The Securities and Exchange Commission (SEC) in the US charged Goldman Sachs with failure to disclose relevant information to clients who purchased a synthetic debt product from it, based on underlying subprime mortgage securities. Stated this way, the issue is stripped of all the drama and emotion that have spilled over into the blogspace and elsewhere in the last 72 hours. It is possible that this episode puts wind behind the sails of the US government to reform the financial sector. If that is the case, it calls for a rethink on the likely return on equity that Western financial institutions would earn.
Since March 2009, banks have scored many victories against those calling for aggressive reform, regulation, higher capital adequacy requirements and so on. The “stress tests” did not lead to any massive capital injection for the banks put through “stress”. Mark-to-market accounting rules were suspended. “Mark-to-model” continues. Programmes announced to remove toxic assets from the books remained non-starters since books could reflect assets at values that bore little or no resemblance to reality. On top of all this, interest rates were kept at rock-bottom levels with assurances that they would remain there for an extended period.
Cheap and abundant leverage has brought back financial “innovations”. Exchange-traded funds on underlying hedge funds, with daily liquidity, are being offered to clients, regardless of whether the underlying hedge funds have liquid or illiquid investments in their books.
In short, much of the moral hazard that developed in the 1990s and in the first decade of the millennium, brutally exposed by the crisis, has come back regardless of whether policymakers intended so or not. Therefore, it should surprise no one that financial sector profits rebounded so impressively—they are within touching distance of the peak (as a percentage of the gross domestic product) reached in mid-2007. One must concede that neither the sector’s supporters nor baiters anticipated this turn of events. This alone is both necessary and sufficient for us to conclude that the “new normal” is far from reach. But SEC has churned the pot and we might yet get the nectar of financial reforms.
It would be wrong to think that the return of complacency and bad habits remained confined to the banking sector. In an article written on the eve of last week’s Bric (Brazil, Russia, India, China) summit, Brazilian President Luiz Inacio “Lula” Da Silva claimed developing countries had acted much more prudently than so-called advanced countries. The message of triumphalism was both uncomfortable and inconsistent with the facts.
Developing countries had their own share of excesses and still have them. The run-up in prices did not remain confined to US, UK or Irish homes. Bubbles developed in real estate and stock markets in Eastern Europe, Dubai and Asia. The price-to-book ratio on stocks in Asia excluding Japan was nearly 3.0 in 2007.
Even now, the haste and desperation with which China is coming down on the property market testify to the fact that real estate prices had spiralled out of control in the country. The problem with blunt administrative controls is that they end up exaggerating both booms and busts since implementation is very hard to monitor. Price tools are different because they are transparent and are difficult to avoid.
Developing countries—as they were doing before the crisis—want to have the best of both worlds. Then, as commodity prices were booming, developing countries took shelter under narrow definitions of inflation that excluded energy prices until they could no longer ignore the spiralling oil price. Thus, they delayed taking steps to rein in demand; and when they took those steps belatedly, they did so even as the real estate and credit crisis exploded.
Fast forward to 2009. Developing countries added their own set of massive stimulus measures while simultaneously claiming that they were relatively unaffected by the troubles in the industrialized world. Then they held on to these measures despite a spectacular rebound in asset prices from the lows of 2008. Something was not adding up. If their economies were going to be permanently and/or considerably hurt by the crisis and repair in the advanced world, then they should have warned investors that there was no justification for asset prices to start rising steeply again. On the other hand, if they believed that their economies were now capable of levitating on their own, then they should have decoupled their monetary and fiscal policies earlier. They are scrambling now to contain the damage.
It is a replay of 2007 with just minor changes to the underlying dynamics. But the policy response has been the same—put off dealing with asset price booms until it is too late. It is important to remember that decoupling only means that you live or die by your own mistakes. Forgetting nothing and learning nothing hurts both policymakers and investors.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at firstname.lastname@example.org