Capitalism.. the scapegoat!!!

Capitalism: the scapegoat !!!

Capitalism... the most hated word among the general public in developed countries who have lost money in the Economic carnage and the recession that ensued the world over following the bankruptcy of Investment bank Lehman brothers in September 2008. 

People have been quick to say that the type of capitalism that originated in the US i.e. laissez-faire Capitalism (translation is "hands off" by the regulators) is responsible for the mess that we are in. They are calling for capitalism to be barred and made way for any other system, not necessarily Communism, but any other system.

But they have not understood that capitalism isn't the reason for the present crisis and Bank losses. Rather it is the humans who are responsible for it. It cannot be due to a single factor. Blaming the greed of capitalist businessmen in the US would amount to giving them more respect than what they truly deserve. It is a combination of "wrong things in the wrong place happening at the wrong time".

Wrong things refer to the Complex Derivatives instruments which no one apart from the person who designed the instrument understood. They were so "customized", that no two Derivative contracts would be same and their valuation was "Subjective". People who invested in them were individuals who "bite off more than they could chew".

The origin, though of the complex derivatives was in the Housing bubble started in the US by the speculators who invested in housing assets as an Investment, not a long term, but for earning through Arbitrage. Banks overextended and gave loans to people who could not pay the EMI. They tried to be innovative by giving loans at adjustable interest rates where in the interest rates would rise as the House prices increased, further adding fuel to the speculative fire. But this bubble was to burst at some time and it started with Bear Stearns in June 2008. The cracks in the bubble were visible but the government agencies the informed people (read Economists) turned a blind eye towards it.

Securitization seems to be the culprit here where it allowed banks to combine these assets in the form of complex derivative instruments such as Collateralised debt obligations (CDOs), Asset backed securities, Mortgage backed securities and the most destructive of them all, Credit Default Swaps (CDS) which was a sort of Reinsurance, and sell it to the consumers where neither of them knew of the true valuation and the true risk attached to it. The Rating agencies were caught in a quandary as to what they should do about rating these complex instruments. Because they knew that if they did not, then some one else would. Rationalization... isn't it?

The real Lacunae in the law were that the rule allowed banks to get these toxic assets off their Balance sheets. Countries such as Iceland, Cayman Islands and other tax havens were only too happy to oblige the incoming money and dummy companies were setup.

When the housing price bubble collapsed, the people could not pay their EMIs and massive Foreclosures happened. Due to this prices went down even further and this resulted in the value of the house going below that of the mortgage. this situation is called as going Under-water.

This resulted in massive losses for the banks which themselves had been heavily leveraged. Some banks to the extent of 25:1 to 35:1. Federal law states that it has to be a maximum of 8:1. The loophole in the accounting system was that it did not consider the treasury bills and loans from the Government sponsored entities such as Fannie Mae and Freddie Mac as debt. Thus the banks were adequately leveraged according to law. 

Billions of dollars were written-off by banks plunging the world economy into crisis resulting in a recession which economists now predict could be a L-shaped recession unlike the previous recessions that were U-shaped. The person who foresaw it all coming, Nouriel Roubini, Professor of Economics, Stern Business School, New York thinks that this could be a prolonged L- shaped recession lasting at least for another 18 months.

American consumerism was also partly responsible for it. Conspicuous consumption resulted in a high fiscal deficit for USA.

Billions of dollars of treasury bills were purchased by China where saving rate was very high unlike in the US where it is low and people have the habit of enjoying materialistic things through debt. This continuous inflow of money further fanned the consumerism even more. China deliberately instead of investing in themselves invested in US so that their currency remains weak vis-à-vis the dollar and they can continue exporting as a cost -effective exporter for the world, primarily to the US.

All the banks were exposed to these CDS but no one including the banks knew the value of it. This is because the value of underlying asset from which it was derived, had nose-dived and hence the present values of the CDS could not be ascertained. Not only the US institutions such as AIG, Bank Of America, Citibank Corp, Goldman Sachs, Manhattan  Chase, Wells Fargo to amen a few but also across the Atlantic, Instituitons such as Credit Suisse, UBS, BNP Paribas, Grupo Santandar etc. thus wrote massive write-offs. Hence no one trusted their liquidity and therefore did not lend to them resulting in a liquidity crunch. This was primarily sentiment driven with due to trust or rather lack of it.

The various central banks all over the world had to announce massive liquidity measures freeing up vast amounts of money led by the Federal Reserve (the US central bank), Bank of England, European Central bank of the Euro zone and Bank of Japan along with Bank of China. All of them took a coordinated effort to free up the system and restart lending. 

Thus capitalism isn't directly responsible for the situation but the people who circumvented the laws.

Capitalism is based on the principle of free markets but regulation and oversight by the government is required to a certain extent when the organisations become mammoth organisations and areToo-Big-To-Fail such as AIG, Citibank, Bank of America etc.

This regulation is required since the institutions failed in the principle of free markets i.e Caveat Emptor (let the buyer beware). The buyers were completely in the dark about the financial product under consideration.