International expert and consultant on financial derivatives Satyajit Das is the author of several standard reference books on the subject and someone who predicted the credit crash in a paper written in February last year. He talks to Mint on the impact of the credit crunch in the financial markets. Edited excerpts:
Do you think the global credit crunch will get worse?
There’s a very serious risk it’ll get worse. That’s because this is not just a subprime crisis—it’s a crisis of the huge amount of leverage built up over the last decade and a half. There are several reasons for that mountain of debt.
First, the entry of low-cost producers such as Russia, India and China into the global economy helped keep inflation down. Interest rates could accordingly be kept low without fear of inflation. And low interest rates led to more borrowing.
Second, countries such as China and even India prefer to save rather than spend. So, the money found its way into the US, keeping interest rates low there and pushing up asset prices. People then started borrowing against the higher asset prices, creating a pyramid of debt.
What’s happening now is that the process is getting reversed. About $100 billion (around Rs4 trillion) worth of assets have already been written off. But bank estimates of the tainted assets range from $300-500 billion and that is yet to be written off.
It’s not just a subprime problem—the same flawed practices in lending to the sub-prime segment were repeated across other mortgage categories. Low teaser rates on mortgages will have to be reset and I estimate that banks may eventually have to take $1-2 trillion dollars of mortgages back on their balance sheets.
That will lead to a severe restraint on lending, which will feed back into the real economy, lowering output and employment. Also, I believe countries such as Spain, Ireland and the UK have identical problems to the US and we’re seeing the first signs of that.
Moreover, it’s not just limited to mortgages—private equity loans, commercial property and corporate lending face similar issues. Too much debt has been built up and the leverage will have to be reduced by selling assets.
Will the Fed’s cutting interest rates help?
I think the central banks realize that asset prices are too high. But a crash will be disastrous in the current environment, so they have hit upon the idea of allowing inflation to do their work for them. So they don’t mind reducing interest rates, even if that stokes inflation. If asset prices stay where they are but inflation rises, then the real value of assets will come down.
Banks will be able to borrow cheaply and park their funds in bonds at a profit, since the yield curve will steepen because of inflationary expectations. That will enable banks to be recapitalized—you can’t depend only on sovereign wealth funds to do that. And it will help borrowers pay back their loans, because they’ll be worth less in real terms.
But I think this is a high-risk strategy, the risk being stagflation. Japan tried this strategy in the early 1990s and it didn’t work.
Why has the turmoil in the credit market affected stocks?
For several reasons. One, investors are leveraged and they sell off liquid assets like stocks when they need money.
Two, there has been a lot of financial engineering in the US markets such as share buy-backs that have been funded by debt. And three, many US companies are financialized—a company such as GE, for instance, gets a large proportion of its profits from financing. And then, of course, there’s the worry about the real economy.
Won’t the money flee the West and come to emerging markets? Do you agree with the decoupling thesis?
It did initially when people thought that the credit problem would be short-lived. But US consumption is anything between 30% and 50% of the total world consumption, depending on which estimate you believe, so the rest of the world can’t be unaffected by what happens in the US.
Also, I think the recovery process in the markets will take a long time, a matter of years. It takes a long time to recover from the after-effects of a debt bubble, unlike an equity bubble where recovery is quicker. The Japanese bubble was in fact rather similar, with excessive leverage and a real estate problem, but then it also had a sclerotic government and regulatory system that worsened things.
Emerging markets are bound to be affected. Also, some of the Bric countries (Brazil, Russia, India and China) have massive equity bubbles. The Indian market may outperform others, but the market is very expensive. Also, it’s no consolation when you’re down 10% to know that others are down 20%.
Actually, recovery is much like dealing with the stages of grief. The good thing is that people have moved from denial to anger. The next stage will be acceptance but we’re still a long way off from resolution.
Will the debacle lead to a backlash against derivatives?
I think it will. I hope we have seen the last of some products such as CDO squared and other exotic derivatives. Products such as securitization should stay, but we’ll need to correct loan origination techniques, where mortgage brokers who brought in the borrowers were only interested in the fee—it was a classic case of distorted incentives.
Countries such as India are doing the right thing by being cautious about derivatives and regulators and market participants need to thoroughly understand these products and have the capability to monitor what’s going on before introducing them.