INTER PLANETARY ECONOMICS THE MELTDOWN AND BEYOND a popular exposition

A bank is an intermediary between those who wish to deposit their funds with it and those whoare eager to borrow funds credit.. Actually, the bank poolsborrowings from large numbers of l

INTER-PLANETARY ECONOMICS: THE MELTDOWN AND BEYOND

A Popular Exposition

C T Kurien

Vikas Adhyayan Kendra

Vikas Adhyayan Kendra (VAK) established in 1981, is a secularVoluntary Organisation engaged in the study and research ofcontemporary social issues Geographically, VAK’s activitiesare oritented towards Western India, viz, Maharashtra,Gujarat & Goa.

Vikas Adhyan Kendra

D-1, Shivdham, 62 Link Road

Malad West, Mumbai 400 064

Preface

This write up was taken up at the suggestion of members

of the family – my wife, daughter and brother – that I shouldmake the complexities of the global meltdown intelligible

to them The draft that they found helpful was circulatedover e-mail to other members of the family and a few closefriends, none of them with special knowledge in finance oreconomics To my surprise all of them found it intelligibleand some offered comments also They felt too that thematerial should be made available to a wider readership.Since I had virtually retired from active academic life almost

a decade ago and had paid only casual attention to theplethora of writings on the topic, I deemed it necessary toget critical professional opinion on what I had written.Hence a modified and slightly polished version wascirculated to about a dozen of my former professionalcolleagues who are still active in research, teaching andwriting Practically all of them responded immediately andenthusiastically with valuable suggestions urging me toplace the material in the public domain at the earliest Thetext has been further revised in the light of the commentsreceived

I am grateful to all of them, members of the family andfriends, for their comments and encouragement; but I amsolely responsible for the piece as it appears now

When the piece was under circulation over e-mail, Ihad suggested to the recipients that they should feel free toforward it on to any one they thought would be interested

in it In that process it reached Ajit Muricken with whom Ihad contacts some years ago, but had not been in touch for

a while He immediately called me and asked for permission

to have the piece brought out as a Vikas Adhyayan Kendrapublication I am grateful to him for his support.

The cover was designed by my daughter, Priya and I amdeeply indebted to her for it and for being my mentor on alltechnical matters

– C T Kurien

I The Two Planets

There is a striking passage in the early pages of Niall

Ferguson’s recent book, The Ascent of Money: A Financial

History of the World: “In 2006 the measured economic output

of the entire world was around $47 trillion The total marketcapitalization of the world’s stock markets was $51 trillion, 10percent larger The total value of domestic and internationalbonds was $68 trillion, 50 percent larger The amount ofderivatives outstanding was $473 trillion, more than ten timeslarger” Stocks (or shares), of course, are claims to wealth,and bonds are widely known as debt instruments Derivativesmay be less familiar although they are widely used anddiscussed in financial circles As the word itself suggests it issomething derived from another word or object To beginwith, we may note that within the realm of finance a derivative

is a financial instrument derived from another and underlyinginstrument such as a debt Briefly, then, what Ferguson says

is that we have reached a situation where finance is clearlydominating what is often referred to as the “real economy”which produces the tangible goods of everyday life and theservices associated with their production Ferguson puts itmore picturesquely “Planet Finance is beginning to dwarfPlanet Earth”, he says The figures given above will make bettersense now

When Ferguson was writing his book (it was published in2008) Planet Finance was rapidly expanding at a rate muchhigher than that of Planet Earth “The volume of derivatives

… has grown even faster” he says, “so that by the end of 2007the notional value of all ‘over-the-counter’ derivatives … wasjust under $600 trillion Before the 1980s such things werevirtually unknown” If international currency exchanges are

also brought into Planet Finance, they increased from $500

billion per day in 1990 to $1500 billion in 1998 and to a

whopping $3.2 trillion in 2007 Indeed, in those heady days

of Planet Finance, reports about it, especially its innovation,expansion and achievements were greatly overshadowing therather slow moving and, at any rate, the older and lessfascinating Planet Earth It was as though Planet Finance hadits own and somewhat mystifying laws of motion which werefar beyond the grasp of the uninitiated

Then suddenly in the last quarter of 2008 there weresigns of panic in Planet Finance – some of its major partscollapsed; resuscitation attempts became visible; and therewas a crash! It is part of the prevailing confusion that the crash

is also referred to as “the meltdown” But even those who donot know what has happened recognize that the glamour isgone The mood now is one of depression

Major Issues

In this context there are many things that call forexplanation The most obvious is the spectacular rise of PlanetFinance in the few years immediately preceding 2008 and itssudden collapse in the last quarter of that year, as noted above.Equally important to consider is whether some kind of revival

is likely, and if so when More important is whether PlanetFinance and Planet Earth are independent of each other, and ifthat is not the case, what is the nature of interdependencebetween the two And third, since these entities are “planets”only as metaphor, how are they related to the realities that weall know and experience? In particular, how are they related

to other realities that we deal with, administration andgovernments in our country and globally?

This article deals with these issues, not necessarily in theorder mentioned above, but in such a way that any interestedreader will be able to follow it No professional training ineconomics or finance is expected of the reader

II The Banking System and Credit

By way of background it may be useful to have anunderstanding of banks and related institutions in the working

of a modern economy A bank is an intermediary between

those who wish to deposit their funds with it and those whoare eager to borrow funds (credit) Credit is required becausethere is a time lag between what is needed now and the ability

to repay later or over time Hence what credit does is to link the present and the future: indeed, because what is lent now was generated earlier, credit links the past, present and future Providing this temporal connection is crucial

for the smooth functioning of a modern economy

But if there are many who have funds to lend and manywho are eager to borrow why do they not establish contactsdirectly instead of going through an intermediary? At least forthree reasons The first is that an individual or any other unitthat has funds to lend may not know the person or unit who

requires credit and vice versa An intermediary connects

those who have funds and those who require credit We may

think of a bank also as an institution that pools information

about lenders and borrowers and makes it available to thosewho need such information Actually, the bank poolsborrowings from large numbers of lenders (that’s why it is abank) so that the borrower does not have to know anythingabout individual lenders and lenders won’t know who isborrowing their funds The bank as an intermediary, thus,

performs the important task of gathering and processing information and that plays a major role in the

effective functioning of an economy

The bank plays a second and more important role.Lending of funds to a strange or even a well-known borrower

is a risky thing to do: you may never get back what is yours!The bank may also lose funds that it lends, but there is a sort ofsafety in numbers What you do when you lend to the bank,the intermediary, rather than to an individual borrower, is toreduce risk considerably Of course, you are taking the riskthat the bank may fail, but if you are into the business of takingrisks you know that you are calculating probabilities, and youknow from experience that a bank failing is less likely than anindividual borrower disappearing or going bankrupt.

Thus information (gathering) and processing and riskreducing are the crucial functions of a bank as an intermediary.The Bank provides these valuable services not free of cost, butfor a consideration The bank pays you (a specified rate ofinterest) for the deposit you make (usually a higher rate for alonger period of deposit) The bank charges a higher rate ofinterest to those who borrow from it The margin between thelending rate and the deposit rate is (part of) the earnings of thebank for the services it renders

We may note also that when there are several banks theycome to have additional roles and powers that individual

banks may not have The banking system as a whole can create credit; you leave your money with the bank trusting that it

will be safe and sure that you will earn something by way ofinterest; the bank knows that you will not withdraw yourmoney immediately and lends it for a while to those who canuse it A group of banks or the banking system as a whole cangenerate more credit than a single bank can do For these andother reasons banks come under regulations from higherauthorities, usually from a central bank (the Reserve Bank ofIndia in our case) which is an independent body, but finallyresponsible to the government

Features of Intermediation

An economic system characterised by intermediaries orthe role of intermediation has some characteristics which wemust note If an important function of an intermediary is togather and process information, it becomes an information

9specialist in selected spheres A bank is a specialist on creditjust as a real estate broker is a specialist on matters relating tothat market Where intermediation is general, therefore, one

must expect information asymmetry, and not a uniform

spread of information as is usually assumed by some widelytouted economic theories

A second feature of intermediation is closely related Anintermediary who is a specialist in some areas tends to use itfor his own advantage After all, he too is an economic agent!And, if distorting information is to his advantage why expecthim not to use it to his benefit? This common senseunderstanding of the behaviour of an economic agent goes

under the name of Agency Problem in technical literature

which states that an agent may (usually does) become moreconcerned with his own interest rather than the interest of theprincipal whom he is supposed to be representing We shallsoon see how this agency problem plays a role in anunderstanding of Planet Finance

Third, intermediation has a tendency to proliferate Wenoted that by resorting to the intermediation of a bank thedepositor reduces risk The bank must find ways of reducingits risk of lending One thing it can do is to turn to an insuranceagency to cover the risk, of course for a payment So anotherintermediary emerges A second possibility for a bank (usually

a big one) is to repackage the debt instruments it holdsaccording to differences in the rate of interest, the date ofmaturity, risk profile and pass on the repackaged “products”

to other agencies Agencies twice or more removed from theoriginal principals come to the scene handling new financialinstruments – “derivatives” – thus contributing to the glamourand rapid expansion of Planet Finance In the next section weshall trace how such changes actually happened, particularly

in the USA

The Banking System and Credit

III The American Scenario

The last two decades of the past century saw manychanges in the credit and banking systems in the US, and manyother parts of the world We shall concentrate on the changesthemselves, not much on the why and the how One majorfactor responsible for the changes was the large surplus thatpetroleum producing countries came to have following the oilprice rise of 1973 Although the US dollar then was not asstrong as it was in the immediate post-Second World Wardecades, it was still the international currency, readilyconvertible to any other in the world Hence those who hadlarge surpluses preferred to park them in US banks (as also thefinancial instruments of the US government) US banks,therefore, became flush with funds and were willing and eager toexpand credit and make it available to those who required it.The lending and borrowing spree of the early 1980s led to severedebt crisis for several poor countries, especially African countriestowards the end of the decade Credit expansion led to new creditinstruments and institutions Since they have a bearing on themeltdown we are concerned with, let us try to understand thecredit growth phenomenon and related issues

When a bank makes credit available to a person or any othereconomic entity, it is done on the basis of a collateral Usuallythe collateral is some tangible asset like land or buildings Thetitle of the asset concerned is passed to the bank which ensuresthat it is not sold till the loan is repaid Banks assist in the purchase

of assets from third parties by paying that party and recoveringthe payment in instalments over time The borrower’s ability torepay is ensured by providing proof of the ability to pay by way

of a salary certificate, for instance Banks also accept non-tangibleassets such as shares as collateral for credit, although since the

11value of shares fluctuates, the risk involved is likely to be greater.The point to note is that the lending bank will usually havecollaterals of various kinds that considerably differ in terms oftheir nature, payment schedules and risks The bank canrepackage these collaterals and pass them on if there are otheragencies willing to take them over Thus, when credit expandsand collaterals increase, a new secondary credit market forcollaterals emerges with new purchasers who then can becomesellers if there are other buyers In other words, a new financial

“product” would become available as long as there was demand,and there would be demand as long as entering into the marketwas considered profitable Since “production” in this case wasalmost costless, it was a demand-generated phenomenon wherediffering perceptions about risks and profitability were the soleconsiderations The generic name for these newly engineered

synthetic financial instruments is collateralized debt obligations (CDO) and soon there emerged CDOs, CDO2,CDO3, each variety being a further step removed from theoriginal lenders and borrowers of Planet Earth Since brandingbecame unavoidable even for these “products” new onesstarted appearing such as Collateralized Loan Obligations(CLO), Collateralized Mortgage Obligations (CMO),Collateralized Mortgaged-Backed Securities (CMBS) and so onindicating proliferation and the standard product-differentiation The process was facilitated by breakthroughs

in desktop computing and the entry of a group of highlyqualified academics into the realm of finance who couldrearrange asset classes depending on even slight differences

in the stock prices of companies or of the rate of interest PlanetFinance appeared to be emerging as a separate entity with alaw of motion of its own, moving up and up as creating paperassets was an easy task and virtual assets even easier It wasnot only business concerns that were involved with these newforms of assets As recently as the mid 1980s, 75 per cent ofhousehold savings in the US was in the form of savings accounts

or fixed-interest securities; by the end of the 1990s the positionchanged substantially with about the same per cent chasinghigh profit, though risky, paper assets around the globe

The American Scenario

The process also meant that a penumbra of agencies wasemerging around the banking system, the most prominent andpowerful among them being “hedge funds” Hedge funds areessentially private partnerships with each partner contributingusually upward of $1 billion They specialize in dealing withhigh risk financial instruments or securities as their fundsenable them to take up greater risk for higher payments Themost widely known among them was Long Term CapitalManagement (LTCM) founded in 1993, famous then becauseits core members included two economists who had won theNobel Prize in the subject for their contributions to theunderstanding and treatment of risk It collapsed by 1998because its management of risk proved to be a failure!Intervention by the government gave it a new lease of life.There are other hedge funds also that have continued, because

as they are huge and influential, they can raise loans waybeyond their capital base, the process referred to as leveraging.Without going into the processes involved, it may just bepointed out that at one stage LTCM controlled $125 trillion inderivatives on a capital base of just around $5 billion

New Financial Architecture(NFA)

Now, if they are big risky enterprises, there will have to

be insurance companies to insure them against risk, agenciesthat specialize in assessing risks, credit rating agencies and so

on Demand created its own supply and many agencies of thiskind emerged in the 1980s and 1990s and there were frequent

references to America’s new financial architecture (NFA).

But note that though many of them were engaged in thebanking function of creating and administering credit(enterprises that simply packaged loans into securities and

made them available styled themselves as investment banks,

though they were neither banks nor did any investing) theydid not come under the formal regulatory regime that bankshad to subject themselves to Hence it may be appropriate torefer to them as “shadow banks” The scene was dominated

by huge and powerful private bodies, well-known corporationssuch as Lehman Brothers, Goldman Sachs, Merrill Lynch, not

13accountable to any external agency or to the public at large.This state of affairs was justified on the belief that “the Market”would discipline them by rewarding those who performedwell with high profits and punishing those who did not Belief

in the efficacy of the market was so entrenched that manyregulations that existed were withdrawn or ignored

One more feature of the NFA deserves attention Banksthat are subject to regulatory authorities have to submit theiraudited statements of accounts and balance sheets to thoseauthorities and so financial auditors have a major role ininforming the management of the banks, their share-holdersand the regulatory authorities about the soundness of thebusiness that each bank does The auditors are assumed to beexternal agencies doing their professional job independently.Over time the auditors had evolved a procedure to assess thesoundness of their clients But the emergence of “shadowbanks” introduced many grey areas where it was not easy todecide on the soundness of banking transactions andinvestment operations Auditors could be persuaded to go asthe bank wanted From the point of view of the auditors, thebusiness was large, the fee substantial and the prestigeirresistible They retained the façade of independence, butfor all practical purposes became business partners with theirclients After all, auditing firms also had to show that theirprofits were increasing so that their share prices would go up!

If this was the case with banks with some sense of publicaccountability, it was not surprising that enterprises notsubject to regulations found it easy to persuade risk-ratingcompanies and auditors to go along with them A risk-ratingfirm, for instance, was not taking any risk by providing afavourable opinion to a hedge fund, but was retaining goodbusiness Profit-making became the only objective for many

“independent” professional service firms All was fair whenthe going was good, but all would collapse when somethingwent wrong somewhere

The American Scenario

IV The Boom and the Bust

We can now move on to the recent boom and bust ofPlanet Finance which originated in the United States, butquickly spread to the rest of the world The Americaneconomy is quite used to booms and busts Who hasn’t heard

of the Great Depression of 1929-32 which caused massiveunemployment and a fall of one third in the GDP of theUnited States? Franklyn Roosevelt’s New Deal projects andthe stimulus received during the Second World Warsucceeded in reviving the economy and put it on a highgrowth path that lasted till the end of the 1960s The 1970sturned out to be turbulent and in the 1980s and 1990s therewere some ups and sharp downs During the last few years

of the century there was the much celebrated dot-com boomthat led many to think that technology would provideuninterrupted upward movement of the economy; but bythe turn of the century there was a crash! And the economywas caught in a recession

A standard way to fight recession is for the bankingsystem to bring down the rate of interest hoping that itwould encourage investment and thus revive the economy.Reduction of the interest rate is signalled by the FederalReserve Board (commonly referred to as “the Fed” and interms of its role fairly similar to our Reserve Bank) and itbrought down its rate of lending to banks from 6.5 percent

to 3.5 percent within a span of a few months The events of9/11 (2001) led to further cuts and by 2003 the rate wasjust 1.0 percent with inflation-adjusted short-term rate

actually turning out to be negative What more incentive

must banks have to lend when there were many institutionsready to purchase debt instruments from them? All that was

15needed was to persuade someone to turn to the banks toborrow Who would that be?

The Real Estate Boom

No problem In a country where “property owningdemocracy” is something of a national creed, there would bemany willing and, indeed, eager to take a housing loan if theterms appeared to be reasonable With property developersready to make land, or if needs be even buildings available,and salaried people and commercial concerns wanting landand buildings, the real estate market would be the naturalsphere of activity for the banks Banks would lend, but instead

of holding the loan in their books, they would package theminto CDOs and sell them to other agencies They, in turn, wouldpass them on also

On the other side, as interest rates came down, thedemand for housing loans increased and constructionactivity picked up leading to land prices going up and thereal estate market booming Thus economic activity overallreceived a stimulus, causing employment and incomes to

go up As on all previous boom periods known in history,there was a great deal of speculative trading (this time notmuch in commodities but in financial papers) that yieldedhuge profits Those who had the institutional facilities toplay with other people’s money (OPM) made enormousprofits too Share prices appeared to be steadily soaringand dividends were increasing Market activities appeared

to be bringing all round advantage and prosperity AlanGreenspan, the widely known and highly respected Chairman

of the Fed gave his enthusiastic encouragement to what hecalled “a new paradigm of active credit management” Of

2006 Forbes magazine proudly announced: “This is the

richest year ever in human history” as the number ofbillionaires had risen 19 per cent to 946 over the previousyear’s 793 and their combined net worth climbed by $900billions to $3.5 trillion, adding, “never before in humanhistory has there been such a notable advance”

The Boom and the Bust

In the meanwhile, rate of interest on housing loans startedcoming down further as the banks were competing to securemore business Refinancing (or “refi”) schemes becamepopular Lower interest rates made it possible to borrow morefor the same monthly payment, pay off the old loan, and still

be left with an extra sum to go on a vacation or buy a new car.Lower rates also enabled the more enterprising to go in for asecond house as a form of investment Refis shot up fromaround $15 billion in 1995 to nearly $250 billion a decadelater It was all achievement and affluence, America!

Sub-prime Lending

Soon housing loans came to be at rates below the prime

mortgage rates of banks (sub-prime lending, also known as teaser loans) For long banks continued to make careful

scrutiny of the economic credentials and repaying capacitybut the belief that land prices would only move upwards led to

light-documentation mortgages, the extreme form of it came to be known as ninja loans – no income, no job, no

assets Sub-prime lending which amounted to $145 billion in

2001 soared to $ 625 billion in 2005, accounting then forsome 20 per cent of the loans

Some of the sub-prime mortgages were tricky in nature;the low rates were applicable only for the first year withinterest rates gradually going up later making it difficult forsome borrowers to close the mortgages Instances ofborrowers not being adequately informed about thesearrangements were not rare Soon defaults became notuncommon and by 2007 doubts were beginning to beexpressed about the sustainability of the real estate andhousing boom By middle of that year it was public knowledgethat two mortgage hedge funds were in trouble The problemspread to CDOs linked to sub-prime mortgages which, in turn,had its impact on some investment banks By the fourthquarter, well-known financial institutions like Citigroup,Merrill Lynch, Lehman Brothers, UBS, and Bank of Americahad to announce major write downs The Fed and other official

17agencies had to take note and attempt remedies, mainly makingavailable credit to institutions in need through the first half of2008.

The Crash

The crash came in the second half of the year, midSeptember with Lehman Brothers going bankrupt Lehmanwas one of the leading commercial paper makers It was acounterparty to many CDS contracts, and a prime brokerproviding finance to hedge funds But being outside the bankingsystem it could not get the support of the Fed or the USTreasury When Lehman became insolvent its clients also faceddifficulties George Soros, the financier called the fall of Lehman

“the game changer” because it changed the complexion of thecrisis by introducing serious uncertainty about how thingswould turn Next to go under was AIG, the giant insurancefirm with global operations To ward off further calamity therewere hectic attempts at mergers and buyouts Merrill Lynchwas taken over by Bank of America Panic was spreading andspilled over immediately to the stock market The creditsqueeze and the lay offs affected the households also, thoserelying on credit cards in particular The drastic reduction inspending led to a deflation which soon turned into a recession.Pension funds, endowed funds of universities, foundations,religious organisations and many more were also impactedlosing anywhere between 20 and 40 percent of their assetswithin a couple of months

The government took a standoffish position in the earlystages partly because of the ideological consideration that themarket would correct itself, but also because there was strongopposition to spending public money to save or supportprivate firms like Lehman But the crisis and panic was sointense that a wait and watch position was no longer tenable.The Fed brought down its rate to close to zero The Treasurydecided to pump in $700 billion to enable banks to lend more,but on the assumption that the crisis was one of liquidity Thereal issue, however, was the insolvency of many big names as

The Boom and the Bust