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Saving Wall Street

After the turmoil, the US financial services sector waits for a bail-out. Whatever happens from here, it’s the death of blueblooded investment banking as we knew it.

Rachna Monga | Print Edition: October 19, 2008

The headline easily could have been Saving America. Or even Saving the Global Economy. The carnage on Wall Street hasn’t ended with Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, Washington Mutual, et al being felled by toxic securities that ate into their reserves. Many more venerable institutions will fall, even if the Bush administration’s $700-billion bail-out package gets the US Congress’ green signal.

The destruction on Wall Street, coupled with rising unemployment, plunging housing sales and an overall cut in business and consumer spending, will bring the US economy down to its knees. The recession there will spread rapidly to other economies. “I have never seen anything like this. It’s a fundamental crisis of confidence,” shrugs Raju Panjwani, Chairman & CEO, Epitome Global Services, a financial services outsourcing firm. Panjwani should know. A former Managing Director at Morgan Stanley, he has spent nearly 22 years on Wall Street.

So, is it just good old greed that veered out of control that’s responsible for the collapse? Or is it poor regulation? Marti G. Subrahmanyam, Charles E. Merrill, Professor of Finance, Economics and International Business at Stern School of Business in New York, points out that the flaw is not in the broker-dealer model per se but in the revenue mix of these banks, which was tilted towards earning huge proprietary income.

“Most of the major investment banks took heavy unhedged exposure to credit derivatives—both Collateralised Debt Obligations and Credit Default Swaps—which were not under the direct control of either the Federal Reserve or the Securities and Exchange Commission. A free and an open market is good, but when it poses systemic problems of the kind we are witnessing today, there is a limit to how far you can argue for an unregulated market,” says Subrahmanyam.

It is inevitable that the pendulum will swing in the other direction in the years ahead and US financial markets will become much more regulated than today. Wall Street will never be the same.

 From big bucks to bail-outs

The housing bubble: Till 2006, rising real estate prices encourage people to buy houses; some buy more than one house, anticipating that prices will continue to rise. Even those who can’t afford to own a house were given sub-prime loans.

Defaults & write-downs begin: As loan defaults rise, the value of subprime loan securities and instruments falls; banks that loaded the instruments start provisioning for the reduced value. The write-down forces a few hedge funds to suspend redemptions.

A hole in the bubble: By 2007, the trend reverses as an oversupply of houses leads to a drop in housing prices. Unable to sell properties at a higher rate, house-owners default on their loans. Rising interest rates only hamper their capacity to pay back.

Banks go belly-up: The provisioning for losses and write-downs of asset values eats into the profitability of banks; they start pruning jobs to cut costs. But that’s not enough. Bear Stearns is swallowed by JP Morgan Chase…the carnage begins.

Banks get sucked in: Housing mortgage companies package the sub-prime loans into complex financial instruments; rating agencies term them safe; investment banks and hedge funds lap them up; they do their own financial engineering.

The big bail-out: As money supply dries up from the financial markets, central banks pump in money. The US Federal Reserve chalks out a $700-billion plan with the hope that dud sub-prime securities across banks can be pooled and kept separately.

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