Recent Crisis in the Financial Markets in the USA. High Leverage and Greed?

Dipock Mondal

With the bankruptcy of Lehman Bros and fire sale of Merrill Lynch at half the value in
balance sheet this week, preceded by the govt bailout of two giant housing finance banks
(FM and FM) and subsequent bail out of the insurance industry giant AIG problems
underlying the modern fin markets are being revealed. The basic problem is extreme
financial engineering that has been taken too far as people thought there was no limit to
such engineering, as we know to be case of engineering in other fields in the real world.
Engineering actually involves human skills and physical materials to get some products,
such as a bridge to connect two sides of a river, construct a house or an airplane to fly.
Financial engineering is devising financial products out of money to sale and buy by
financial houses mainly. The modern banking system was the first such engineering-
devising proportional reserve system in banking history. That is banks keeps 10-20% of
depositors’ money cash and near cash and they lend the rest to customers at interest rates
to cover the interest to be paid to depositors and dividend to the shareholders/owners.
This is engineering because as an individual no one would borrow and then lend to some
one even if they are well known. It is engineering because what we do not do
individually we allow banks to do that collectively on our behalf. Hence banks are
considered so essential in a modern economy, including their other services. The NBFIs
that have failed are another form of engineering because they are another layer of
intermediaries in that they are allowed to borrow from deposit seeking banks and others
and lend to creditors against value of properties in bundles, of which housing loans were
prominent.
The crux of the problem lies in human behaviour in doing business with “other peoples
money” OPM as called by some. In this system whereas banks are allowed to operate
with less than 1/10th as equity capital of the total value of the assets financed and acquired
in the B/S. The rest 9/10th or more are loans taken from depositors and others -a term in
finance called leverage. NBFI’s are allowed to operate even with equity capital further
way down- 1/30th to 1/40th (Bear Stern and Lehman). Leverage is known to cut both
ways as noted in finance textbooks. When goings is good the owners enjoy the extra
earnings as higher returns on equity. That is if the returnon on total assets of a bank was
1-2% in a year, with that kind of equity multiplier (high leverage) owners get 12-15%
return on equity. Note that if the value of the assets in the b/s goes down 2-3% owner’s
wipe out equity and creditors money is affected. Let me explain this high leverage issue
with a simple generalized balance sheet of a NBFI such as Lehman Bros.

Assets: Liabilities & equity

Mortgage backed securities $80 bn Loans from banks & others $ 97bn
Other investments 20 Equity 3
Total assets $ 100 Total liab and equity $100

Assume mortgage backed securities what ever was their assumed market value goes
down in price by 20%. Even if their initial value was 10% higher, a 20% decline cuts into
the book value by 10%, that is by $8 bn making its book value/market value equal to $72
bn. This loss in value exceeds the equity book value by $5 bn. The market value of the
equity could be much lower may be $1 bn or less when the crisis started unfolding.
Creditors who gave loans, mostly deposit taking banks, may suffer all of the $8 bn or
more loss depending on how much over valuation went on before at the time of sale of
the properties. In a bubble market the over valuation was significant as the report goes.

The question is why banks are allowed to operate with such low capitalization when so
many investors are willing to buy their stocks? That is matter of politics and not
economics or finance. And who are the politicians in all over the world? By and large
they are rich people and they maintain their hold on moneymaking machines all over the
world. Take the case of sponsors of banks and NBFIs in BD. Most of them made money
in real estate, construction, garments and earlier stock market booms. They could start
banks with low capital because of the western model of low capitalisation ratios
prescribed under the Basle-1 and now Basle-2, slightly higher than the former. By putting
Tk.20 crore you are collecting funds over Tk.1000 crore as deposits. In a weak
accountability culture this is openly inviting trouble unless there is strong supervision
from Bangladesh Banks. If the BB is not an independent agency then some of the friends
of the politicians may pull triggers to allow lending in certain sectors to help their cronies
to get more rich. What happened in the USA is the extreme form of deregulation ideology
practiced by the former Fed Chairman Alan Greenspan and that matched with the
Republican Bush administration. They allowed interest rate to remain artificially low to
encourage property buying by not so good standing borrowers. Even they borrowed the
5-10% initial down payment as equity from credit card loans with high interest charges.
So leverage was pushed down to the individuals level at its extreme that created rising
prices for housing property and banks found larger amounts to lend. There are allegations
that some of the banks even paid kickbacks to buyers in cars etc to buy. On a TV
interview recently Greenspan also blame greed as the main factor behind such
unprecedented financial crisis in the USA after the 1930. The Boston Globe in its
editorial on Sept 18, 2008 headlined as “ Shocked, shocked by greed”. It wrote; “ Greed
in Wall Street is like vanity in Hollywood, or ambition in Washington- an occupational
hazard that wont be cured anytime soon. Any way a healthy economy doesn’t require
saints. It does require transparency in markets; in other words people need to know what
they are buying and selling.” Transparency has vanished with all the financial
engineering through derivatives and all that. Paul Krugman, a famous economist and
author of the book: The Conscience of a Liberal termed the recent collapses stemming
from what he called in a NYT op-ed as “ shadow banking”.
The issue of corporate social responsibility also came into focus again this time. It is not
doing social works this time. How much money should CEOs and their high ups get for
leading these NBFIs to go down. Mr. Fuld who was CEO of Lehman for last ten years
got $45 million last year and the CEO of Merrill Lynch Mr. O’Neil got $130 million
before left it six months back. And due to some loopholes in the tax code they could
avoid paying income tax on such sky-high earnings and that amount last year was
reported as $20bn.
While we may not do much about greed in human beings specially those of the rich to
become richer we can certainly change banking laws to raise the burden on the equity
holders by raising capitalization ratios above 30%of assets at least so that depositors and
creditors are protected at least from the 30% decline in the value of assets in a banks
portfolio. That would encourage more equity offerings and may be more banks to
compete in the market. Despite such hoopla about the bastion of capitalism stock
investment is close 40% only in the USA and it is much lower in their European
counterparts. In Bangladesh we must debate how soon we can apply capitalisation ratios
based on higher ratios than what we have and express the requirements in percentage
terms rather than Tk.100 or Tk.200 crore.
On the other hand it is past long time when and for what interest on loans were allowed
as deduction before tax. Now is the time to put debt and equity on the same level and
make payments to the providers of funds on equal footings. That will also force
companies to issue more equity and share ownership with larger numbers of owners. It
seems we have a long way to improve democratic governance at both the level of nations
and the corporations. May be more economic democracy will lead to more political
democracy by the participation more non-rich in the world of politics of nations.