Monthly Archives: April 2009

The Financial Crisis – An Accident Waiting to Happen and the Way Forward

When you run too fast you are bound to stumble.
Ever since the end of the cold war and the fall of the Soviet bloc the world had seen the hand of capitalism rock the cradle of nations. Countries were caught up in the heady euphoria of a super sonic growth rate. With decreasing rates of interest it paid more to invest than to save. The risk appetite was whet time and again. The most conservative of bankers and underwriters were being drawn to take mad risks and insane gambles. All on the assumption that house prices would rise in perpetuity.
Assumptions, unfortunately, have a way of coming unglued at the most inopportune of times. Around August of 2007 the world credit market first showed signs of something untoward. Suddenly the price of risk became unacceptable. There was a mad scramble to reduce exposure to risk. But whatever measures that were taken were too little and too late.
The main features that emerged during this time were irreconcilable global imbalances, irresponsible lending practices, and an insatiable Wall Street. It helped matters little that all of these were being given a free run by an ever-expansionary Federal Reserve.
Ever since the late 1990’s the world was desperately searching for financial assets to store value. The rising savings needs by an increasingly aging population fueled this search. Since the US was at the centre of the global capital market a lot of the demand for financial assets was directed toward this land of infinite opportunities. The creation of sub prime mortgage assets stemmed not just a result of reckless lending but also from the for a necessary instrument to fill the void in financial assets.
Trust banks to fill a void. US banks came up with a fresh set of sub prime assets that were unparalleled in there risky nature. Regulatory and credit agencies played along by labeling these assets as AAA, clothing them in the guise of credibility.
The result was an extremely volatile concoction waiting to go “poof” at the slightest provocation. Thus it is clear that the crisis was bound to happen.
And finally the housing bubble began to quiver and finally gave under the immense pummeling it had received. Alan Greenspan, the former Chairman of the Federal Reserve, demonstrated uncharacteristic acumen when he made certain observations at this stage.
He said, “The financial crisis …. Was an accident waiting to happen”. He went on to add that with the kind of risk appetite that had been cultivated and the rate at which country’s growth rate was exploding, “something had to give”.
And give it did. The current economic crisis that nations are floundering in is just an aftermath of the Sub Prime crisis.
Thus far it has been simple and it does not take a degree in rocket science to grasp the situation. What needs to be understood is that the crisis was inevitable considering the rate at which things were moving. The fact the bubble burst because of erroneous pricing of securitized U.S. Sub prime mortgages is just the path that world economy took. If it had not happened here it would have happened in some other sector or market. But happen it would for sure.
And way it happened is something not to be forgotten in a hurry. Financial losses were seen to rocket to trillions of dollars. Financial Behemoths like Lehman brothers and others imploded and came down with earth shaking implications. Fear and mistrust had an unchecked run amongst investors and lenders with credit markets seizing up. Governments have come up with unorthodox policy interventions and the world teeters on the brink of a global financial meltdown.
A rescue act of gigantic proportions is in order and this does not refer just to financial bailout packages but to a more comprehensive approach to the crisis.
At this time the world is sitting on stacks money ready for investment. The problem lies in the fact that, with the risk of the unknown making waters murky, no one is willing to take the first step toward thawing the frozen credit market.
Normally the instinct to arrive first at the deal drives economies and makes investors take intelligent risks. But with the world economy still quivering from the shocks it has received there is an increasing tendency to let someone else make the first move. The ice is so thin that many feel it would be prudent to let someone else test it before they put their own selves at risk.
As the financial crisis deepens and rigor mortis sets in some crucial sectors one insight emerges prominently. The bailouts that are being talked about are piecemeal and on a national level, whereas the crisis is global in its nature. Aggravating the matter is the fact that there is still plenty of debate about the very nature and extent of the crisis and its roots. With so much uncertainty floating around, steering the ship of global economy safely into the harbor of financial security is a gargantuan task.
The main problem at this time is of potential illiquidity. There are many big institutions that are so big that they cannot be allowed to fail. Failure for such institutions would spell bankruptcy, unemployment and wiping out of savings of many smaller corporations and individuals. The first step should be for treasuries and finance ministries to buy shares or warrants in the troubled financial institutions, thereby providing them with capital they have been lacking. It goes without saying that such capital infusion would have to come with additional regulation and supervision in order to make it effective. This would also serve to cleanse the world’s financial system of toxic assets.
There should be an effective method of providing solvency insurance to these institutions. Such insurance, however, must go hand in hand with greater supervision and stronger regulatory guideline. Perhaps a global financial body must be set up to tackle this task.
By the time the current credit crisis will come to an end very large losses will, no doubt, be taken. But after a period of protracted adjustment, the world economy in general and the U.S. economy in particular, will be able to get back to business.
One thing is clear it will take all that we have to weather the worst global economic crisis in living memory.