<b>A V Rajwade:</b> Masters of the universe

The rainmakers who preached the mantra of complex finance to transform business couldn’t save themselves and jeopardised the world in the bargain.

Just about a month back, former chief economist of the IMF, Kenneth Rogoff, had predicted the collapse of a large US bank. His prediction came all too true when, on Monday, Lehman Brothers, the 158-year-old and fourth-largest US investment bank, filed for bankruptcy. With total assets of $640 billion, this would be the largest ever bankruptcy filing in history. Those who charged millions of dollars as fees for advice on restructuring or selling others’ businesses could not manage to save their own! The weekend also witnessed the takeover of Merrill Lynch by Bank of America. And, the American International Group (AIG), America’s largest insurance company, received a $85-billion rescue package from the authorities on Tuesday. How the dominoes are falling!

 

Previous records for the largest bankruptcy filings were held by WorldCom and Enron — in both cases it was fraud by the top management that led to bankruptcy. In Lehman’s case it was probably arrogance: A little over a year back, when HSBC had disclosed its worries about the property sector, Lehman increased its bets through a $20-billion-plus acquisition of a property company. In the last couple of weeks, it spurned offers from the Korea Development Bank and China’s CITIC to invest capital on grounds that the price offered was too low. The word I saw repeated a dozen times in the last few days in relation to Lehman’s bankruptcy is ‘hubris’ (exaggerated pride). In retrospect, Lehman’s chairman was prophetic in an interview published in Euromoney in July 2005. He said, “I worry that we could get arrogant. If you get arrogant, you lose your way, and start making mistakes”. Those words will haunt him for a long time.

The banking crisis started with defaults in the sub-prime mortgage market, a little over a year back, and the consequential losses on credit derivatives based thereof. The aggregate mark-to-market losses for banks are around $500 billion, leading to the demise of Bear Stearns, the takeover of Freddie and Fannie, the bankruptcy of Lehman brothers and the huge bailout of AIG. I would not put Merrill’s takeover by Bank of America in the same bracket: BankAm paid about 30 per cent above the market price, but still less than 50 per cent of Merrill’s market value just about a year back. Merrill’s desperation showed in the way assets were sold at 20¢ on the dollar, that too with 75-80 per cent financing!

To my mind, there are some interesting perspectives to these events:

 

 

The ‘Greed is Good’ mentality, at some stage, ends up consuming the greedy themselves. It also bred a culture where one measured self-worth only by the money one was making. The chairmen of both Bear Stearns and Lehman fired their immediate number twos, placing the blame on their subordinates who, incidentally, happened to be their closest friends — obviously, they did not suffer from weaknesses like loyalty! While technically banking losses can be attributed to weaknesses in risk management, they can equally be attributed to a lack of character in the leaders of banking. (Ironically, J Pierpont Morgan, arguably the first modern investment banker, gave more importance to character than money and property in choosing his clients.)

 

The money and bonuses needed to enjoy $-2,000 meals and $-5,000 bottle wines could only be earned through trading profits. Trading, of course, is a euphemism for what, in an earlier, more honest, era, used to be called speculation or satta. In fact, there is little to distinguish between banks’ trading books and hedge funds. Banking as perceived and practiced by major global banks, commercial or investment, is now very far removed from the definition in our venerable Banking Regulation Act, namely, taking deposits for lending money.

 

Increasingly, trading in genuine assets — currencies, bonds or equities —was not enough to satisfy the hunger for eight-digit bonuses. Complexity had been introduced in various investment and derivative instruments under the guise of “innovation” aimed at “satisfying client demands”. But much of this complexity was aimed at making risks and pricing of instruments opaque and non-transparent. Ultimately, the complexity of the dozens of three-letter instruments (SIVs, VIEs, CDOs, CLOs, ABS, MBS, ARM, ALT-2, etc — there were some four letter words as well, CPDO for example), all rated AAA by pliant rating companies overwhelmed the creators themselves. Clearly, they had created a Bhasmasur, but had no access to Vishnu for rescuing them.

I recall Professor Jagdish Bhagawati (author of In defense of Globalisation) arguing more than a decade back that capital account convertibility for developing countries was a “conspiracy by Wall Street”, with the backing of US treasury and the connivance of the IMF and the World Bank (my memory is that this was before the Asian crises, whereafter the Bretton Woods twins would become far more muted on the subject). They also helped companies like Enron and Parmalat to hide losses and cheat investors and helped clients to evade taxes. The aggressive pursuit of profits, irrespective of the effect this may have on the less knowledgeable, on those less able to understand and manage the risks, continued unabated. The sub-prime crisis, which has now consumed so many of its protagonists (Lehman itself was a specialist in mortgage-backed securities), was the result of the greed of perhaps a thousand real estate brokers marketing loans known to be unserviceable and bankers practicing the “originate and sell” lending model. The tragedy of those who have been dispossessed of their houses may well turn out to be only a small part of the total cost to the world economy. If the recent events lead to an even greater reluctance on the part of banks to lend, we could well be facing a global recession.

One other point worth keeping in mind: Reports convey that many of the unsecured creditors of Lehman are Asian banks and financial institutions. In fact, it is Asian investments in dollar assets that have been the biggest prop to the US dollar. The bankruptcy of Lehman could lead to Asia getting disenchanted with US dollar assets. It is worth recalling that, in the first few hours of trading on Monday morning, the dollar slumped against the euro, the pound and the yen. It has recovered since — but for how long?

avrajwade@gmail.com