Of rash exuberance and its aftermath

Of rash exuberance and its aftermath

When irrationality becomes the norm rather than an aberration, the consequences can be perilous. The current crisis reminds why regulators and market players need to adopt a different approach

Jojo Puthuparampil

Sustained virtual growth of seemingly exotic sectors (for instance, home loans), driven by innovatively crafted assumptions (that realty prices will perpetually rise), leads to heightened confidence in the ability of the markets to thrive. Confidence, after a certain threshold, makes market players and subsequently investors irrational, leading to reckless indulgence in amassing hollow financial instruments (say, sub-prime debt) disguised as hallowed assets. After a while, when exuberance turns irrational and then insane, the titanic bubble of greed bursts, crushing the global financial façade under its weightlessness.

This, in a nutshell, is why the US banking and financial sector is badly battered and global financial markets are shivering (no one is guessing when the mess will be cleared). This also proved that even robust economies are under the jurisdiction of poetic justice (simply, this means whatever goes up will come down as long as gravity prevails).

No method in madness

Securitization—wherein cash-flows from a pool of underlying assets (such as mortgages) are turned into bonds, which are then repackaged and sold to investors as smaller slices—has been existing for over 30 years. But over the past five years, it turned into a dubious means to camouflage the huge exposure of exotic financial instruments, such as collaterized debt obligations (CDOs), to delicate underlying mortgages.

Securitization originally aimed to reduce risks—instead of banks holding every loan on their balance-sheets until it matures, risks would be sold and spread among a wider group of investors. But, of late, it has started betraying its grand motives, and became a coveted tool for revered financial re-engineers who mistook it for a magic potion to rake in exaggerated returns.

For one, securitization didn’t disperse risk effectively; when assets turned toxic, risks flowed back to banks’ balance-sheets. Two, it degraded credit quality by weakening lenders’ ability to monitor the status of the loans they write. The estrangement, and the subsequent widening gulf between lenders and borrowers, deepened the crisis.

Weapons of financial destruction

CDOs were just one of the myriad exotic instruments that lured and then trapped an entire generation of institutional and individual investors. Credit default swaps (CDSs)—contracts that insure against the default of financial instruments such as bonds and corporate debt—and structured investment vehicles (SIVs)—funds that borrow money by issuing short-term securities at low interest and then lend that money by buying long-term securities at higher interest, thus making a profit for investors from the difference—were equally glossy but lethal. As these instruments abounded, the distance between imagination and reality grew; nobody asked how many times they were re-repacked, and expecting gravity-defying 25% plus returns year after year ceased to be a sin.

Unprecedented damage

Bigger stars suck as much matter around them when they collapse. The present crisis is a colossal financial back hole, threatening to wipe the entire market cap growth that global markets underwent over the past decade.

It is also unprecedented for many reasons. Economic slumps lead to the death of companies; but this time, investment banks vanished en masse; the death of an exalted business model is even more shocking. Economies rebound when central banks tweak interest rates; this time, landslide cuts in rates announced by banks across the globe—along with massive bailout packages—did not stir even a minuscule ripple. Normally, economists and bankers fathom the depth of crises, though they may not come up with tailored solutions; now, it may take a few years before we approximate the extent of damage.

Be radical, else perish

An unprecedented crisis requires an unparalleled solution. Thirty years ago, everyone exhorted China to emulate capitalism to survive; today many wonder if China’s protectionist, authoritarian capitalism is a better alternative to US-style capitalism that helped lead many western economies to prosperity. Till now, markets were thought to be efficient, capable of fixing fair value and taking care of themselves. Today, banks shudder to lend without prudent regulatory norms.

Radical thinking can spawn unique solutions. For instance, London-based New Economic Foundation, which predicted the current crisis five years ago, proffer ‘deconsolidation’ as a means to reduce the chances of similar crises in future. Consolidation blew up the current crisis—banks are so big that when one slumps, everything collapses. If we slice banks into innumerable smaller entities, in times of distress, we will have many alternatives to resort to.

“Demerge banks to reduce the risks of systemic failure. Instead of further consolidation, the discredited financial institutions that have needed so much public money to prop them up during the credit crisis should be reduced to a size whereby their failure would not jeopardise the system itself,” it says. Any takers?

(This opinion piece was written when the mighty Bear Stearns, Lehman Brothers et al went belly up following arguably the biggest crisis in financial market history)