Woes of U.S. credit crisis: lack of regulation?

“Issuers should only launch products which are easy to understand and easy to measure risk”

The developments in the U.S. sub-prime markets or housing mortgage markets have brought to the fore several issues which are an eye-opener for countries like India.

Free market economy is facing one of its worst crises today. Reeling as it is under severe credit market defaults, the U. S. has come to contend with a series of banking failures for the past one year — of the kind and magnitude the country has not witnessed since the mid eighties.

The seizure of IndyMac Bancorp by U.S. regulators, last week, marks one of the largest bank failures in American history. The bank, once part of Countrywide Financial, is the first major bank to shut shop since the mortgage crisis erupted more than a year ago.

Though five local and regional banks have shut shop during the period, they are smaller in comparison with IndyMac, which held $32 billion in assets as of late March. The last major banking failure was witnessed in 1984, when Continental Illinois National Bank & Trust in Chicago had hit trouble, presaging the savings and loan crisis.

The woes of U.S. credit market are continuing and nervousness threatens market stability world over, especially after the government took over failed bank IndyMac on July 11. Further, the US Treasury Department and the US Federal Reserve announced steps to reassure markets that they support U.S. mortgage giants Fannie Mae and Freddie Mac.

The compounding global issues — high inflation readings, slowing growth indicators and credit crisis — have compelled the Reserve Bank of India to keep in abeyance the issuance of the final guidelines on introduction of credit derivatives in India as “time is not considered opportune to introduce the credit derivatives in India, for the present.”

The developments in the U.S. sub-prime markets or housing mortgage markets have brought to the fore several issues which are an eye-opener for the fast developing markets like India. Even the well developed U.S. markets now accept the fact that how regulators and rating agencies failed to assess the markets and products. Swapping financial products were created to spread the risk. Instead of reducing risk, these derivative products have in fact caused bigger mess.

Complex products

Interestingly, many never understood these products. There are several types of swaps and derivative products — like interest rate swaps and currency swaps — which are difficult to understand. For example, currency swaps are mainly used by companies which are involved in foreign trade. The depreciation of the U.S. dollar against most of the currencies of the world caught many banks including India’s premier bank, the State Bank of India and the leading private sector bank, ICICI Bank, on the wrong foot. Other banks like Axis Bank, HDFC Bank and Kotak Mahindra Bank were also undertaking profit hits as their customers refuse to accept the losses in certain transactions of derivatives which they entered into on the advise of these banks.

Many companies moved courts against some banks on certain disputed transactions, in which they have incurred huge loses. The companies have also alleged that banks have mis-sold the derivative products to them without explaining the complexity of products and the impact of possible losses. Banks were in a hurry for making provisions for possible losses. However, mark-to-market losses on account of banks’ exposure to global credit market are still not very clear. Many banks were not ready to disclose the exact loss in the international derivatives market.

Finance Minister P. Chidambaram recently urged market participants to desist from mis-selling complex financial products — which are difficult to understand — to customers. According to him, these complex financial products have created a financial furore world over, which would be a difficult task for the regulators to tide over in the near future. Issuers should only launch products which are “reasonably simple, easy to understand and easy to measure risk.” He also lamented that innovation had overtaken regulation. “This means regulators have failed. A country like India, only sell products that people are able to understand. Why should innovate a product which is not needed? Issuers should be careful when offering products to investors,” a candid Mr. Chidambaram averred.

Rating agencies fail

Globally the rating agencies too have failed to assess the risk involved with these derivative products. Later, stung by criticism from various quarters world over, Standard & Poor’s (S&P), a leading rating agency, (S&P) stated in its review of rating and transparency enhancements while rating complex financial structures: “We have made significant progress in implementing the actions, which are designed to enhance independence, strengthen the rating process and increase transparency. We are committed to helping bring stability and transparency to the capital markets and believe our actions will help build greater confidence in credit ratings.”

At the conclusion of its review of global universal and investment banks, in the beginning of June, the S & P lowered its ratings on Lehman Brothers, Merrill Lynch & Co. and Morgan Stanley. The outlook for all these entities slipped to “negative”. S&P also stated that it affirmed its counterparty credit ratings on the Goldman Sachs Group and its outlook is negative. Among major players in the securities industry, Goldman Sachs has one of the heaviest concentrations in trading and investment banking.

S&P also revised its outlooks on Bank of America Corp. and JPMorgan Chase & Co. to negative. In addition, S&P affirmed its ratings on Citigroup, removed the ratings from CreditWatch negative, and assigned a negative outlook. “We also placed the ratings on Wachovia Corp. on CreditWatch negative. The outlooks on the large financial institutions sector in the U.S. are now predominantly negative,” S&P stated.

“The negative actions reflect prospects of continued weakness in the investment banking business and the potential for more write-offs, though not of the magnitude of those of the past few quarters,” explains S&P’s credit analyst Tanya Azarchs.

“They also reflect a reassessment of the vulnerabilities of the wholesale and less diversified model of funding for the specialised investment banks.”

In sub-prime mortgage-related assets, global banks have already disclosed losses of $165 billion or 80 per cent of the forecast total, leaving the remainder still to be announced, according to Fitch ratings agency research. Investors are now pushing these investment banks to come out clean. Goldman Sachs’s bail-out of a $7 billion Structured Investment Vehicle (SIV) — off-balance sheet vehicles banks have set up — shows investors are pushing hard for banks to clean up their troubled assets, which is likely to speed up billions worth of new write-downs.

In a sign that the credit crisis is far from over, U.S. investment bank, Lehman Brothers few weeks back announced plans to raise $6 billion, following its first quarterly loss as a public company. Goldman Sachs had disclosed losses of $775 million in credit products.

The closure of IndyMac reminds emerging markets several issues. In view of rapid expansion on overseas operations of Indian banks and introduction of new products and processes, increasing off-balance sheet exposures including derivatives products, “a need has arisen for review of the reporting system”. The RBI has set up an inter-departmental group to review the existing regulatory and supervisory framework for overseas operations of Indian banks and recommend appropriate changes, including off-site reporting systems.

Conservatism while regulating markets and market participants was very often criticised, but it is playing a major role in maintaining an “orderly growth” of the financial markets.

Free market proponents never want governmental intervention and they want business should be run without any intervention. On its part, the RBI has done a commendable job while regulating the financial markets.

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