Dear Editor,
The massive financial meltdown − extraction of capital in the US financial industry, now requiring capital injection has at least two important lessons for new regulations, namely increasing financial middle companies own-capital injection in proportion to increased risk taken and re-regulating the capital requirements for derivative traders. For simpler financial systems in less developed countries, borrowing money from one part of a financial system and re-lending it to government or government related businesses could result in capital extraction, albeit legal. I would like to add my comments to Dr Maurice Odle’s paper published in Stabroek Business on 12.9.08.
There are meltdown situations involving capital extraction when a private company lends money to government at interest rate plus income tax exemptions. For example, if a private company lends a billion dollars to government at say, 20 per cent tax free, a huge amount of money could be extracted from the financial system. The interest payment becomes a cost to taxpayers and future generations who have to pay interest on local debt to the middle company. Less visible income and wealth extraction occurs when money is borrowed at a low interest from one point in the financial system and re-loaned to a middle company in exchange for an IOU of the middle company. In the name of development and capital mobilization, the middle company could then take its interest earnings and pay dividends, etc, or invest in a government sponsored project. Now, some may argue that it is perfectly legal to earn interest in this manner and besides it is being done for a worthy cause as a special transaction.The point is being missed when we allow money and capital to be taken from point A in a financial system and use it to earn interest income from the same financial system at point B, without affecting the nation’s gross domestic product, except for the high salaries and allowances that middle company officials have at their disposal. Without owned resources flowing into the financial system as capital, the transfer from point A to B would add to upfront interest cost to a project financed from the middle company’s new-found wealth. The middle company is not likely to donate its new-found wealth to government or the government sponsored project. The recovery of middle company capital will have to come from users of the project or from future taxpayers’ income taxes. Yet another example occurs in a wealthy neighbouring country. Bank loans are taken out in excess of the selling price of a home and part of the loan is deposited in the name of the borrower. This was explained to me as a sublime gesture from the banker to its customer in order to ensure that the borrower has the ability to repay the loan. Well, what are friends in the banking and finance circles for? If capital extraction in this manner is so lucrative and is also good for a country, should we not do it a little bit more, say on a weekly basis and use multiple billions?
Dr Odle referred to the US crisis in hallowed terms. Yet, the problems facing the financial system, as loopholes are created and regulators look the other way, can impact adversely on our daily lives, irrespective of geography.
The US current financial crisis originated in four related markets − the housing market in the real economy and three related financial markets each with its own IOU as financial instrument − mortgage backed security, backed by the underlying housing market real assets, credit default swap −a bond or security insurance that guarantees payment on IOU risk-packages sold by an investment banker or middle independent buying companies, including Freddie Mac and Fannie Mae, and at the top of the caste of weaponry − derivative cash flow that remotely sets the price of a financial IOU for housing market related assets.
In the derivatives market for housing related IOUs, speculators bet on price movements of mortgage backed securities and credit default swaps. The derivative market price does not reflect the full valuation of capital or the true risk to capital if the trader is not required to put up a required amount of capital for the trader’s bet. Further down the chain, housing derivative pricing does not relate adequately to income-ability to repay mortgage loans in an environment where borrowers do not have job-loss insurance.
At the broker level, the price expectation from the top mortgage backed securities instrument and derivative markets inspires appraisers to value all houses using ‘comparables’ to reach higher expected price during an expansion. The separation of finance from economics creates lucrative risk-modelling opportunities for maverick bankers and traders to extract capital from the US financial system through IOU risk-setting rather risk-taking using one’s own-capital. Derivative trading without own-capital sets IOU prices independently of the true worth of a dollar of capital.
Risk setting and compensation for a package put together by investment bankers permits up front extraction of huge amounts of capital that must now be made good through tax dollars or borrowing to fill a hole.
Strong capital adequacy rules, based on progressively scaled risk regulations and comparable borrowers’ risk protection through the financial chain are needed to avoid future crises. For a small economy like Guyana the price of homes is not related to the level of income per person, but by other valuation mechanisms where the rich set prices for the poor. A financing system that has to face global capital markets and live up to international standards of financial institution and banking practices should examine its internal links to its assets and IOUs markets − its financial frameworks for deposit-taking and capital adequacy, in order to identify cracks in the financial wheels.
Finally, Mr Editor, permit me to thank Dr Maurice Odle sincerely for his significant influence on my education while he was lecturer in Financial Economics at the University of Guyana. Dr Odle permitted me to present my 4-hour research paper on the rate of expansion of non-bank financial intermediaries IOUs − the Guyana insurance companies and the New Building Society’s abilities to make loans and increase their IOUs. I also thank him for acknowledgement in his book on Financial Intermediation in Guyana.
Yours faithfully,
Ganga Prasad Ramdas
Lincoln University, PA
Professor of Economics and
Business
