such that the underlying risk was less obvious and for a time the rise in real estate prices fuelled consumer spending. Less nimble financial institutions were left holding the risk on their books and some of the firms which provided CDS cover did not have adequate risk capital.

To summarise, is it deregulation which is at the root of the financial sector’s current problems? Deregulation cannot be blamed since it decreased costs through increased competition and also raised efficiency levels. The financial meltdown was due to an abdication of regulatory responsibility, conflicts of interest leading to irresponsible behaviour on the part of rating agencies, and excessively leveraged bets taken by financial institutions combined with loose monetary policy, the last of which was made possible by global trade imbalances.

The writer is the Ambassador of India to Belgium, Luxembourg and the European Union. Views expressed are personal. Contact: j.bhagwati@gmail.com.

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