The Knight in Shining Armour

Comes to royally screw everyone again. The knight? Bangladesh Bank. What happened? This. “So, that’s a good thing.” No, it isn’t.

The current financial crisis blew up on everyone’s faces because the banks were engaged in fraud of unimaginable proportions that was magnified by securitization. Loans were fraudulently passed, which were then chopped into pieces and sold to other investors with the promise of a cut of the profits. The money received from the securities sales went into providing more loans, passed by fraud. So when those who got the loans were unable to pony up the cash (which is where the fraud comes in), the securities based on the loans handed out to the financial investors lost market appeal overnight and crashed in value, leading to where we are.

That brings us to the article. Bangladesh Bank (BB), the country’s central bank, has stated that there will be no oversight of the amount of money banks plow into wholly-owned financial intermediaries. A little financial history now, right after the Great Depression that started in 1929, the US government passed the Glass-Steagall Act in 1933 that banned financial speculation using money that is deposited in banks. This ensured that banks would not be tempted to engage in risky gambles using depositors’ money. Removal of this barrier in 1999 is argued to have directly led to the current financial morass we find ourselves in by allowing banks to engage in speculation (gambling) using depositors’ money.

Using an asset entrusted to one in speculation is illegal (let me check up on that, and regardless of the legality, it is stupidity of epic proportions), even more so if the depositor has not been forewarned. ”Why? All this capital lying around will be wasted doing nothing, better to engage it in business. It’s good for the overall economy.” Yeah, that’s what she said, back when Lehman Brothers were in action. Then the shithouse collapsed and economic nightmare is still being lived through.

The problem is not entirely due to them indulging in, what is known in financial circles, as leveraging, the problem lies in the fraud perpetrated by the financial corporations to achieve leveraging of ratios upto around 40:1, i.e. a single dollar is lent and re-lent 40 times. The contracts agreed to, when carrying out this leveraging, between investors and banks, may or may not specify insurance in the case of a loss occurring. This is how insurance intermediaries got dragged into this mess. They wanted a quick buck by ensuring that they will provide cover in the case of a loss. The result is plain for all to see but understood by few (even I don’t know all the details!) but my understanding is that when the securities lost value, the insurance intermediaries could not provide full cover, obviously, and the banks were left to provide cover against the investors’ losses. Can anyone provide cover for leveraging conducted at this scale? 40 to 1? Thinking of providing cover for leveraging conducted in the scale of even 10 to 1 is mind-boggling and makes me wonder about the sanity of those who thought they could provide cover for leveraging on a scale of 40 to 1.

What does “providing cover” mean and why is it important at all? Let me try to explain. Let’s say there are two entities – A and B. B keeps $100 with A for safekeeping. Knowing that B won’t show up for the money for sometime, A does business with the money. A lends out $50 to C1, keeping $50 as backup in case C1 does not pay back. The problem here is obvious, A does not have B’s $100 anymore! Only $50 of it. So if C1 cannot pay back, A and B are both screwed. Suppose, that everything looks fine and dandy and A sees that C1 pays back, with interest, so then A thinks that since A is required to keep $50 for rainy days, keep that $50 and let’s expand business with the other $50. So once C1 is given the loan, A then goes to investors saying that since C1 is paying back the loan and the interest, they can have a share of the profit. The investors decide to chip in convinced by all the “hoopla” and slick marketing. So a bunch of investors, let’s keep it small at 2, pay, let’s say $22 each for a share of the profit from the deal. They get sweeteners that they will get future securities for cheaper, securities based on loans made with money gained from sale of the securities of the first loan. That is true leveraging. Compared to the process of “securitisation”, fractional reserve banking sounds like a joke. Fractional reserve banking has a limit, this is endless, you can choose to make new loans as long as you sell the securities; a modified Ponzi scheme is what it is.

Now a bunch of the loans (many of which were passed by fraud) have to be written down as the debtors cannot pay them back. So the securities based on those loans become loss-making, or atleast not-profit making, non-performing I believe they are called. If A made promises to back up the securities in the event they became non-performing, then we have a problem. For $50 of securities, A has to maintain $50 in reserves if the situation were to worsen. Liquid assets. For the rest of the securities that were based on loans that were fraudulently approved, A does not have liquid assets. If A did have reserves to cover for the securities, then it will be similar to factional reserve banking and the party will have to end. This is how leveraging works.

Coming back to here, with no limit placed on how much money banks can put into their subsidiaries, which then put the money into speculative activities. So if anything were to go wrong, then who picks the tab? In the simple example above, B would have to give partial backing, the rest of the losses would either have to be picked up by the investors or A (who does’t have it). There is a third option here, let the government pick up the tab because everyone made bad business decisions. Sounds good. The government can print all the cash in the world and save us from financial armageddon. The problem is inflation and providing cover for financial leverage of the scale committed by financial institutions is economic suicide. The government cannot let runaway inflation to occur, so they have to cut back on spending to finance bailouts. That is why we are currently seeing rioting in Greece, social tension all over Europe and the Occupy movements in the US.

A poor country like Bangladesh, where almost 40% are below the poverty line, can ill-afford such an occurrence. Such a move, even if good for the short-run, has too great a cost in the long-run. The government has once again displayed myopia in pursuing a policy (again).

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