Rising from the ashes

THERE will be a new financial system rising from the ashes of the old. Recently, we saw the demise of one of the oldest independent investment banks, Lehmann Brothers, which filed for bankruptcy. Another large investment bank, Merrill Lynch, was bought by Bank of America and AIG, the largest US insurance company, is fighting to shore up its capital.
These are unprecedented times and, inevitably, we have moved into uncharted territory, and it is very difficult to predict how all this will pan out over time. No doubt all markets are jittery, as they should be at a time like this, and are desperately looking for direction and some understanding of the repercussion of this debacle. Unfortunately, only over time will we begin to comprehend some of the issues that have led to this disastrous state.
For over a decade the global financial markets have been rising, but gravity seems to have defied the relentless climb of asset valuation, be it financial or real estate, including the global housing markets. What brought about this explosion in prices? The simple answer is leverage.
At no time in history was the world so precariously leveraged than in the past years. Access to money was easy and one didn't need much proof to borrow. In the US mortgage market brokers and financial institutions were almost giving away money without much evidence of the capability to repay, which one would have thought was a pre-requisite for lending. This was because the lenders were not the ultimate holders of the debts, they had no skin left in the lending they had initiated and could, therefore, afford to be irresponsible with their decisions.
The assets that were created through these mortgage lending were packaged into marketable securities and off-loaded to financial investors, many of which were financial institutions and banks. These packaged securities were also highly rated for their creditworthiness by top rating agencies like Standard & Poor's and Moody's.
The higher ratings were achieved due to over collateralisation, which, in simple terms, means that at issuance $100 worth of bonds that represented the underlying mortgages it held were actually higher in value than $100. The over collateralisation would act as a cushion for a percentage of default, hence the triple A to single A investment grade ratings for most of these bonds issued in the international markets.
On paper, all this looked fantastic and hunky-dory as long as the economy thrived and people continued to have jobs and were able to pay their debts from mortgages. However, once the economy turned and people lost jobs and their ability to service debt deteriorated, this highly rated securitised asset class, commonly known as sub-prime assets, began to sour.
The default of mortgages accelerated, and despite layers of cushioning of such securitised assets the value of these bonds fell sharply as the non-payment in the underlying mortgages grew.
The post mortem for this collapse will no doubt be long but, for the moment, suffice it to say that two key reasons that were principally responsible for this meltdown of financial markets were the easy money policy of low interest rates and the irresponsible behaviour of the unregulated investment banks on Wall Street and rest of the world.
Since the tech bubble burst in 2001, the US Federal Reserve Bank, under Greenspan then and Bernanke now, has been pursuing a fairly easy monetary policy with Fed Fund rate going down to as low as 1% in 2003. With interest rate so low, there followed an explosion of credit in all sectors of the economy.
Initially, the low interest rate policy in the US was pursued to avert financial collapse from the aftermath of the tech industry caving in from a state of over-valuation. But sustaining a persistent low rate policy beyond a limited period of time was a major folly, a key consequence of which is the current high rate of inflation that we are encountering, let alone the near meltdown that the financial markets are also faced with.
Sustained low interest rate encouraged financial institutions in the US and around the world to lend aggressively as access to money was cheap. Easy money was the root cause of the enormous leverage edifice that real and financial assets were built on for the last seven to eight years.
From financial portfolios to real estate assets, all were allowed to be leveraged more than its prudential norm as it was money for old rope for the lending institutions. This turned out to be a self-fuelling proposition as more leveraged money was poured into the financial system directed towards financial and real assets and prices of these assets kept rising on the back of higher demand.
As prices of assets rose, the lending institutions also felt comfortable with higher collateral value on which they were willing to lend even more. It was like a pack of cards waiting to be toppled with the slightest of knocks.
Not only did the financial institutions freely lend money and helped their clients to leverage, the institutions also got greedy and leveraged more than prudence dictated. This happened principally with major banks and investment banks where they piled on the triple A and double A rated securitised assets, as this required a minimum capital allocation for the regulated banking industry.
As for the investment banks, they piled on such assets even more and leveraged even more as they remained outside the banking regulations and, therefore, were not subjected to capital allocation requirements which would have automatically put a limit to the leverage they could do.
Bear Stearns, which was one of the first investment banks to go under -- and eventually rescued by JP Morgan -- was leveraged forty to one whilst Lehman, which threw in the towel, was about thirty-two to one leveraged.
Inevitably and indubitably the global financial world has changed, and we will see a new beginning for global financial institutions; probably an industry built on fundamental and original values of conservatism and prudence.

Galib Chaudhuri is a freelance contributor to The Daily Star.