Watching the global markets bounce around and blue-chip financial stocks vaporize like the morning dew, it seems that risk is everywhere these days — and increasing. Or maybe that risk was always around, except we are measuring it more and, in the process, trying to manage it better (something like the rise in crime rate when the police system gets better — is law and order deteriorating, or are people reporting crime more openly than before?).
This is a critical week for the world’s financial markets, as the US Congress debates the $700 billion Paulson-Bernanke bailout package for the US banking system. The dust is flying around like a desert sandstorm, and hundreds of horsemen are kicking hooves on various aspects of the situation — the factors that led to the crisis, as well as the audacity of a bailout proposal that demands unprecedented leeway and little oversight. Into this melee, here are my own grains of grit:
1. Credit default swaps (CDSs) are not the culprit; in fact, they have played their role extremely well: This $60 trillion market has come in for enormous criticism — as having possibly triggered this crisis; and as being an opaque, unregulated, illiquid market that can be easily manipulated. In reality — while there are some correctable gaps — the CDS markets have offered all one could expect of any price discovery mechanism. They also gave early warnings of impending challenges to companies such as Bear Stearns (with CDS spreads widening a whole month before), Lehman Brothers (spreads at 370 basis points, or bps, in August, and 800bps the Friday before its collapse) and Merrill Lynch. The financial crisis wasn’t created by CDSs — they are only a mark-to-market mirror of events and sentiments.
I would argue that CDSs have helped the US financial system avoid the pain of an extended process of denial, which is what happened to the Japanese banks. Self-important bankers — who look in the rear-view mirror and see the triumphs of past successes — don’t like admitting to the dangers in their balance sheets. CDSs — among other market instruments — forced them to see the writing on the wall, and helped telescope the timeline of reaction.
2. All bailouts are not the same: The difference between the Bear Stearns and AIG rescue plans is remarkable. In the first, JPMorgan got the entire upside from the insurance contract provided by taxpayer funds, while in the second, the US government got a huge equity carrot in the form of an 80% stake (the impact is so telling that AIG shareholders are frantically attempting to find their own sources of funds rather than accept these onerous conditions, thereby validating the structure). In the debates about how the proposed $700 billion fund will be used, there are already proposals being floated of some sort of preferred stock which gives equity to the government for its support to banks. I want to propose an extension to this idea: Set up a rainy day fund that can pool the upside returns from such structures. This has two benefits: first, to have set-aside funds, given that this isn’t going to be the last financial crisis we will face; second, to firewall such surplus funds from indiscriminate use by the government.
3. Don’t believe the haggard looks and strained faces at the Fed and treasury: In public office, leaders revel in dealing with crises. In a perverse way, Bill Clinton and George Bush Sr envy Bush Jr for 9/11 — because it gave him the mother of all crises. Similarly, this is the perfect showcase for Ben Bernanke and Henry Paulson to show their leadership, to get a shot at playing master architects and to leave their fingerprints in the history books. Thirty years from now, chances are that Bernanke will be remembered more than Alan Greenspan. A year ago, who would have taken that wager?
4. Paulson-Bernanke will get their way: For all the criticism from economists and politicians of all stripes, this deal should go through with only a few compromises. This is because of two factors, one created by the market, and the second, pure serendipity. The first: compressed timing. Today’s markets are reacting in the order of days and hours. The velocity of change ripping through the markets highlights a critical principle for 21st century leadership: If you have as much information as you need, don’t delay decision-making because it only makes the situation worse. This lesson works for Paulson-Bernanke and against the US Congress, because they only have a few days to decide.
The second reason is the political calendar: 45 days before the elections, with a Democrat-controlled Congress that has even weaker ratings than the president. A rejuvenated Republican party is suddenly threatening Democrat control of House and Senate. They wouldn’t want their dithering to be the hanging chad of the 2008 elections.
Ramesh Ramanathan is co-founder, Janaagraha. Möbius Strip, much like its mathematical origins, blurs boundaries. It is about the continuum between the state, market and our society. Your comments are welcome at firstname.lastname@example.org