The financial market meltdown in the US has shaken the world. The big names of the Wall Street are licking the dust. It all started with the subprime crisis and now the problem appears to have reached its nadir with the collapse of firms like Lehman Brothers. The globalization of financial capitalism and interconnectedness of financial markets mean that the crisis will cast its spell well beyond the boundaries of the United States. A lot of questions hover over our heads. How can everything go so wrong? Is the world of finance so complex and beyond the reach of regulators and governments? It is not rocket science, isn't it? Let us try to decipher how this earthquake happened.
Yes. The world of finance is indeed a complex one. The most worrying aspect is the amenability of financial products to a bewildering possibilities of engineering and re-engineering. An underlying asset may not be a prime one. Or it may be a junk bond which your regulator may now allow you to dabble in. But what if you bundle the prime loans with sub-prime loans and try to offload them to some other lender? This lender might be completely oblivious to the default risk lurking around every such exotic structured product. Worse still, this lender may find some aggressive and smart chaps who provide funds to facilitate such transactions also. After all, your Central Bank has slashed interest rates to help you guys prop up the sagging economy and credit has got cheaper. And who does not want to earn 'risk premium'? You are not here in this world of high finance to dabble in T bills only. You may not like to imagine that real estate boom is not going to be there always. You continue to innovate and repackage securities and loans. You take other decent guys also on board who are sick of doing the mundane job of taking deposits and lending money. Don't banks find their task a 'no brainer'? Why shouldn't they also fuel the creativity triggered by the mortgage market? And who is watching? Most of these innovations are off balance sheet transactions. The Central Banks and governments (if these two entities are indeed considered independent and separate !) are busy reversing the slowdown and burning midnight oil to inject liquidity in the system. And the regulators are still learning the ropes. Let the party go on until, of course, you find yourself at the end of your rope.
The thriller does not end here. Banks are smart enough to insure their exposures with the likes of AIG. You go under. You drag down the system with you. And you look to the governments to pay for the follies which, but for this crisis, would have passed off as creativity and ingenuity. The game starts with a small time home loan borrower who may miss his repayment but stops when the giant insurer finds itself gasping for breath. And you have a government who willy nilly extends an olive branch called a bridge loan worth USD 85 billions to AIG. But the same government, weary of bailing out failed 'innovators' and 'alchemists', turns away, somewhat enigmatically, when it comes to salvaging Lehman Brothers.
AIG has been nationalized. Now we know nationalization is not something which can happen in India only. The state is not in retreat. Governments are still relevant to our lives.
So, that is how the Wall Street has been disgraced. Capitalism does not look confident. Thus, the world of complex high finance, though resting on the foundation of something as predictable and straightforward as mathematics, is still fraught with grave dangers. And here, human inventiveness is the main culprit besides greed and ever expanding desire for netting arbitrage.
Will we learn lessons from this debacle?
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