Virtual Banks

August 27, 2009

Professor Jayanth Varma has posted his Financial Express oped on his blog, in which he tells us that a CDO is just a small bank, while a bank is a really big CDO:

In 2007, when the first problems emerged in CDOs, people thought that these relatively recent innovations were the cause of the problem. Pretty soon, we realised that a CDO is simply a bank that is small enough to fail and conversely that a bank is only a CDO that is too big to fail.

Both banks and CDOs are pools of assets financed by liabilities with various levels of seniority and subordination. As the assets suffer losses, the equity and junior debt get wiped out first, and ultimately (absent a bailout) even the senior tranches would be affected. In retrospect, both banks and CDOs had too thin layers of equity.

This is actually an incredibly strong insight. We are so used to thinking of a bank as an organisation and a CDO as an exotic security that it seems like a revelation when you realise that actually both have the same sort of balance sheets.

So if CDO’s weren’t the problem, what was? Bad credit practices in general. That said practices were probably caused by too much cheap money sloshing around is left unsaid.

It is becoming clear that what the US is witnessing is an old-fashioned banking crisis in which loans go bad and therefore banks become insolvent and need to be bailed out. The whole focus on securitisation was a red herring. The main reason why securitisation hogged the limelight in the early stages was because the stringent accounting requirements for securities made losses there visible early.

Potential losses on loans could be hidden and ignored for several quarters until they actually began to default. Losses on securities had to be recognised the moment the market started thinking that they may default sometime in the future. Securitised assets were thus the canary in the mine that warned us of problems lying ahead.

So basically, the exotic instruments were symptoms and not the disease. I’d add here that securitising mortgages into CDOs rather than pure pass-through certificates probably created an extra level of complexity, though.

Ajay Shah often talks about how financing through exchange driven markets (whether for bonds or equity) is preferable to financing through banks which are forced to deal with much more illiquid levels of risk. If you accept that as a basic assumption, then if a CDO is a virtual bank, it represents a throwback in the evolution of finance. Oh dear.

The problem is that investment banks were still able to create and sell CDOs rather than selling a simple package of pass-through certificates on mortgage-backed-securities. Hopefully, this is a generational thing that will die out soon – now that every chhappar in the world is getting an MBA, a CFA, and at least a basic knowledge of financial instruments, the power that investment banks have over purchasers of securities may dissipate once this glut of finance professionals starts trickling into treasury and fund management offices where they can do their own structuring, dammit.

Of course, the stranglehold that I-banks have over issuing securities is unlikely to go away. So we should have strong regulations to ensure that they only sell vanilla products and the customers do their own structuring.

Before I forget, do read the whole thing, especially for the last few paras, where Prof Varma talks about why we should embrace securitisation and the advantages it has given to American consumers.

Even More on Land Sale Reform

February 5, 2008

Barun Mitra has a Mint oped today on why not allowing the free sale of agricultural land is a bad idea. Excerpts:

Which leads us to the question: Why is it legitimate to acquire land for industrial use, but prohibit farmers from consolidating and expanding their landholding to improve agriculture? Why shouldn’t a farmer be able to legitimately acquire a thousand acres?

Indian industry can raise capital from the global market on the basis of a prospectus, which promises performance in the future. But Indian farmers can’t raise adequate capital on the basis of the land asset which they already possess.

However, it is critical that the value of the land of farmers, often their only asset, is maximized, and it is made simple to capitalize. The problem facing the poor is not their poverty, but inability to capitalize their assets. Typically, agricultural land hardly fetches Rs2-3 lakh per acre. Agriculture income, even if the land is cropped twice a year, can hardly be more than Rs30,000 per acre, at current productivity levels.

The industry could also offer shares or bonds in lieu of land. Or even provide alternative land if the farmer decides to continue with his vocation. In an open land market, with protected property rights and security of contract, there would be a wide range of choices to meet almost every requirement.

Very much worth reading. So do read.