Crisis

There are two sides to the current crisis that has enveloped the financial world – a crisis of liquidity and a crisis of credit. The liquidity crisis resulted from lack of immediate access to funds to meet liabilities that were due yesterday; the credit crisis resulted from large scale defaults on low quality home loans.

Liquidity
There is one cardinal rule when it comes to finance – never use short term funds to fund long term assets. And businesses that have their feet on the ground understand this – the manufacturer, the retailer, the service provider (their primary assets are people, but still). Everyone in fact, except most of the banking and financial sector. Why is the rule so important (although the names are self explanatory, an explanation will do no harm)?

Short term funds – loans – need to be paid back within a short period of time (the normal classification is anything that is payable within one year is “short term” and everything else – “long term”). So you should only use it to create assets that can be liquidized on demand or within a short period of time. Long term funds, on the other hand – whether your own money or money that is borrowed – is repayable or available to you over a significantly longer time frame. So, if an investment has to go into construction of a building, or buying machinery, or doing similar stuff, care needs to be taken that you are not obliged to return the entire money whenever the lender demands it. This requires that you either embark on the project on the strength of your own equity, or on the basis of a long term loan where the lender cannot demand that you pay up the entire money at once – something that cannot be done because all your funds are locked in a long term venture. The asset classification may vary depending on the business, but the classification still exists. And when someone fails to follow the rule, they end up with a “liquidity crisis”.

Every business more-or-less understands and follows this rule – that is why they differentiate between fixed assets and current assets; equity and long term funds, and current liabilities. And that is why they have a concept of working capital – the difference between current assets and current liabilities, a difference that is generally positive and which is therefore funded either through equity or through special funding in the form of cash credit facilities from banks. Every finance professional worth his salt knows about it, and the bankers even more so (but only when it comes to their debtors) – they will have a fit if you tell them you have a negative working capital – that you are funding your fixed assets from money payable to creditors or from your cash credit facility.

The problem in such a case does not result from the quality of assets – the business is still solvent, but from a mismatch in the time taken to liquidate an asset and the time when a liability needs to be repaid. It is a kind of asset-liability mismatch – a time-based one.

Banks, however, believe that they are exempt from this rule – that they can use demand deposits and lend the money for 10-20-30-year periods. Consider how your average bank operates. They accept “deposits payable on demand” – whether in the form of balances in a current account, or savings account, or a “fixed deposit” – the interest rate offered decided by the rules that govern each account; and they lend the money to businesses and individuals for long term uses. This is a serious mismatch and a disaster waiting to happen – a consequence of the “fractional reserve system” that banks follow, and the only reason banks can get away with this is because of an implicit government guarantee in the form of support from the Central Bank. If, for example, the Federal Reserve and similar central banks across the world were to be dissolved, modern banking will be history by next weekend. But the Central Bank and so called Deposit Insurance Corporations mask the perpetual liquidity crisis by guaranteeing enough funds in case of a bank run one one hand, and if a bank fails because it has to engage in a fire sale of its assets, guaranteeing a minimum amount that would be paid to every deposit holder. If you want to compare this with something you can relate to, think about the overbooking that hotels and airlines indulge in. The only difference is they don’t go bust when the chickens come home to roost – their business model does not depend on a balancing act.

Hence, fractional reserve banking, central banks and deposit insurance corporations are “solutions in search of a problem”, and these solutions fail when the problem raises its ugly head. The answer to this is full reserve banking and stripping government of its “monetary policy” making authority. Banks have to keep at hand a sum equivalent to all demand deposits they are liable for. The only money they can lend is that which they receive specifically for such a purpose. This system will raise the cost of banking, but will eliminate the need for central institutions controlling banks. A beneficial effect of this will be the elimination of inflation – a pernicious side-effect of government control on money supply.

Credit
Credit is a much simpler concept. When a prospective borrower meets a lender, in a free market, the lender will lend only if he is reasonably sure that he will get his money back. If the borrower defaults, the lender loses his money. And interest is the reward that the lender gets in return for taking this risk. So the whole system will work as long as people keep paying up the loans that they borrowed, and the scale of operations of banks and companies help them absorb the few losses that are inevitable when lending is done on a large scale.

The problem appears when lenders don’t pay attention to the risk profile of their borrower, either because of their increased risk appetite, or because they are forced by government to grant loans so that people can buy homes. Even in this case, when multiple defaults occur in a particular category of borrowers, as long as the loans are present on the books of the original lender, it is the one who would take the hit, and in a worst case scenario, it would go bankrupt.

The Current Crisis
In the present “credit crisis”, banks and other financial institutions threw caution to the winds, put their loans in a single basket and sold the basket in pieces to other companies who piled up even more complex financial instruments on top of them and sold them to another series of buyers. A pyramid was built on a fragile foundation, and the foundation collapsed when people who were granted loans way above their repayment abilities started defaulting. The shock wave was felt throughout the system and most banks and credit rating agencies realized that they had no idea of what they were holding and how to measure its risk or value-

ONE of the fastest-growing and most lucrative businesses on Wall Street in the past decade has been in derivatives — a sector that boomed after the near collapse of Long-Term Capital.

It is a stealth market that relies on trades conducted by phone between Wall Street dealer desks, away from open securities exchanges. How much changes hands or who holds what is ultimately unknown to analysts, investors and regulators.

Credit rating agencies, which banks paid to grade some of the new products, slapped high ratings on many of them, despite having only a loose familiarity with the quality of the assets behind these instruments.

Even the people running Wall Street firms didn’t really understand what they were buying and selling, says Byron Wien, a 40-year veteran of the stock market who is now the chief investment strategist of Pequot Capital, a hedge fund.

“These are ordinary folks who know a spreadsheet, but they are not steeped in the sophistication of these kind of models,” Mr. Wien says. “You put a lot of equations in front of them with little Greek letters on their sides, and they won’t know what they’re looking at.”

Mr. Blinder, the former Fed vice chairman, holds a doctorate in economics from M.I.T. but says he has only a “modest understanding” of complex derivatives. “I know the basic understanding of how they work,” he said, “but if you presented me with one and asked me to put a market value on it, I’d be guessing.”

Such uncertainty led some to single out derivatives for greater scrutiny and caution. Most famous, perhaps, was Warren E. Buffett, the legendary investor and chairman of Berkshire Hathaway, who in 2003 said derivatives were potential “weapons of mass destruction.”

And the market for these financial instruments vanished overnight leaving financial jargon like “mark-to-market” meaningless. As a reader of The Telegraph points out – “You can’t mark to a market that doesn’t exist.”

Most companies would have suffered losses but could still make it through if they did not suffer from a “liquidity crisis”, like AIG found out – even while being solvent – just – it had no money available to pay off creditors who demanded additional collateral. When Bear Stearns was being rescued in March 2008, this is what I said-

If the subprime mortgage crisis, and the Federal Reserve coming in with a huge bailout package for affected banks was bad idea, the Bear Stearns distress sale, underwritten by the Federal Reserve is worse. Conventional wisdom, and most pink papers, favors bailouts so that the overall banking system remains unscathed by such crises. But the fact of the matter is, bailouts fix the symptoms, not the cause. The main problem hardcore capitalists and libertarians (at least I do) have with bailouts is that those responsible for the mess don’t pay a financial price. If the tax payer has to pay for the financial jugglery done by employees of investment and commercial banks, and if the only thing that prevents people from losing their trust in banks is the backing of the government in the guise of the infallible Federal Reserve with an infinite credit rating, then a private banking sector makes no sense. In that case, nationalizing all banks should be the way to go.

There is a hint of sarcasm if you read a bit further, but my position is clear, and I stand by it. The crisis is a result of persistent government interference in the market, and the market failing to understand risk. And hence shareholders, bond holders, everyone who has invested in companies that took bad decisions should pay the penalty and take a hit. If they are not willing to do that, then the answer is not a bailout but a 100 % nationalization of the entire US banking and insurance sector. If companies don’t appreciate the free market but seek handouts on every available opportunity, socialism is what they deserve. And Bush can learn valuable lessons from Indira Gandhi on this one.

Bear Stearns, Northern Rock, Western hypocrisy and an Indian mess

P. Sainath, Rural Affairs Editor of the Hindu has launched a scathing attack on the downright hypocritical (my phrase) practices of Western countries that preach about open markets and criticize the 15 billion dollar loan waiver granted to Indian farmers, but who jump in to bail out their banks and financial institutions whenever they fall into a hole that they have dug themselves. He does not stop at that, but goes on to attack the economic policies of successive Indian governments that, according to him, are responsible for the rise in prices of agricultural commodities that India has been experiencing over the last few months.

In my last post, which was a reply to Arun Maira’s article on Capitalism, I criticized his position because he took liberties with words like capitalist and capitalism. But I am unable to do the same with Sainath’s current article because what he says is more or less right.

Think of it: a tiny Wall Street cabal which gave itself bonuses worth billions of dollars just weeks before the crash gets a bailout of Rs.1,19,520 crores. That’s almost double the Rs.60,000 crores given to tens of millions of farmers in dire straits in this country. A country where one farmer kills himself every 30 minutes in despair. The problems of farmers do not even begin to end with that waiver.

On the other hand, a bunch of thugs in tuxedos who did pretty much whatever they wanted, laying a minefield across the world, have got the waiver of a lifetime (or many lifetimes). The lifejacket for the bank does not require the return of their bonuses. So much so that Jim Rogers, CEO of Rogers Holdings and a staunch free marketer, calls it “Socialism for the rich.” In his words “the Federal Reserve is using taxpayer money to buy a bunch of Bear Stearns traders’ Maseratis.” He points out that hundreds of billions of dollars are being spent to bail out Wall Street as a whole. The theologians of the global market are between a rock and a hard place. Hypocrisy has rammed into reality.

You can read the rest of his columns at India Together.

Sainath points out huge problems that Indian farmers and our rural sector faces. And he has the authority to do so. But his solutions are no solutions at all, not to a capitalist. A return to government controlled agricultural (or any other) markets – whether government intervention is non-existent is a point of debate – is not a good idea because it does not work. Our PDS system is corrupt and moribund. The PDS shops will run out of stock precisely when their need is felt the most. The Food Corporation of India spends billions of dollars on procuring and hoarding bad quality grains in its warehouses. And its officials make money by diverting the grains to the black market when they should be sent to villages and towns facing a shortage of food. How do you fix such problems? All this only leads one to conclude that the Government is at the root of all problems.

The basic idea behind Capitalism is that a free market manages supply and demand on its own. But for a capitalist system to work, coercion has to be eliminated from relations. And that has not happened. What we have instead, is government abdicating its responsibilities in one sphere – law and order, and encroaching upon other spheres – economics, media, personal lives of citizens, etc.

No one is happy with the current system. The economic left is not happy because they still dream about a socialist paradise. The economic right is not happy because the present system is hardly what one would call capitalist. But both groups want a government – they only differ on its size and scope. The only problem is government is not an automaton. It has to come from within the society itself and will be managed by people from that very society. And, when a government does begin functioning, only one question, and a big one at that, remains – Quis custodiet ipsos custodes? Who will police the police?

Capitalism is fine; lets revisit Big Government instead

Let’s revisit Capitalism, Arun Maira says in the Times Of India. Consider what he has to say on it -

“Is it fair?” This is a question asked not just by people in the developing countries, but even in the US, the bastion of free markets and capitalism. In his book Supercapitalism: The Transformation of Business, Democracy, and Everyday Life, Robert Reich, a member of former President Bill Clinton’s cabinet, observes that the wealth of the two richest Americans – Bill Gates and Warren Buffet – is equal to the combined wealth of 100 million poorer Americans.

He argues that this is a result of the capitalist process. He does not grudge the two their wealth. But he says a system that can result in such huge disparities cannot be completely right.

Bill Emmott, former editor-in-chief of The Economist, in his book 20:21 Vision: 20th Century Lessons for the 21st Century says, “Capitalism in its present form is unpopular, unstable, unequal, and unclean”.

And then some more -

These critics of capitalism are not communists. They are capitalists. Yet, they are calling for a better way. Therefore, let us not be stuck in ideologies. Let us face realities. Why is it ‘socialist’ and wrong to forgive the loans of struggling farmers in India, while it is ‘capitalist’ and right to help Bear Stearns’ rich investment bankers on Wall Street pay off their loans?

It is a real tragedy that people (including me, when I have to offer some example of a country that even remotely practices capitalism) consider the US to be the bastion of free markets and capitalism. It is neither. At most, it is a pseudo-capitalist economy practicing a kind of crony capitalism. The reason is – there is too much of government interference in the economy. But as far as the general perception goes, the US is a capitalist country, and if anything goes wrong in the economy, capitalism becomes the whipping boy because most capitalists are ashamed of being found holding a bag of their hard earned money. That the government manages its finances in a manner which, if the same had been done by a private company, it would have seen its board being jailed, doesn’t seem to concern most people.

Coming to Bill Gates and Warren Buffet and comparing their wealth to that of the 100 million poorer Americans (Why don’t you compare the number of shirts each group has? The 100 million poorer Americans would surely win), and the assertion – a system that can result in such huge disparities cannot be completely right, the argument has no legs to stand on. Did Bill Gates and Warren Buffet go and rob people? Bill Gates made money from something that did not exist 25 years ago. He and the software industry together have created millions of high paying jobs and made the lives of hundreds of millions of working folk easier (and people were ready to pay for this increase in the quality of their life). And Warren Buffet made his money by investing and staying invested in companies that ran a good business. He understands the meaning of investment. Is that his fault? Whether Robert Reich grudges these two their wealth or not is irrelevant (though when a person starts comparing bank balances, what other motive exists is beyond me). The very fact that he can make such asinine comparisons and then extrapolate the results and come to a nonsensical conclusion convinces me that he either has no idea of capitalism or has mistaken the money game being played in today’s United States for the real deal.

The biggest danger comes when people believe Bill Emmott when he says – Capitalism in its present form is unpopular, unstable, unequal, and unclean. At the risk of repeating myself, what we have at present is not capitalism, but pseudo-capitalism.

As for Maira’s statement on Bear Stearns, I will say this – NO TRUE CAPITALIST would ever support the Bear Stearns bailout. I am a capitalist and I was strongly against it. The only people who would support it are those people who would lose the most if government allowed the market to function absolutely freely – and they are definitely not capitalists.

The rest of Maira’s article is mostly a rehash of existing ideas floating around on how corporates should play a more inclusive role in society. He wants them to look at the way they are making their profits and care not only about their customers, but also about the citizens. Basically, he wants them to stop doing just business and also start look at how they affect society and the environment.

A business should do one thing and one thing only – do business. A government should do one thing and one thing only – govern. When neither do what they are supposed to do but try to encroach on each other’s territory, is it surprising that we find ourselves in a supreme mess?

Reduce the size and power of government and let the market work freely if you want to see things change for the better. The only people who won’t survive in a capitalist system are those who refuse to work. And they probably shouldn’t survive anyway, definitely not by riding on the backs of those who do work.

The Emperor’s New ‘Bear’ Hug

H.C. Anderson proved yet again that his classic tale, The Emperor’s New Clothes, will always come back to haunt people who do not pay heed to it. Ignoramuses acting as know-alls under the threat of ridicule by peers in a similar position are a very dangerous breed. And they have underlined that fact yet again. What Created This Monster? (NYT) attempts to figure out what the hell has been going on in the US financial sector over the past few months.

If the subprime mortgage crisis, and the Federal Reserve coming in with a huge bailout package for affected banks was bad idea, the Bear Stearns distress sale, underwritten by the Federal Reserve is worse. Conventional wisdom, and most pink papers, favors bailouts so that the overall banking system remains unscathed by such crises. But the fact of the matter is, bailouts fix the symptoms, not the cause. The main problem hardcore capitalists and libertarians (at least I do) have with bailouts is that those responsible for the mess don’t pay a financial price. If the tax payer has to pay for the financial jugglery done by employees of investment and commercial banks, and if the only thing that prevents people from losing their trust in banks is the backing of the government in the guise of the infallible Federal Reserve with an infinite credit rating, then a private banking sector makes no sense. In that case, nationalizing all banks should be the way to go. But that of course is unacceptable. How can a capitalist country go down the nationalization road? So, if the banks don’t want that to happen, as it will sometime in the future, if they don’t learn their lessons, they have to take responsibility for their actions and should not come running to mommy every time they face a crisis. Here lies another problem. It seems that it is mommy who is more worried about its children, and who in an attempt to save them, will probably end up killing them – through over regulation.

It is disgusting to see the way governments worldwide favor tight regulation of the banking industry. Consider these paragraphs from the above NYT article-

TWO months before he resigned as chief executive of Citigroup last year amid nearly $20 billion in write-downs, Charles O. Prince III sat down in Washington with Representative Barney Frank, the chairman of the House Financial Services Committee. Among the topics they discussed were investment vehicles that allowed Citigroup and other banks to keep billions of dollars in potential liabilities off of their balance sheets — and away from the scrutiny of investors and analysts.

“Why aren’t they on your balance sheet?” asked Mr. Frank, Democrat of Massachusetts. The congressman recalled that Mr. Prince said doing so would have put Citigroup at a disadvantage with Wall Street investment banks that were more loosely regulated and were allowed to take far greater risks. (A spokeswoman for Mr. Prince confirmed the conversation.)

It was at that moment, Mr. Frank says, that he first realized just how much freedom Wall Street firms had, and how lightly regulated they were in comparison with commercial banks, which have to answer to an alphabet soup of government agencies like the Federal Reserve and the comptroller of the currency.

This is precisely the problem. Most parliamentarians (there are a few sane voices among them, but not too many, unfortunately) will always blame every thing on insufficient regulation. Why couldn’t Mr. Frank of Massachusetts not think of loosening the noose around commercial banks so that they could take greater risks, instead of looking at things the other way round?

In conclusion, the financial sector needs to take a hard look at their practices. And governments worldwide need to rethink their financial laws. Regulation will only work when they are small in number and are enforceable. For, for (sic) every new law brought into being, ten new loopholes will soon be found. And gullible investors and depositors will not pay heed to the quality of their investments believing that the government is looking out for their interests, which in fact is not the case. If the people know that they and only they are responsible for the safety of their assets, only then will they take a deep hard look at their banking and investment practices. Putting all your eggs in the Federal Reserve’s (or any other US government agency involved in the financial sector) basket is a recipe for disaster. The next time a bank finds itself in a mess, the FR should let it sink. If it does not, people will never come to terms with the gravity of the situation.