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The fall of the giants

By creating instruments that enabled superfast trading out of loans, a huge supply push for mortgage lending was made. But it worked only as long as house prices were rising and interest rates were low.

Dipen Sheth
Dipen Sheth

Investment banks are collapsing like nine pins. At first it was Bear Stearns, then other worthies followed. Gold-plated names like Lehman Brothers and Merrill Lynch have passed into history. Morgan Stanley and UBS are fighting street rumours and bad press about their impending demise. Tomes are being written and debated about what’s wrong with the global financial system.

Why is it that the investment banks have failed more spectacularly than the traditional banks? I think the answer lies in the perverse and profligate marriage that they arrange between brilliant financial brains, and naked, aggressive and blind greed.

Letting a bank ‘trade out’ a mortgage is not a bad thing. Securitisation of assets is as old as banking. But designing a bundle (a collateralised debt obligation or CDO) of several such loans, creating a secondary market for trading such bundles and making windfall profits (or losses) on such trades is a recipe for increasing system risk. That is precisely what the financial whiz kids on the Wall Street did.

It was clear to them (and to many of us as well) that one could never lose money by creating a home mortgage. After all, if house prices were always rising, the loan was safe, even if the borrower defaulted, right? By artificially creating instruments that enabled superfast trading out of loans, they created a huge supply push for mortgage lending. This supply expansion opportunistically rode the easy money, cheap credit and housing boom era unleashed by several benign central banks throughout the world.

If this was not enough, investment banks became active players in the secondary trading of CDOs. They made huge profits by being early buyers of these bundles of their own creation and trading them out to other financial players. It worked, but only as long as house prices were rising and interest rates were low. As soon as the tide turned, mortgage foreclosures and interest rate resets kicked in. The first losses began to trickle in on many loan bundles, now held by players who did not have the faintest idea about how to tackle these losses. And CDO valuations crashed. The first casualties of the contagion were the investment banks, as they were left holding many CDOs that they had themselves designed, traded and profiteered from.

That world has come crashing down. I am not saddened, except that a lot of ordinary people have been misled into taking loans that they should not have, and many solid, traditional banks and insurance companies have bought bundles of such loans. Such is the contagion throughout the financial system that the US government has announced an assistance package of $800 billion to clean up the mess.

Perhaps investment banks should concentrate on what they were originally mandated to do: help businesses raise money, facilitate restructuring, mergers and acquisitions as well as advise investors on what to do with their money. They should certainly not be allowed to create exotic instruments that encourage financial misbehaviour. And they should do all of this at a much lower cost to their shareholders. And to the rest of us.

— Dipen Sheth, Head of Research, Wealth Management Advisory Services. He can be reached at dipen@wealthmanager.ws