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<b>Ashwani Windlass:</b> Crisis, not cause, being cured

The actors keep reappearing at alarming alacrity

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Ashwani Windlass Usa
Last Updated : Jan 29 2013 | 3:33 AM IST

The latest in the series of unravelling stories about the current financial crisis is former Nasdaq Chairman Bernard Madoff’s Ponzi scheme, which gobbled over $50 billion from its investors. His mantra: just promise great returns, find a way of escaping the regulator and keep paying out of the money coming in from the next investor, even if you are siphoning off the funds. This is the kind of stuff and more that economic bubbles are made of.

The global financial crisis only appears to be getting bigger and murkier as governments, the US in particular, struggle to stem this with unprecedented bailout packages. Tigers like Citi Group, Bear Stearns, Fannie Mae and Freddie Mac, AIG, and almost all major investment banks are in deep trouble. And it doesn’t look as if things are going to turn around quickly.

While the intensity may vary, global financial markets have been witnessing these upheavals with amazing regularity. While the wrong-doers have chased obscene profits, the authorities have done little to strike at its root cause. In fact, regulators have not practised the oversight expected of them and have ungrudgingly worked on bailouts with taxpayers’ money, already crossing over $3 trillion in the current crisis.

At the centre of each crisis is the issue of asset value, always a basis for lending. A fair market value of asset is generally the value at which the asset will trade in a competitive free market. Ideally, an asset should exchange at a valuation between a willing buyer and seller in an arms-length transaction after proper marketing where each one acts knowingly, prudently and without compulsion.

This is where the rub lies. There exists a different reality of nexuses and partnerships which come to the fore when a crisis surfaces. They also blatantly defy the fair-valuation basis, fudging the earning capability, and hence the economic value, of the asset.

In the 1980s, there was the infamous junk bond king Mike Milken and his Drexel Group who invented junk bonds. First, Milken convinced the banks of merit in lending against junk assets. He almost single-handedly helped build a junk bond market of over $200 billion, of which his corporation Drexel was a sole judge — in other words, values were ‘created’ by one interested party whose only agenda was reckless profiteering. This was followed by the dotcom bubble which burst in 2000. In this case, the same investment banks which are in the news today saw big business in the power of Internet. These investment banks flaunted newly-invented concepts, valuation models, and research to prove the veracity of the mind-numbing valuations of dotcom, technology and telecom companies. The power of Internet is infinite, they said. And therefore, valuation of the Internet companies extraordinary. The conventional fundamentals were consigned to the dustbin.

As reality dawned, the Nasdaq Composite Index lost almost 50 per cent of its value, wiping off over $5 trillion in market value of technology companies from March 2000 to October 2002. Once globally renowned corporations like Global Crossing and WorldCom just went down with the US Securities and Exchange Commission (SEC) for slapping a fine of millions of dollars on top investment banks like CitiGroup and Merrill Lynch for misleading investors. And don’t forget corporations like Enron who even sent one of the big five accounting firms, Arthur Anderson, into oblivion.

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The current sub-prime loans-led burgeoning financial crisis has engulfed assets of over $10 trillion worldwide. Banks rode the real-estate boom, lowered the bar to include sub-prime borrowers and successfully built a chain of buying and selling banks with complex financial instruments that had poor underlying borrowers and base assets. With underlying assets suffering in values after oversupply, the lid got blown off. Between the US government and central banks of advanced nations, this crisis has already taken the toll of over $2 trillion. These are the same central banks that kept the short-term rates low and completely failed in their oversight.

So it is déjà vu as the financial contagion sweeps the global markets, wiping off over 35 per cent of stock market valuations in the US, over 60 per cent in China and 30 to 50 per cent in emerging markets including India. There is, therefore, no escaping the truth that the driving force behind every crisis is the same — the same greed and the desire to find a way to escape the established financial fundamentals to multiply earnings quickly. This greed unscrupulously seeks insidious ways to show artificially created higher earnings and valuation potential. Sometimes infinite earnings are shown, as was the case with dotcoms and technology companies; or by creating instruments which, by definition, prohibit study of the underlying assets for establishing earnings, as is the case with the current sub-prime crisis.

The erring regulators have literally become subservient to them — first in turning a blind eye and, in fact, extolling their virtues as they throw up artificial growth numbers; and then in their bailouts with hundreds of billions of dollars of public money.

So even as you pat Fed chief Ben Bernanke or Treasury Secretary Henry Paulson for infusing almost $2 trillion of public money to save the financial system from collapsing, the underlying cancer remains unattended and unscathed. There will be more Milkens and Madoffs arriving on the scene with alarming regularity. Another few years and yet another rise of markets will follow, yet another great fall and another set of poor investors will be born.

Sadly in all of the above, what is lost is what Adam Smith said on the innate honesty of mankind in his first book, The Theory of Moral Sentiments, “How selfish so ever man may be supposed, that there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it, except the pleasure of seeing it.”

Did you ever hear the phrase — “their happiness” on the smart street!

*The author advises corporates and private funds globally on strategy, telecom and technology and is Chairman SA & JVs, MGRM Technologies Inc, USA

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First Published: Jan 10 2009 | 12:00 AM IST

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