The Collapse of Wall street

The articel was published in IIM Shillong finance Magazine Niveshak August 2009 edition (page 52).

Introduction

The current financial crisis has been described by many as unprecedented in living memory. It was so sudden and so powerful that many were caught unaware. Many tumbled and could not climb back up. The “golden period of finance” is said to have come to an end. A new world order is emerging from the ashes of the old one. But who was responsible for it. Was it due to the bozos at investment bank or the louts among the regulators or were it the nimrods in the banks who played with our lives. Lets go back and find out.

Lessons from 1929 collapse

Stock market crash of October 1929 still inspires political and economic debates. "Many people blamed the crash on commercial banks that were too eager to put deposits at risk on the stock market. " We can’t be sure if it was a credit inspired economic bubble which burst. But we know that it very quickly sucked out huge amount of consumer credit and they instantly stopped spending. The collapse of Wall Street might have acted as the precursor to the great depression.

The banking industry was divided in two segments, lending firms and brokerage firms i.e. investment banks. To rein in the stock market, the uptick rule which prevented the short sellers driving the bear market further down, was implemented after 1929 crash. It also inspired Keynesian economic which says that Governments should spend the money they don’t have in order to save capitalism.⁶ It is this theory which emerged as saviour of world economy in 2008.

History of USA policy

After WW II, international monetary policy revolved around USA as it agreed to make dollar convertible to an equivalent amount of gold. Subsequently dollar emerged as the reserve currency of the world.  In early 70’s USA failed to honour its promise and this system came apart. However dollar remained as the reserve currency of the world due to lack of other currency options.

From 1960s USA adopted a strategy of diverting its attention from core manufacturing to Finance, Insurance and Real Estate (FIRE) sectors. The economy became overly dependent on services sector. The savings rate of US consumer declined from 11% in May 1985 to -2.7% in Aug 2005.¹

"In two generations it seems that we've lost the culture and habit of savings," says Nancy Register, of the Consumer Federation of America. Federal Reserve Chairman Alan Greenspan warned that the low savings rate is impairing the nation's long-term economic prospects. An improved savings rate would provide investment money for businesses, which would create jobs, he said. ² Hence the absence of diversified economy placed it on a high risk of finance and real estate markets collapsed.

USA engaged in military driven trillion dollar expenditure instead of concentrating these funds in high end manufacturing and technological advancements. The domestic market was ignored and the power shifted from Detroit to wall street.³

Bursting of housing bubble and credit crunch

The nadir of Soviet central planning was supposed to be a heap of left shoes without any right pair to match them. The housing boom of USA which started in late nineties witnessed a series of empty houses in 2008 without any buyer for them. Many people were lured into buying home with “teaser rate mortgages” and “Adjustable Rate Mortgages (ARM).” As interest rates climbed up, they found it difficult to pay interest as the instalments rose substantially. This resulted in increased home loan foreclosure rate.

“One in six mortgages is upside down, and 50 million families can’t pay off their credit card bills. Last year one out of seven households was called by a debt collector. More than a million people declared bankruptcy. Foreclosure has reached levels unmatched since the Great Depression.” ⁷   Washington was forced to bail out two of the biggest US mortgage banks, Fannie Mae and Freddie Mac, to prevent the American home loan system from collapse. Lehman brothers which had invested most in the American real estate of all banks saw its portfolio shrink very fast and could not sustain in the end.

As economy first began to stall, the underlying problem of consumer and corporate indebtedness in USA totalled about 380% of GDP, nearly two and a half times the level at the beginning of the Great Depression.

Market collapse and decline of organisations

The financial market witnessed a lot of consolidations. J P Morgan chase bought Washington Mutual and Bear Stearns. Merrill Lynch was bought out by Bank of America. Citigroup acquired Wachovia. Lehman Brothers filed for bankruptcy. Investment Banks like Morgan Stanley and Goldman Sachs converted themselves from securities firm model to financial holding company model i.e. commercial banks.

Thus ended the last of five standalone investment banks in Wall Street, marking the end of an era which has started with the Glass-Steagall act of 1933 when investment banking was separated from street banking. Bill Isaac, a former chairman of the Federal Deposit Insurance Corporation, said “They are the only two left and the handwriting was on the wall, It's a shame because this country was built, in part, on risk-taking by Goldman and Morgan and by a whole bunch of firms before them.”

The conversion allowed them to take public money but bought them under regulatory scrutiny. The risk which their traders could take was severely limited and the amount of money which the firms could borrow was severely restricted.

Many countries in the world including El Salvador and Iceland suffered. The depreciation of krona along with the exposure of the large banks of Iceland (the total assets of banks is 10 times the GDP of Iceland)⁸ to huge foreign debt and high inflation created major problems for the country.

Ordinary citizens saw their investments melt away in front of them. The borrowers had no access to credit. The unfortunate participant in pension fund scheme saw his/her life’s savings evaporate because a trader in some distant place decided to take too much risk.

Huge stimulus packages were announced all over the world to suck up toxic underperforming mortgage-backed assets. IMF says that world has already spent $11.9 trillion to fight the financial crisis. That comes out to be 1,779 pounds per person on this planet. British government led by Mr. Gordon Brown started nationalising financial institutions such as Northern Rock, Bradford & Bingley etc  which was followed all over the world. Britain witnessed its first bank run case after 1870s. We again saw the resurgence of state capitalism.

Rise of new world order

Voices are being raised to replace dollar as the reserve currency. The Commission of Experts of the UN has suggested a gradual move from the US dollar to the SDR. It wants to increase the share of SDRs in total international reserves in a gradual manner starting from an issue of $ 250 billion. Hong Kong is issuing bonds denominated in renminbi (currency of China). Countries are starting to use their currencies in mutual trade instead of dollar (China and Brazil). USA would be having harder time financing its trade deficit. Would China be the next superpower? Only time would give a definite answer for that.

The shop till you drop attitude of Americans is showing signs of change with personal saving rate rising to about 7% from less than 1% a year before. With increase in savings, spending is less. As consumer spending accounts for 70% of USA spending, the economy is going to contract in short term due to increased saving rate. Leading economists call it “the paradox of saving”. The new America is going to inherit more from the “savers” which would spur investment of long term nature in the American economy, thereby reducing trade imbalance.⁹

Current condition and outlook

The financial results of the recent quarter show that few things are getting worse and many are getting better. However the consolidated sales of the companies are still below what it was last year. Banking sector credit in India grew at 27 % in 2007-08, 18%in 2008-09 and is expected to grow at 12-14% in 2009-10 as per Crisil.

Financial products have been brought under great regulatory control now. Hopefully like foods and beverage, financial consumers would be having greater options and protection. When the market picks up, the consumer is likely to look for one thing in any financial product-‘trust’, thanks to Mr. Bernie Madoff.

Kabirdas, the famous medival saint said “Kadli seep bhujang much, swati ek gun teen.” When the first drop of rain falls on the banana tree, it forms camphor, in the oyster’s mouth, it forms pearl and in the snake’s mouth forms venom. It is our choice what financial system do we want to gift to future generation, venom or pearl.