financial crisis in us

8/8/2019 Financial Crisis in US

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CREDIT DEFAULT :: FINANCIAL CRISIS IN US ::

Beginning of the Endof the

US Economy in FULL AND FINAL

While attention is being paid on the US SUB-PRIME , homemortgage loans default crisis as if it were the centre of thecurrent financial and credit crisis affecting the banks in theWest and much bigger problem is being slowly coming outi.e.the High Risk Collaterized Mortgage Obligations in shortCMOs ( not to be confused with our CreditMonitoring/ Marketing Officers in our PSU Banks). CMOs have aoverall market size of around US$50000 BILLION plus.

Credit Default Swaps w as invented by Ms. Blythe Masters, hiredby JP Morgan Chase Bank who developed this high-risk bankingproduct and in due course caught the eye of all leading USBanks and CDS has revolutionalised the entire US and EuropeanBanks.

A Credit Default Swap is a derivative or agreement betweentwo counterparties, in which one makes periodic payments tothe other and gets promise of a pay off if a third party defaults.The first party gets credit protection and is called Buyer . The

second party gives credit protection and is called the Seller.The third party the one that might go bankrupt or default, isknow n as the Reference Entity. CDS became very popular asthe risk taking behaviour in the US banks zoomed in the lastdecade and the argument put forth by the US bank heads wasthat they could spread the risk of CDS around the globe andleverage their new product (CDS) .

Although this new product in many ways looks like aninsurance policy, as they can be used by their owners to hedge,

insure against a default on a debt; but as there is norequirement to actually hold any asset or suffer a loss, creditdefault swaps can be used for speculative purposes, which isactually the main reason for today’s financial mess in USA.

Laurence Summers one time head of Harvard once said thatderivatives bought for no valid reason are like weapons of mass destruction and unless the derivatives contracts are





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collaterized or guaranteed, their value depends on the creditworthiness of the counter parties to the transaction. Althoughthe parties to the transaction record profits / losses quite oftenin huge volume only in their current statements without even apenny changing hands. The contracts are limited only by theimagination of the men who are parties to the transaction.Thereby in addition to spreading the risk among creditderivative transactions they are amplifying the riskconsiderably in all these transactions.

The US financial market after being hit severely by the Sub-Prime Crisis is now about to face this massive CDS crisis whichmeans that out of a volume worth of US$50000 – US$60000billion CDS around US$1000 – US$5000 billion is in crisis as of today making it one of the biggest financial crisis the mankind

has ever faced. The reasons for this crisis is mainly due tounregulated lending, not keeping proper records fortransactions, no preventing vigilance measures, absence of onsite and off site surveillance mechanisms. There is no systemto check as to whether the sellers have the assets / creditworthiness to pay out in case of defaults. One of the reasonsas experts claim is that the previous Fed Reserve ChairmanAlan Greenspan who permitted this product to be developentirely without any supervision and there was no regulatorybody to watch , monitor, control these markets. The greed forhefty pay-checks, bonuses, stock options by the CEOs resultedin taking unacceptable risks and the result of such actions is forus to see. It w as due to these inaction The FED Reserve had tobail out during the first quarter of 2008, Bear Stearns and JPMorgan Chase Bank who were one among the biggest buyerand seller of CDSs as the Fed had their own fears about thismarket as they have already failed in monitoring the SUB-PRIME crisis.

A surge in corporate defaults w ill now leave swap buyers tryingto collect hundreds of billions of dollars from their

counterparties and this will complicate the financial crisis,triggering in due course numerous disputes, law suits asbuyers battle with sellers over the technical definition of default :: this requires proving which bond or loan holderswere not paid and the amount of payments due. Some expertsfear that this could freeze the entire financial system. Now thecrisis will most likely start with hedge funds that w ill be unableto pay the banks for contracts tied up to say atleast US$150-





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300 BILLION in defaults. Banks w ill try to pre-empt thisdefault by demanding the hedge funds to pledge morecollaterals for future losses. This may not work out as many of the hedge funds do not have any assets ( liquid cash ) to meetthe bank’s conditions.

The Basel Committee on Banking Supervision in its recentreport has remarked that thousands of billions of dollars incredit swaps traded by hedge funds pose a threat to thefinancial markets around the world and as it is difficult todevelop a clear picture of which institution or bank are theultimate holders of some of the credit risk transferred, it can bedifficult to quantify the amount of risk that has beentransferred. In a typical CDS deal, a hedge fund w ill sellprotection to a bank, which w ill then resell the same protection

to another bank, and such dealing w ill continue some times in acircle. This has created a huge concentration of risk and thisrisk keeps spinning around and around and only a handful of dealers are in know of all these transactions. One of thereasons as one dealer puts it is that banks have a vestedinterest in keeping the swap market opaque, because asdealers the banks have a high volume of transactions, givingthem edge over other buyers and sellers. Since manycustomers do not necessarily know where the market is, onecan charge them much wider profit margins. And as the bankstry to balance the protection they have sold with credit defaultswaps they purchase from others, either on the same companyor indexes. The idea is mainly to take a profit on each tradeand avoid taking on the sw ap risk. The most respected quoteon these transaction is Banks are just like bookies. Bookiesdon’t want to bet on games. Bookies just want to balance theirbooks . That’s why they are called bookies. As the USeconomy is contracting with more and more bankruptcies isbeing spread there is a big chance that many who bought swapprotection will land in courts trying to get their payouts. Thatw ill be the beginning of the end of US Economy in full and final.

In other words remember the old village saying of our countryNothing Regulated has failed and Nothing Free has succeeded.One hopes that our Honourable Financial Minister will learn athing or two before taking a decision of merger of nationalizedbanks in our country as such mergers w ill result in having hugebanks whose actions / transactions w ill be largely un regulatedas most of the banks that became bankrupt in US / EUROPEand Japan ( in the 90’s ) were very large financial corporations





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which suffered huge losses due to absence of adequate on siteand off site surveillance systems, regulations etc. As thephysicians normally say Anything obese is not healthy howeverwatchful you are ; you are bound to get infected any time if youare obese these words are not only to individuals but also toinstitutions. We hope better sense will prevail upon our FMbefore taking a decision on merger of nationalized banks.India being the 7 th largest nation in the world 30 banks withonly 38000 + branches will no way suffice the needs andaspirations of 1.2 billion population . There is a really goodcase for opening of more number of branches in the Tier II ,II I, IV cities. The prudent approach and implementation of Narasimhan Committee have worked in India. But Despitebeing computerized, networked and introducing the Basel I & II committee norms the Leading US and European Banks have

failed and gone bankrupt due to the total absence of Inspection, Audit, Surveillance Mechanisms and StatutoryRegulatory Authority to keep a close watch on their moves andtransactions.

Jai Hind

V S Thiagarajan

financial crisis in us

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