Derivatives, especially the exotic kinds, have become a bad name across the world. India, too, has had its share of problems with over-the-counter (OTC) forex derivatives. One good outcome of all this is that the case for exchange-traded derivatives has only become stronger vis-a-vis OTC markets. It has become increasingly clearer to more policymakers and market participants that wherever standardization is possible, a derivatives contract must be listed on an exchange to avail of the benefits of transparency and the elimination of credit risk through centralized clearing and settlement.
In India, the Percy Mistry committee report on “Making Mumbai an International Financial Centre” had emphasised the importance of having exchange-traded markets over OTC even before the current global crisis erupted in mid-2007. The recommendations of the committee with respect to introducing new derivatives markets on an exchange-traded format are strongly endorsed by officials at the ministry of finance, and even by the new chiefs of the Securities and Exchange Board of India and the Reserve Bank of India.
As a result, India now has the distinction of being one of the rare countries to introduce new derivatives markets this year, at a time when most countries are clamping down with bans or more regulations. A new currency futures market was introduced right in the middle of the global financial crisis and the interest rate futures market is only a few months away. All this is good, but the larger lesson to be learnt from the global financial crisis is that markets—exchange-traded or OTC—offer early warning signals, which policymakers can use to take decisive action. Instead, the derivatives market is being demonized and the opportunity to learn this lesson is being missed. Even Indian policymakers are feeling rather smug about protecting the Indian markets from the ill effects of fancy derivatives, reflecting the broad view that the derivatives markets are at the root of the current global crisis.
But it is increasingly becoming clear that the root of the problem is aggressive real estate lending and not the securitization of those loans and the trading of related instruments. J.R.Varma of the Indian Institute of Management, Ahmedabad points to an important statistic in his blog: According to the latest IMF (International Monetary Fund) Global Financial Stability Report, 30% of the estimated financial sector write-downs were related to unsecuritized loans. A year ago, this figure stood at 17%, which means that the percentage of losses attributable to unsecuritized loans has almost doubled.
Varma says, “What we see is that because of the mark-to-market approach, securitized assets show losses earlier while the held-to-maturity approach allows losses on loans to be concealed and deferred. In this sense, the securitized paper was the canary in the mine that alerted us to problems quite early. Policymakers are completely mistaken in believing that absent securitization, we would not have had any problem. All that would have happened is that banks would have been in a state of denial longer.”
In the US, the market for collateralized debt obligations (CDO) gave warnings of a huge problem in the making over a year ago. Back then it was the CDO market and its users that were largely blamed for the mess in the markets. Policymakers went after the messenger (the markets), rather than heed the important message it was carrying. If policymakers had acted decisively since then, perhaps we wouldn’t have been in the current situation.
In India, we’re facing a similar situation with a clarion call by brokers and some politicians to ban short-selling. The pertinent question to ask is: “What is the message current prices of equity and equity derivatives are carrying and is there a cause for alarm?”
According to Varma, the 80% drop in share prices of real estate companies indicates that a 30-40% fall in realty prices from peak to trough is quite conceivable. Already, prices in some parts of the country have fallen by 20%. Real estate developers are hoping for a miracle during Diwali, but the stock markets belie any such notions. If indeed real estate prices drop by 30-40% and this is coupled with job losses and/or salary cuts, both consumer and corporate loans linked to the sector can come under threat. After all, home loans in India offer enormous leverage to the consumer, when compared with the market price of the property. The problem of falling real estate prices and high leverage, which has hit the US financial sector, could hurt the Indian financial system as well.
Already, there are signs of stress visible in mutual funds (MFs), who have lent to real estate firms. With the expected slowdown in the economy and with the days of easy cash over, there could be delinquencies in other sectors as well. In the worst case scenario, Varma says some banks and MFs would have to be rescued by the government.
And all this could happen without derivatives trading in collateralized debt. The problem is that policymakers view the stock markets and more so of the derivatives markets like casinos and little importance is given to the prices they generate. India has been slow on the uptake as far as introducing new markets is concerned. At least, it shouldn’t be lackadaisical about using the warning signals that come from existing markets.
In The Money runs every other Tuesday. We welcome your comments at firstname.lastname@example.org
Also Read Mobis Philipose’s earlier columns