The current credit crunch is more than the bursting of a ‘bubble’

"Excessive lending against over-optimistic asset valuations is a time-honoured recipe for asset price bubbles. The largest credit bubble that the world has seen is finally deflating. The current credit crunch is more than the bursting of a “bubble”. It is the crucible in which theories of the “new money” and the financial jiggery pokery (more politely known as financial engineering) of the structured credit markets, financial innovation and global money is being tested and found seriously wanting.

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Governments throughout the world have forced people to take more and more responsibility for their own finances. For example, the company pension plan (based on final salary) has given way to schemes where you save personally and rely on your savings and investment earnings to finance your retirement. The general trend from regulators is to force sellers of products to disclose risks. However, most people are not equipped to make these choices.The trend is heavily influenced by self interest. The cheerleaders – fund managers and banks – are huge beneficiaries of the privatisation of retirement savings and pension arrangements. For examples, in Australia (where I live) compulsory pension savings have created the 4th largest investment market in the world (completely out of proportion to Australia’s population) and created a massive and lucrative investment management industry."


The current credit crunch is more than the bursting of a ‘bubble’

The Hindu News
January 16, 2008
Source

Chennai: If you find the web of international economies and money incomprehensible, take heart. You are not alone. That is how it is: “beyond comprehension,” as Satyajit Das says. He is the author of Traders, Guns & Money,’ a book that talked about the known and the unknown in ‘the dazzling world of derivatives.

It was ‘part thriller, part expose,’ describes Das, talking to Business Line, over the phone from Mumbai. “The whole point was to make it a fun read but teach something about the business and how these markets work in a non-technical way. It is also satiric, irreverent and black in its humour – is that too many adjectives?”

His account of derivatives trading and the financial products business, even when explaining ‘the high-minded theory,’ bared the ‘sordid reality of the industry,’ Financial Times, London had commented. “Ordinary readers liked it,” reminisces Das, cheerfully. But insiders at bank were either amused or mortified, he adds.

“Some in banking and finance found it a wry and entertaining read. They recognised themselves or people they work with. Others were aghast that someone had ‘spilled the beans’ on what really goes on – a no holds barred expose!”

An insider, Das definitely was, having worked in the area of financial derivatives and risk management for over three decades, with experience in banks (including CitiGroup and Merrill Lynch), corporation (TNT Group), and as a consultant. He has written the standard reference works on the topic.

“People entering the industry who want to bluff their way through a interview for that high-paying derivatives job love the Guns book – it’s a great Bluffers Guide to Derivatives,” Das jests over the e-mail, when answering at length the many questions I’d put to him during the telecon…

Excerpts from the interview

Looking back, what was the trigger for ‘Traders, Guns & Money’?

I thought people should know about what was going on with their money in this curious world. It’s all done with OPM (other people’s money) – your pension money, the money you deposit with banks, the money of companies whose shares you own. It will help ordinary people understand what your money is sometimes used for.

This is a world that few people know about and fewer understand. It’s a world where a small group of gifted, if rapacious, individuals parlay their knowledge of financial products into wealth, leaving shareholders, clients, regulators, and the tax-paying ordinary public to bear most of the risk.

Traders Guns & Money tells a little of the truth of what really does go on. It may help explain why, in the words of Groucho Marx, “You worked yourself up from nothing to a state of extreme poverty.”

Do you see the events since the publication of the book have borne out some of the fears you had written about?

Ironically, the book anticipated some of things that are going on currently with the sub-prime crisis. The book exposed the sophistry of derivatives and the structured credit market. It highlighted the moral hazards and distorted incentive structures that posed major threats to market stability.

In a 2006 speech – ‘The Coming Credit Crash’ – I argued that: “an informed analysis of the structured credit markets shows that risk is not better spread but more leveraged and (arguably) more concentrated amongst hedge funds and a small group of dealers. This does not improve the overall stability and security of the financial system but exposes it to increased risk of a ‘crash’ during a credit downturn.” These problems are now becoming readily apparent at enormous cost to ordinary investors and taxpayers.

What is your take on the sub-prime meltdown in the US?

It is a mistake to thing about this as the “sub-prime crisis”. Recent history has been a period of ‘too much’ and ‘too little’ – too much liquidity, too much leverage, too much complex financial engineering, too little return for risk, too little understanding of the risk.

Excessive lending against over-optimistic asset valuations is a time-honoured recipe for asset price bubbles. The largest credit bubble that the world has seen is finally deflating. The current credit crunch is more than the bursting of a “bubble”. It is the crucible in which theories of the “new money” and the financial jiggery pokery (more politely known as financial engineering) of the structured credit markets, financial innovation and global money is being tested and found seriously wanting.

How bad is the problem?

Major global financial institutions have racked up losses to date of over $100 billion and I don’t think we have seen all the losses emerge. There are more losses to come in prime mortgages, credit cards, commercial real estate, private equity loans and “junk” bonds. Similar problems are emerging in England, Ireland and Spain. To put the number into perspective, the US S&L (savings and loan) losses in the 1980s totalled around $240 billion (in 2007 dollars). As they say, “a billion here and a billion there and soon you are taking about real money”.

The $1-2 trillion of assets that banks have parked off-balance sheet in special purpose structures are coming back onto their balance sheet. Banks must find the money for this. They also need capital to cover the losses and the also the assets coming back – we even have a new acronym for this: IAG (Involuntary Asset Growth).

All this will choke off credit creation and bring on a sharp contraction in the availability of credit. This will reduce economic growth (the US looks likely to slow down sharply) and asset prices (houses and shares) around the world. It is perhaps the most serious crisis that we have faced in a very long time.

Can the actions of central bankers and the interest rate cuts solve the problem?

In the past, ‘the committee to save the world’ and interest rate cuts managed to save the day. Lower rates set off asset price bubbles that allowed the US consumers to raise cheap debt to support further consumption.

This time interest rate cuts are unlikely to have the same effect. Excessive borrowing levels limit the scope for the consumer to borrow and spend their way out of the problems. Asset prices, especially house prices, are also falling lowering the ability to create debt.

The rates cuts will, at best, smooth the adjustment process and support the fragile banking system. If the lower rates create higher inflationary expectations then long-term bond yields may rise further accelerating the slowdown.

How will this affect India, our markets and the rupee?

Favourably and unfavourably! The short-run effect has been positive. The current investment theme is “decoupling” – equity markets have decoupled from debt markets, emerging markets have decoupled from developed markets and the US dollar has decoupled from just about everything. India, like other emerging market economies, has benefited from large short-term capital flows that have pushed up the rupee and boosted the Indian stock market.

The long run is more difficult. All this money has created a speculative bubble that will eventually have to correct. De-coupling assumes that India will not be significantly affected by a US slowdown. Exports account is significant for most emerging market economies.

A slowdown in the US and Europe will affect growth. The belief that domestic consumption can take over from exports as the growth engine in emerging markets is untested.

The Indian economy may be capable of self-sustaining growth but only in the longer term. India also faces infrastructure constraints that will constrain growth. Inflation (higher energy and commodity costs and rising domestic costs) and rising local currency interest rates may slow growth.

The Indian rupee’s appreciation against the US dollar attracts capital flows but reduces local currency earnings and the competitive position of exporters.

The overall problem is of unbalanced global and capital flows. That created this crisis. Until these correct (and there are few signs that these are even being addressed) we are in for a period of great volatility and financial uncertainty.

Are there trends in Indian financial markets that worry you?

Share prices in India are reminiscent of the surreal valuations of the dot.com and (earlier) Japanese equity bubbles. The quality and performance of recent initial public offerings have been variable and (in some cases) poor. Earnings growth has increasingly been driven by investment income – stock market, currency and property speculation. There is a nagging suspicion that prices are prone to being influenced by insiders and their associates.

Will this affect the pace of development of India’s financial markets?

India’s markets are relatively closed despite the relaxation of recent years. It is not clear whether this will make the process of adjustment to the developing global crisis easier or more difficult. The crisis may slow down the pace of de-regulation and development.

Hasn’t the world of finance become too tough for the common man to follow? More so, for the old who find their sunset years unpredictable from a financial perspective?

The maze of international finance is now almost beyond understanding. For example, in 1988, the Mexican Finance Minister mused how he could explain to a Mexican housewife that her mortgage repayments were going to rise as a result of Russia defaulting of its international debt.

Governments throughout the world have forced people to take more and more responsibility for their own finances. For example, the company pension plan (based on final salary) has given way to schemes where you save personally and rely on your savings and investment earnings to finance your retirement. The general trend from regulators is to force sellers of products to disclose risks. However, most people are not equipped to make these choices.The trend is heavily influenced by self interest. The cheerleaders – fund managers and banks – are huge beneficiaries of the privatisation of retirement savings and pension arrangements. For examples, in Australia (where I live) compulsory pension savings have created the 4th largest investment market in the world (completely out of proportion to Australia’s population) and created a massive and lucrative investment management industry.

Are you planning a follow-up book?

I would like to do one more book if the opportunity presents itself– the working title is ‘Extreme Money – The Masters of the Universe and the Cult of Risk.’ The idea is to show how it has become possible to make vast fortunes not from producing real goods and services but from money itself.

It focuses on the “Masters of the Universe” – elite financiers – who invented and continue to invent a whole range of extreme money games that have allowed them to generate extraordinary returns for themselves (some hedge fund managers earn in excess of $1 billion) and for their backers. I would like to explore how the culture of risk and extreme money games has changed our world in ways that few fully comprehend.

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Bio

Das is the author of a number of key reference works on derivatives and risk management including ‘Swaps/ Financial Derivatives Library’ – Third Edition (2005, John Wiley & Sons), a 4-volume 4,200 page reference work for practitioners on derivatives, and ‘Credit Derivatives, CDOs and Structured Credit Products’ –Third Edition (2005, John Wiley & Sons). He is also the author (with Jade Novakovic) of ‘In Search of the Pangolin: The Accidental Eco-Tourist’ (2006, New Holland), a travel narrative offering ‘passionate and often poignant insights into the natural world and the culture of eco-travel.’ Born in Calcutta, India, Das has been living since 1970 in Sydney, Australia.

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