18.09.2008

• What you are currently witnessing is history in the making
• Remember the 1998 East Asian currency crisis? Something far larger than that is unfolding right before our eyes.
• News is pouring in that AIG was given a bail out package of $85 bn for a stake of 79.9% by the US government. The US government seems to have been bitten by the non-working of its hands-off approach in Lehman Brothers case.
  
• The financial institutions of the US are tumbling like a pack of cards. Who are the two last men standing? Morgan Stanley and Goldman Sachs. How long will they stand? Nobody seems to have a clue as yet.
• Why should we care? Just read this piece. It will give you a glimpse of how financial contagion spreads. But the basics for those who are beginners. When bank after bank collapses, its lenders will demand that they be repaid what it owes them and no new lender will be willing to lend. Mere suspicion is enough for others to stop lending to an institution. When banks thus refuse to lend to each other, liquidity in the markets dries up. This can be stopped only if confidence is restored in the financial system. That comes only from a bail out or nationalization. That is what is precisely being prescribed by the US Fed in its attempts at stopping the contagion.
• Will it not remain a problem confined to the US? Why should we bother about it?
• It will not remain a US problem alone. Many of our banks will be affected because they have transactions with these US banks. Lehman Brothers and Merrill Lynch had invested substantially in the stocks of Indian banks. The banks, in turn, have invested in derivatives which might have exposure to these investment bankers. Prices of derivatives directly depend on the value of one or more underlying securities, equity indices, debt instruments, commodities, other derivative instruments, or any agreed upon pricing index or arrangement. These products are mainly used to hedge risk for fixed rate of return. Derivatives include futures, options, and swaps. Secondly, the contagion doesn't confine itself to banks. It is engulfing all the financial players -- insurance companies for now. Will it spread to others like Mutual Funds, Pension Funds etc., can only be known as time passes by.
• A look at this graphic tells you how panic spreads far and wide in such situations. Stock markets, commodity markets etc., may collapse for indirect reasons.
  
• What is the Wall Street model?
• In a very good article TT Ram Mohan throws some light on the failed Wall Street model. Recommend a strong read of the article at least once. It is here. Some excerpts from this article worth our noting:
  
• The failed model: Investment banks started off as brokerages and then branched off into underwriting of securities and advisory services. None of these businesses requires large amounts of funding. When commissions on these businesses declined, investment banks started setting aside bigger and bigger sums for proprietary trading. From proprietary trading, investment banks moved on to private equity. In other words, investment banks started betting their own capital on risky assets — and illiquid assets at that. Worse, they chose to increase leverage to stratospheric heights.
  
• In August, even after fresh infusions, Lehman Brothers had a leverage of 20:1. The one deal that killed Lehman was the acquisition of a property investment company at the height of the property bubble.
  
• The investment banks thought they had the expertise to manage asset risks. But there are two problems with this model.
  
• One, the assets are funded in the wholesale markets. The moment there is uncertainty about the value of assets, access to funds is cut off — and this triggers a collapse.
  
• Two, in the presence of high leverage, managers have every incentive to take huge risks. If the gambles work out, managers get big rewards. If they fail, it is shareholders who get wiped out. Fuld’s own pay vaulted to $40 million in 2007 from $12.5 million in 2002.
  
• Writing about the implications of the demise of the top investment banks, he opines:
  
• First, it calls into question the standalone model of investment banking. For most capital market activities, a stable base of funds makes sense. Banks, with their access to deposits, are better placed to succeed. That is what the acquisitions of Bear Stearns and Merril Lynch by J P Morgan Chase and Bank of America respectively signal. In other words, ‘financial intermediation’, on the wane for many years, is back with a bang.
• Secondly, leverage in banking itself may have to fall from the present levels.
  
• Thirdly, when investment banks come to be part of banks, investment banking too comes under the purview of central bank regulation. Wall Street, they say, reinvents itself every few decades. This time round it’s not so much reinvention as disappearance.
• What is the impact of these developments going to be on Indian markets and banking system?
  
  • Writing on this subject Omkar Goswami suggests that the trend of net FII outflows will continue for a while as growth forecasts for Asia, especially for India and China, start getting cut for 2008 and 2009. Indeed, one expects a period of flight to safety as global investors move to US treasury bills, euro bonds and attractively underpriced US equities.
  • How can we deal with this scenario? There are three levers that we need to work on in a concerted manner.
  • The first is to publicise the India growth story in a calm, collected and data-driven manner.
  • The second is to fast forward all the reforms that can be passed through administrative action. Doing some of these at a time of global turmoil will demonstrate the State’s resolve to go ahead with reforms.
  • The third is not being an ultraconservative inflation hawk. We have done a great deal in squeezing out liquidity, raising interest rate and tightening credit to demonstrate our anti-inflationary bias. Thankfully, inflation is going down. Further restrictions will not accelerate the rate of decline; instead it will further restrict liquidity and choke off growth.
• What is a Pigouvian tax?
• It is a tax levied to correct the negative externalities of a market activity.
• Pigovian taxes are named after economist Arthur Pigou (1877-1959), who also developed the concept of economic externalities.
• Want to know more? Read about it here.
• All this and no other news? My dear friend, yes. No other news for us today. Let us try to digest history as it unfolds. So we stay focused only on covering the financial contagion for today.