The recent events in the financial markets across the globe have left most people completely flummoxed. What makes the developments in the United States financial markets over the past fortnight extremely painful is the fact that it has comprehensively exploded our collective belief in the ability of the US to regulate its gargantuan financial markets by itself.
At this point in time experts have come to a view that this is by far the worst financial crisis to have visited the US since the Great Depression of the 1930s.
Consider this:
Experts predict that this financial crisis will result in a loss of at least $1 trillion and could probably end up at a far higher figure of $2 trillion! The resultant crisis, when it is full blown, is expected to severely hit the financial and banking sectors.
The worrying part is that experts predict that this crisis will last several years leading to a severe and persistent liquidity and credit crunch.
Contrary to the popular belief that the losses are limited only to sub-prime assets, the fact of the matter is that this crisis is spreading from sub-prime to prime mortgages, home equity loans, to commercial real estate, to unsecured consumer credit (credit cards, student loans, auto loans), to leveraged loans that financed reckless debt-laden leveraged buyouts, to municipal bonds, to industrial and commercial loans, to corporate bonds, to the derivative markets whose risk are indeterminate at any point in time and where counterparty risk -- and the collapse of many counterparties -- could well lead to a systemic collapse of all markets.
In short, the financial crisis is not limited to merely the sub-prime mortgages. In fact, this crisis is a result of an 'entire sub-prime financial system.'
And that to me is a crucial issue and central to this piece at hand.
The shortcomings of the US regulation
In fact, it is not the failure of the US financial markets that has caught analysts by surprise. It is the failure of the US regulatory mechanism, touted as infallible and followed as a model by regulators across the globe, which has caught analysts by surprise.
It is often remarked that Kolkata's rasgullahs will not contain Kolkata within them! Likewise, there is hardly anything Federal about the US Federal Reserve mechanism.
It may be recalled that the Federal Reserve system was formed in 1913 by an act of the Congress to serve as the central bank of the US. Interestingly, the Fed Reserve system consists of a seven-member board of governors and twelve Reserve Banks located in major cities throughout the United States.
In effect, the US Federal Reserve system is a cartel of these twelve major banks. I have in one of my previous columns -- Who cares for the dollar? Not the Fed, surely! -- pointed out that the ownership of these twelve banks remains a secret even to this day. And to this extent the working of the US Fed as a government agency suspect.
The seven-member board of governors is appointed by the US President and confirmed by the Senate to serve 14-year terms of office. Further, in making appointments, the President is directed by law to select a 'fair representation of the financial, agricultural, industrial, and commercial interests and geographical divisions of the country.'
These aspects of selection are intended to ensure representation of regional interests and the interests of various sectors of the public.
The primary responsibility of the seven board members is the formulation of monetary policy. The members constitute a majority of the 12-member Federal Open Market Committee (FOMC), the group that makes the key decisions affecting the cost and availability of money and credit in the economy. The decision of this group makes or breaks fortunes across the globe.
The other five members of the FOMC are Reserve Bank presidents of the twelve banks that form a part of the syndicate, one of whom necessarily is the president of the Federal Reserve Bank of New York.
This is where things begin to get interesting.
A bit of search on the Internet about the president and CEO of the now bankrupt financial giant Lehman Brothers Richard Fuld throws up something quite surprising.
Readers may be startled to know that Fuld was (he resigned last week) on the board of governors at the Federal Reserve Bank of New York as the elected representative of the 'member banks to represent the public.' This is akin to an Indian industrialist sitting on the board of the Securities Exchange Board of India!
If the distinction between the regulator and the regulated gets blurred, such disasters are bound to happen.
But where are the Chinese Walls?
Obviously, that makes the claim of independence in the functioning of the US Federal system quite hollow. Remember, one of the five outsiders in the FOMC is the president of the Federal Reserve Bank of New York with a lot of influence!
And it is not the US Fed alone that is at fault. Rather this -- collusion between the regulator and the regulated -- seems to be a pandemic amongst the regulators in the US.
Experts have been repeatedly pointing to the prevalence of collusion between the players and the market regulator by tolerating massive 'creative accounting' and other forms of 'window dressing of the balance sheet.' Obviously, this is to prevent firms from recognising and reporting their true losses.
This obfuscation of truth by the regulators is with an avowed objective of avoiding a financial meltdown. But in the process most of these earnings reports are not worth the paper they are written on.
Further, most financial institutions, thanks to the lax supervision by regulators are manipulating the value of illiquid assets without any fear totally disregarding accounting standards. It is as if fudging is almost being encouraged.
Auditors, especially the bigger ones, do not seem to have great track records on such issues. So, if the management, the regulators and the auditors -- the key players in any financial oversee mechanism -- collude, there is very little that can one can do.
With the auditors, regulators and the regulated having a convergence of purpose, it does not take a seer to say that the global system is not in very respectable hands.
Further, contrary to the belief that the financial markets have become more transparent, they have actually become opaque. One of the reasons put forth by experts for this is the development of new financial instruments, notably exotic derivative instruments which are both hard to value and price.
Many of these instruments are illiquid and are purchased over the counter rather than at an exchange. The value of such OTC derivatives, which involves banks as one of the parties to the transaction, exceeds $600 trillions yes, $600 trillion -- as on date!
And the response to all this skulduggery in the financial markets is to unleash newer accounting standards and issue fresh disclosure norms. Cancer cannot be cured by applying pain balms. Neither can there be a substitute for ethics and discipline.
Consequently, there is very little information about such instruments, their ultimate beneficiaries, the exact nature of risk they hedge and its possible negative impact on the beneficiary. All these issues are waiting to explode.
And they will, shortly.
When these instruments mature, the events of the last few days will seem like a mere trailer of a horror movie. The main movie will be much scarier and far more painful.
To conclude, the US financial system -- and, by extension, the global financial system -- is a creation of bad laws, regulators who are out of sync with the developments (especially in case of creation of newer instruments) in the markets, auditors who even before you wink are ready to sign on the dotted line and some corporates with lax ethics.
In short, the global financial architecture and the regulatory mechanism that goes with it are entirely dominated by crooks.
Strangely this was accepted by the others, especially in countries in India, as infallible and as a model worth emulating reducing us to the level of buffoons. In effect, global finance is a cross between crooks and buffoons.
The author is a Chennai-based chartered accountant. He can be contacted at mrv1000@rediffmail.com
