FINANCIAL TSUNAMI: UNDERSTANDING THE GLOBAL MELTDOWN

Dr. Navaratna Rajaram

Dr. Navaratna Rajaram is a mathematical scientist and
international consultant.

First I want to thank Prasara Bharati for this opportunity to
share with you some of what I have learnt in the past several
months relating to the financial meltdown that will affect our
economic future. The first point I would like to make is that
unlike a real tsunami, this financial tsunami is entirely man-
made. Also, it was not entirely unexpected. Several of us had
been warning about the consequences of the reckless course taken
by global financial institutions and the dangers in articles that
have appeared in national and international publications. But
human nature being what it is people responsible did nothing
until the crisis was upon us.

What I plan to do in this talk is to give you a picture of the
problem in non-technical language and how we got into this mess.
I will also suggest some steps that we need to take to protect
ourselves from things getting worse. But first we need to
understand the true nature of the problem. Public and the media
seem worried about the fall in share prices the world over
including in Mumbai. But that is not the real problem. What
threatens the world's economies is not the fall in the share
prizes, but something far more serious - the collapse of the
credit markets. This is what needs to be addressed. Share prices
will recover when conditions improve, but if credit markets
collapse, there will be a banking crisis and whole economies can
collapse.

So the real danger is the collapse of the credit markets. Modern
economies run on credit - not stocks and shares. Businesses
including banks need to borrow from one another even to meet
their daily expenses. Every business, great and small needs
access to credit. Most of us need to borrow money - for buying a
vehicle or a home or even for our children's education. Even
governments cannot function without credit. Just as shares
represent ownership of companies, bonds represent credit or debt
obligations. Borrowing is done by issuing bonds. Even though they
don't enjoy the glamour associated with share markets, credit
markets are far more important to the economy.

Banks in particular depend on credit. To loan money, banks need
to borrow money. This is why they pay interest to depositors.
Today in India banks pay something like ten percent for fixed
deposits. These are loaned to individuals and businesses at a
slightly higher rate. This gives banks an operating profit for
their expenses and also for paying dividends to shareholders. For
this to work, depositors should have full confidence in the
banking system that they can get their money back at any time.
Otherwise they will not put their money in the banks.

This means banks cannot function without the confidence of its
customers. The word credit comes from the Latin word credre,
which means trust. Credit ensures free flow of money in the
economy. This is called liquidity because it allows money to flow
freely like a liquid. A credit crisis dries up the liquidity.
This is what has happened. This is because people in some
countries have lost faith in their banks and the financial
system.

To enjoy the trust of its customers a bank should be solvent. In
order to be solvent, a bank needs to have enough reserves to meet
customer requirements or should enjoy the confidence of other
institutions to borrow the money to meet its needs. This
confidence is called credit rating.

When a bank has neither the reserves nor the credit rating that
allows it to borrow from other banks, it becomes insolvent. This
is exactly what happened to the largest banks in Iceland . The
money they had loaned was more than the size of the national
economy. Rumors began to spread that the banks had made many bad
loans and were insolvent or bankrupt. Depositors were afraid they
could not get their money back. So there was a run on the banks
with people rushing to get their money out. The banks could not
meet it. With so many banks going bust, the Iceland economy
collapsed.

Something almost like this happened in the United States . The
largest banks and other financial institutions faced a similar
problem. Most of these have their offices on Wall Street in New
York . So they are called Wall Street firms. They include such
household names as CitiBank, JP Morgan, Goldman Sachs, Morgan
Stanley, and others that all of us have heard about. The name
Wall Street is synonymous with high finance. Because of the
credit crunch and the resulting liquidity crunch, several of them
including such famous names as Merrill Lynch and Bear Stearns
have disappeared. The famous investment bank Lehman Brothers
founded in 1850 went bankrupt last September.

No economy, not even the economy of the United States , can
afford to have so many large banks fail. This is the reason that
the U.S. Government has come out with its emergency plan to put
700 hundred billion dollars into the banking system to provide
liquidity. This is like a blood transfusion to a patient who has
lost a lot of blood. No one knows if it will be enough. But like
a blood transfusion it is only an emergency measure.

The important point to note is that what brought down Iceland 's
economy and what later threatened the economies of Europe and
America is the credit crunch or the liquidity crunch, not the
fall in share prices. In fact share prices are falling because
there is shortage of liquidity, which means people don't have the
spare money to buy stocks. This is what is driving down share
prices.

The next question is how did this liquidity crunch come about?
What did the banks do with all the money that people had
deposited with them? To put it simply, a combination of greed and
breakdown in the regulatory mechanism led to the near collapse of
the American banking system. Government institutions that should
have overseen and regulated banks and other Wall Street firms
failed in their duty. Worse, they became tools of Wall Street
speculators. A small group of Wall Street financiers were allowed
to make huge profits by creating a bubble economy. The bursting
of this bubble is what has landed the world economies in the
credit crisis.

This is why I said the crisis is entirely man-made. Most of you
have no doubt heard that it was triggered by losses in sub-prime
mortgage based derivatives. You know what a mortgage is - it is
a home loan that is paid back in monthly installments. What Wall
Street bankers did was to turn mortgages into securities that
could be traded on the stock exchanges and then create
speculative instruments called derivatives. Let me explain what
this means.

A piece of property like a house or an apartment is not easy to
sell. It takes time to find a buyer willing to buy at a price
that is acceptable to both parties and then find a new mortgage
to finance it. It is different with a share or a bond. All it
takes is a phone call to your stockbroker. To get around this
difficulty, what Wall Street bankers did was to create mortgage
bonds by combining a large number of mortgages. These now could
be traded like shares and bonds so speculators could make profits
by trading them on the exchanges.

This is called securitizing the mortgage because it can be traded
on the exchanges like any other securities. Once this is done,
the personal link in a mortgage between the borrower and the
lender is broken. The mortgage now becomes simply a piece of
financial paper traded on some exchange. The value of the
mortgage now is also detached from the conditions of the local
housing market, while getting tied to price fluctuations on the
stock market. By this, from being the means for providing shelter
to a family, the mortgage becomes an exchange tradable security
like a stock or a bond.

But these bankers didn't stop there. They created derivatives
based on mortgage securities. While a mortgage is based on the
present value of the property, a derivative is a contract to buy
or sell a product based on future value. A lender looks not only
at the value of the property but also creditworthiness of the
buyer who is borrowing the money. This is necessary because the
borrower will take several years to pay back the mortgage.

But an investment banker isn't interested in all this. All he or
she wants is a product that can easily be traded on the exchanges
for profit. For this reason, when derivatives are created they
are highly leveraged. It means that it is possible to buy and
sell these papers by putting up only a small part of its value
called the premium. The object is to turn a solid asset like a
house into an instrument used for speculating on the stock
markets and get maximum profits.

In order to increase profits these Wall Street financiers
artificially inflated the value of the mortgages and derivatives
to unrealistic levels. This also artificially increased the
prices of the underlying houses and their mortgages. This means
that the borrowers had to make bigger and bigger payments on
their home mortgages. When some owners tried to sell their homes,
they found that the mortgages were more than what they could sell
their houses for. This means that they owed more money on their
mortgages than the value of the houses.

In their quest for profits, the Wall Street bankers had built a
house of cards made up of borrowed money on a foundation of over-
valued houses. People soon could not afford those monthly
mortgage payments especially since the house values were much
less than the loans. So they started defaulting on payments. To
make things worse, many of these mortgages were of poor quality,
because banks had loaned money to people who did not really
qualify. But they didn't care because they were only interested
in using those mortgages to create derivatives to speculate on
the exchanges and make profits.

The crisis that hit the U.S. economy began when these low quality
housing loans called sub-prime mortgages fell into default. This
is the sub-prime mortgage crisis. Essentially, the banks were
left with large numbers of poor quality mortgages that were
defaulting. Their holdings became worthless and a severe drain on
the banks' finances. With no money coming in the banks themselves
began to fail.

Some people will claim that I have oversimplified a complex
situation. This is deliberate on my part. A large part of the
crisis is because things were made so complicated that no one
knew what really was going on until the crisis hit the markets.

Here is an example of this over-complication. The first domino to
fall that brought down this house of cards was the collapse of
AIG, the world's largest insurance company. We were told that AIG
went bankrupt losing 85 billion dollars because the large number
of Credit Default Swaps or CDS in its portfolio failed. What does
this mean? A CDS is nothing but a bad loan insured fraudulently
as a good loan. AIG was carrying a large number of such bad loans
which defaulted within a very short time. Naturally it couldn't
make the payments.

So in simple English, AIG went bankrupt because it was insuring
bad loans close to default. This can be compared to a life
insurance company carrying the policies of a large number of
terminally sick patients believing them to be healthy
individuals. Of course such an insurance company will eventually
fail. Why give it a name like Credit Default Swap? To hide the
truth. When the insurer AIG collapsed, loans could not be insured
and no one lends money without insurance. This is what
precipitated the credit crunch.

The real question is - how could the American Government allow
this to happen? It was due to a combination of greed and
corruption. Wall Street bankers had managed to infiltrate vital
financial institutions of the United States Government including
the Treasury Department and the Federal Reserve Bank. Henry
Paulson who used to be the head of the Wall Street firm Goldman
Sachs became the Treasury Secretary, the American equivalent of
the finance minister. He brought with him people from several
Wall Street banks into the government. These men used their
positions to help banks make huge profits at the cost of the
taxpayers. Even after the collapse, former Goldman Sachs official
Neel Kashkari was put in charge of the 700 billion dollar bailout
package.

What can we learn from all this? First and foremost, you cannot
allow people with profit motives to be in charge of vital
national institutions like the Treasury Department or the Federal
Reserve. What you then get is not free market capitalism but
crony capitalism leading to profiteering. Next - and this applies
to individuals as well as to companies and governments - there is
no free lunch. You cannot create money out of nothing by simply
creating and trading paper wealth. The result will be a bubble
that is bound to burst sooner or later.

Most importantly, we cannot have a small priesthood of
financiers, economists, bankers and the like get a stranglehold
on a nation's or the world's resources at the cost of everyone
else. Remember that these people don't create wealth, they only
reallocate and redistribute wealth created by others. Given a
free hand they will try to enrich themselves at the cost of
others. Wealth is created by farmers, factory workers, thinkers,
knowledge workers and others whose work and ideas enrich the
world.

At best economists and bankers improve the efficiency of how
money is used. At worst they will squander and misuse their trust
and power. There is never enough money to satisfy them. As
Mahatma Gandhi once said: "World has enough to satisfy everyone's
need, but not everyone's greed."