The perils of unfettered capitalism

NO doubt, these are difficult times for the US financial market. Convulsion after convulsion is shaking the very foundations of the system. Institutions which were until recently considered as icons of capitalism are either filing for bankruptcy or being taken over by other banks with US government guarantee or being nationalised.
First it was New Century Financial, and then came the turn of Bear Stearns. Fannie Mae and Freddie Mac, two of the largest mortgage lenders and guarantors, who together account for over $5 trillion of mortgage debt were taken over by the US government on September 7.
Some analysts have described it as "the biggest nationalisation in modern American history." A nearly two-hundred year old venerable institution, Lehman Brothers, filed for bankruptcy on September 15 because of losses incurred on property, mortgages and leveraged loans.
Another prestigious bank, Merrill Lynch, was lucky. It avoided the collapse by being acquired by the Bank of America. On September 16, the US government in effect, nationalised AIG, the largest insurance company of the world.
As a consequence, stocks around the world, including Russia, plummeted and investors everywhere started pouring money into ultra-safe government bonds (as opposed to corporate bonds) and gold.
It is unbelievable that all this started with something as simple as giving mortgages to some home buyers without checking their solvency status. The lenders loosened the standards to such a level that loans were given to people with no income, no job, or no other collateral except the house on which the mortgage was given.
Everything hinged on a false assumption that house prices would never fall. So if the worst came to the worst, the bank would simply take possession of the house through foreclosure, and eventually recoup the loan by selling the house.
This was not a very orthodox way of running a banking business but one could keep track of the individual loans, repayments made and mortgage defaults. But the process became far more complicated when, taking advantage of the slack regulatory system, the ever-innovative financiers, who are adept at financial engineering, found a way to trade these sub-prime mortgages as complex derivatives to investors all over the world.
The mortgages were classified by credit rating agencies and bundled together as blocks of CDOs (collateralised debt obligations) or (MBSs) mortgage backed securities, making it impossible to assess their real value at any given point of time.
Yet, banks (both depository and non-depository), hedge funds, and insurance companies merrily used these CDOs to swap loans and risks with one another without bothering to update their real values.
Thus the bubble was created which kept growing until about a year ago when the number of foreclosures became unbearably high and house prices started to fall. The rating agencies were forced to downgrade the CDOs, thus starting the process of the sub-prime mortgage meltdown.
When this turmoil spread to other parts of the securities market, it created a huge liquidity crisis because financial institutions became hesitant to lend money not only to outsiders but also to each other because of a collective loss of faith in the financial system. Central banks across the world pumped and are still pumping billions of dollars into the market to stop the collapse.
There is no doubt that the current American administration bears a lot of responsibility for this debacle. Bush, Greenspan, and even Paulson are devoted to a free-market ideology and believe that the markets should be left to have their way. But the recent events have demonstrated clearly that when there is a crisis, the government, in order to avoid a total collapse of the economy, is forced to intervene with taxpayer money.
This ideology also believes more in deregulation than in the need for a set of new rules and new mechanisms to take preventive actions before the crisis sets in. It thinks that too much regulation destroys innovation in the financial market and that "market discipline" would ensure proper functioning of the market.
Again the current crisis has shown that the financial market, in general and the investment banking in particular, in the words of one analysis: "Need stricter regulation, more attentive supervision and new operating rules, in order to curb the unlimited risk-taking in a motley variety of markets which until now financial institutions have enjoyed. The survival of healthy and sophisticated financial markets will depend largely on the ability of banks, monetary agencies such as the Securities and Exchange Commission (SEC) to reach general agreement on the new rules of the game. The era of carefree, cheerful deregulation and the remote supervision of banking risks ought to have come to an end."
The global dimension of today's financial market makes it even more urgent to have new regulations to control the market. Actually, the US was forced to nationalise AIG not only because its collapse would have wreaked havoc on the US economy but also "because it plays a critical role in the opaque and largely unregulated multi-trillion dollar market for a complex financial instrument known as credit default swaps --insurance contracts that protect investors against losses and bond defaults" on a world-wide basis.
Again, one of the principal reasons behind the decision to nationalise Fannie and Freddie was the fact that America's creditor countries like Japan, China and oil producing countries purchased Fannie and Freddie bonds amounting to many billions of dollars on the understanding that both these organisations were backed by the US government, therefore risk free. Being the world's largest debtor country, the US could not take the risk of seeing its reputation sullied. One may, of course, wonder how the US which is already burdened with fiscal and current account deficits will be able to honour its newly acquired commitments. But that is another story.

Chaklader Mahboob-ul Alam is a columnist for The Daily Star.