The Italian Prime Minister, Mr Silvio Berlusconi, has resigned after
17 years in office. Most people blame him for ruining his country's
economy. However, Italy has not been alone: Greece, Spain, Ireland,
Iceland or even the US are in no better condition.
For instance, Iceland had a reputation of very low unemployment and an
equally low crime rate. Its population is about only 320,000; yet, its
GDP was over $13 billion in 2010. When its banks were deregulated,
they took loans 10 times the country's GDP and ultimately incurred
losses of a $100 billion. Now, Iceland is a country in distress.
I doubt whether many people have seen the documentary film Inside Job
even though it has won many awards, including the Oscar Academy award
in 2011. The film review and criticism website called ‘rotten
tomatoes' gave it an extraordinary approval rating of 97 per cent. The
film's concern was about the global economic crisis of 2008 which cost
tens of millions of people their savings, their jobs and their homes.
GAMBLING ON DERIVATIVES
It all started when bankers heard of a new phenomenon known as
derivatives. Actually, trading in derivatives is age-old. For
instance, farmers take loans from the village money lender with a
pledge to repay it with grain when the harvest comes in. That is
risky: The prices may rise and the farmer may lose; alternately,
prices may fall and the lender may lose. However, the system, based it
was on a single transaction, has worked well.
In recent years, the system has become far more sophisticated. Complex
computer calculations indicated that by combining a large number of
risky transactions into what were called Collateral Debt Obligations
(CDO), the overall risk may be reduced. The whizkids forgot to mention
that their dreams worked only for small changes and they could become
a nightmare when movements were large.
However, many bankers who knew little about mathematics and less about
derivatives suddenly were fascinated by the possibility of making huge
profits by trading in derivatives. For instance, the venerable owners
of the ancient Barings Bank – bankers to the monarchs of Britain –
were fascinated by the winnings that their agent Nick Leeson produced.
When his gamble failed, the bank went broke. A traditionally
conservative bank which had operated for centuries became bankrupt.
In the 1970s, a bond trader had to work as a train conductor at night
as his income was not sufficient to look after his three children. Ten
years later he was making millions of dollars. Understandably, bankers
thought – quite wrongly as it turned out – that they had discovered
the Midas touch. Unfortunately, no lessons have been learnt from the
disasters that ensued.
LETHAL CHANGE IN LAW
For forty years, the Glass-Steagall Act of 1933 kept the US economy
stable by regulating banking and prohibiting them from speculating
with depositors' money. Once the bankers and the financiers tasted the
illicit fruits of derivatives, that salutary act was repealed by the
Gramm-Leach-Bliley Act of 1999. In fact, even before that Act came
into force, the CitiBank was allowed to merge with Travelers Insurance
to become CitiCorp. That was not legal but was permitted in the
expectation that the Gramm-Leach-Billey Act will come into effect.
That did happen a year later to clear the way for many more future
mergers of similar type.
That deregulation doubled the National Debt of the US and tripled the
rate of unemployment. Yet, credit rating agencies gave very high
ratings, even AAA ratings, for derivative products and for housing and
savings institutions like Freddie Mac and Freddie Mae, both of whom
collapsed within days of receiving such extraordinary ratings. The
tragedy was not that the rating agencies made any mistake but that
they would not admit it.
“What we gave was merely an opinion” was their defence. Further, those
that created this disaster were not punished. They got huge bonuses
from over $50 to as much as $485 million as a parting gift. These
disasters were not unforeseen. Ms. Brooksley Born, who was Chairman of
the Commodity Futures Trading Commission (CFTC), proposed regulation
of derivatives trading. She was overruled by her boss – an even more
famous economist who is a household name.
Three equally famous topmost officials of the government – all former
employees of large banks – formally issued a statement condemning
Born. They said they seriously questioned the scope of the CFTC's
jurisdiction and insisted that derivatives remain unregulated. I am
not mentioning their names – you can find them out by seeing the
documentary film.
THE MELTDOWN
As Professor Satyajit Das has stated, these financial titans initiated
a titanic battle to prevent regulation of derivatives. In fact, Dr.
Raghuram Rajan presented a thoughtful paper titled Has Financial
Development Made the World Riskier? He was ignored. Thus, bankers who
had never heard of CDOs bet on riskier Credit Default Swaps (CDS) – a
new insurance that protected them if the CBOs failed. Some banks
actually sold CDS as legitimate investments on which they themselves
took bets their own CDOs will fail.
In year 2008, they did fail. Lehman Brothers and the AIG, two of the
largest corporations of the US, collapsed even as they had credit
rating of A2. As pointed out before, the perpetrators were well
rewarded. In fact, the whole thing was a giant Ponzi scheme which
permitted huge private gains at the expense of an equally huge public
loss. It created something out of nothing. Banks became so powerful
that they had captured the political system of the US.
In India, the Reserve Bank of India has been cautious. But Nifty
allows trading in derivatives, assuring us that it is not risky
because it has been designated in rupees. That, I believe, is a farce.
(To be continued)
--------------------------------------------------------------------------------
The award-winning film, Inside Job, reveals how banks scuttled
attempts at regulating trade in derivatives. What's worse, those
responsible for the 2008 meltdown have not been brought to book.
--------------------------------------------------------------------------------
This is 316th in the Vision 2020 series. The last article appeared on
November 5.
(This article was published in the Business Line print edition dated
November 19, 2011)
--
CA Ramachandran Mahadevan,M.Com.,F.C.A.,
17 years in office. Most people blame him for ruining his country's
economy. However, Italy has not been alone: Greece, Spain, Ireland,
Iceland or even the US are in no better condition.
For instance, Iceland had a reputation of very low unemployment and an
equally low crime rate. Its population is about only 320,000; yet, its
GDP was over $13 billion in 2010. When its banks were deregulated,
they took loans 10 times the country's GDP and ultimately incurred
losses of a $100 billion. Now, Iceland is a country in distress.
I doubt whether many people have seen the documentary film Inside Job
even though it has won many awards, including the Oscar Academy award
in 2011. The film review and criticism website called ‘rotten
tomatoes' gave it an extraordinary approval rating of 97 per cent. The
film's concern was about the global economic crisis of 2008 which cost
tens of millions of people their savings, their jobs and their homes.
GAMBLING ON DERIVATIVES
It all started when bankers heard of a new phenomenon known as
derivatives. Actually, trading in derivatives is age-old. For
instance, farmers take loans from the village money lender with a
pledge to repay it with grain when the harvest comes in. That is
risky: The prices may rise and the farmer may lose; alternately,
prices may fall and the lender may lose. However, the system, based it
was on a single transaction, has worked well.
In recent years, the system has become far more sophisticated. Complex
computer calculations indicated that by combining a large number of
risky transactions into what were called Collateral Debt Obligations
(CDO), the overall risk may be reduced. The whizkids forgot to mention
that their dreams worked only for small changes and they could become
a nightmare when movements were large.
However, many bankers who knew little about mathematics and less about
derivatives suddenly were fascinated by the possibility of making huge
profits by trading in derivatives. For instance, the venerable owners
of the ancient Barings Bank – bankers to the monarchs of Britain –
were fascinated by the winnings that their agent Nick Leeson produced.
When his gamble failed, the bank went broke. A traditionally
conservative bank which had operated for centuries became bankrupt.
In the 1970s, a bond trader had to work as a train conductor at night
as his income was not sufficient to look after his three children. Ten
years later he was making millions of dollars. Understandably, bankers
thought – quite wrongly as it turned out – that they had discovered
the Midas touch. Unfortunately, no lessons have been learnt from the
disasters that ensued.
LETHAL CHANGE IN LAW
For forty years, the Glass-Steagall Act of 1933 kept the US economy
stable by regulating banking and prohibiting them from speculating
with depositors' money. Once the bankers and the financiers tasted the
illicit fruits of derivatives, that salutary act was repealed by the
Gramm-Leach-Bliley Act of 1999. In fact, even before that Act came
into force, the CitiBank was allowed to merge with Travelers Insurance
to become CitiCorp. That was not legal but was permitted in the
expectation that the Gramm-Leach-Billey Act will come into effect.
That did happen a year later to clear the way for many more future
mergers of similar type.
That deregulation doubled the National Debt of the US and tripled the
rate of unemployment. Yet, credit rating agencies gave very high
ratings, even AAA ratings, for derivative products and for housing and
savings institutions like Freddie Mac and Freddie Mae, both of whom
collapsed within days of receiving such extraordinary ratings. The
tragedy was not that the rating agencies made any mistake but that
they would not admit it.
“What we gave was merely an opinion” was their defence. Further, those
that created this disaster were not punished. They got huge bonuses
from over $50 to as much as $485 million as a parting gift. These
disasters were not unforeseen. Ms. Brooksley Born, who was Chairman of
the Commodity Futures Trading Commission (CFTC), proposed regulation
of derivatives trading. She was overruled by her boss – an even more
famous economist who is a household name.
Three equally famous topmost officials of the government – all former
employees of large banks – formally issued a statement condemning
Born. They said they seriously questioned the scope of the CFTC's
jurisdiction and insisted that derivatives remain unregulated. I am
not mentioning their names – you can find them out by seeing the
documentary film.
THE MELTDOWN
As Professor Satyajit Das has stated, these financial titans initiated
a titanic battle to prevent regulation of derivatives. In fact, Dr.
Raghuram Rajan presented a thoughtful paper titled Has Financial
Development Made the World Riskier? He was ignored. Thus, bankers who
had never heard of CDOs bet on riskier Credit Default Swaps (CDS) – a
new insurance that protected them if the CBOs failed. Some banks
actually sold CDS as legitimate investments on which they themselves
took bets their own CDOs will fail.
In year 2008, they did fail. Lehman Brothers and the AIG, two of the
largest corporations of the US, collapsed even as they had credit
rating of A2. As pointed out before, the perpetrators were well
rewarded. In fact, the whole thing was a giant Ponzi scheme which
permitted huge private gains at the expense of an equally huge public
loss. It created something out of nothing. Banks became so powerful
that they had captured the political system of the US.
In India, the Reserve Bank of India has been cautious. But Nifty
allows trading in derivatives, assuring us that it is not risky
because it has been designated in rupees. That, I believe, is a farce.
(To be continued)
--------------------------------------------------------------------------------
The award-winning film, Inside Job, reveals how banks scuttled
attempts at regulating trade in derivatives. What's worse, those
responsible for the 2008 meltdown have not been brought to book.
--------------------------------------------------------------------------------
This is 316th in the Vision 2020 series. The last article appeared on
November 5.
(This article was published in the Business Line print edition dated
November 19, 2011)
--
CA Ramachandran Mahadevan,M.Com.,F.C.A.,
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