Paul Jay speaks to Sony Kapoor, the Executive Director of Re-Define. A former financial banker, Kapoor explains the mechanism by which one risky bank’s failure leads to others suffering and says it’s similar to musical chairs. “Everybody’s dancing, everybody’s doing this leverage game, but when the
music stops someone will be left standing.” He goes on to explain that “it doesn’t matter to the individuals who get around the seats, but if this person left standing fails (like Lehman was), it generates a negative footprint on other banks.”
PAUL JAY, SENIOR EDITOR, TRNN: Welcome back to The Real News Network. We’re in San Francisco at the Momentum Conference of Tides Foundation, and we’re talking to Sony Kapoor, who emerged from the nether world of finance capital and is here to tell us their dark secrets. Thanks for joining us again.
SONY KAPOOR, MANAGING DIRECTOR OF RE-DEFINE: You’re welcome.
JAY: So we left off with this idea that in the name of diversification, finance companies were supposed to minimize risk by putting different investments in different baskets, except everything is now digital, and everybody has the same information, and everybody has it almost instantaneously, so everybody jumps in the same baskets at the same time. So where does that all lead us?
KAPOOR: Well, the whole concept of diversification in finance goes back to, you know, this portfolio theory, and that was developed in the 1950s, when we lived in a world where investors had to go look at ticker tapes and try and analyze the information using paper and pencil. We live in a world now where everybody has near-instantaneous access to asset prices as they are traded across the world, not just the New York Stock Exchange but perhaps Malawi’s Stock Exchange or the Indian bond market. That has reduced the diversity of the financial system. The second development has been with the opening of capital accounts. Capital flows much more freely between countries. So it used to be that markets in different countries were segmented, but now almost every big financial institution has access to almost every single country. The third big thing has been an increasing standardization of regulation. Almost every big financial institution, you know, banks in particular, are subject to the standard Basel Accord of capital. They use similar risk-management models. They’re using similar models to construct their portfolios, looking at the same data, investing in the same set of markets. So what you’ve ended up in is, in the pursuit of diversification, they try and, you know, invest whatever looks good with their portfolio. So if some market is not correlated, they will try and go there. But the act of going there makes the market correlated. So the pursuit of diversification carried to its logical extreme will mean that every financial institution will be invested in every market in the world will lead to uniformity [sic]. And while we’re not quite there yet, but that’s the direction which we have moved in, and that means that the financial system as a whole—because resilience comes from diversity, from having different points of view. So if somebody is buying, somebody else should be selling; if somebody’s selling, somebody else should be buying. But not everybody wants to buy at the same time and sell at the same time. And the second problem with this is that if there’s a shock in one particular market—let’s say the Malawi Stock Exchange falls. If you’re also invested in London real estate markets, that loss will generate some pressure for you to sell some of their assets to reduce risk, and you will start selling London real estate markets, which will lead to pressure to sell the New York Stock Exchange, and so on and so forth. So it infects disturbances and risk from one market segment to another, from one financial institution to the other. So the system as a whole has become extremely fragile and vulnerable because of all these developments.
JAY: And if we go back to what you were saying in the first segment of the interview, so much of the global purchasing power now is being fueled by credit card and by debt, this river of capital flow has underneath it a riverbed which is cracking.
KAPOOR: Absolutely. The second problem with that is, because a lot of the asset prices right now, you know, in the lead-up to the crisis, have been inflated because of leverage—too much money floating around—it works very sharply to accelerate the movement downward. You know, let’s say you put in $10,000 in a house and you take a $90,000 mortgage and you have a $100,000 house. If the price goes up by $10,000, you end up with a $10,000 profit and you you’re like, “Hey, that’s 50 percent profit.” But if you had only a $1,000 investment and $99,000 in mortgage and you ended up with a $10,000 profit, that’s 900 percent profit for you. So leverage magnifies profits, but it works the other way, too. Let’s say your house was worth $100,000 and the price fell by $10,000. You’d be wiped out if you had only $10,000 of skin in the game. And that’s been the problem.
JAY: No, the mortgage is now worth more than your house is.
KAPOOR: Exactly. And this is true of banks, which had too little capital. It is true for households, which had too little skin in the game. They had too little equity. And, you know, there was massive amounts of mortgage equity withdrawals, which was being used to finance consumption. It was true of a lot of other assets which were invested in using very thin risk-capital margins. So what we need is more risk capital, more equity, and less leverage, less debt.
JAY: Now, the people in this game, how much did they understand what was happening? Did they not understand the potential crash to come? Or they did, and they didn’t care because one of two things: either après moi le deluge, like, you know, the world can go to hell while I’m getting so rich now, and/or even when it crashes we’ll get the government to come bail us out anyway?
KAPOOR: I think it’s a mix of three things. It’s more complicated than the way you just said it. And those three things would be—the first is, as the CEO of Citicorp so accurately said, he said, “As long as the music’s playing, you’ve got to keep dancing.” I think he lost his job for it, but that was rather unfair ’cause everybody was doing the same thing. Now, the thing is, individually this is rational. So a financial institution is thinking, well, you know, everybody else is making a lot of money on CDOs and subprimes, and if I don’t jump on this bandwagon I’m going to have, you know, lower bonuses, lower profits. The shareholders will force the CEO out. And this is something we actually saw. In the UK, for example, the Northern Rock Bank, which almost went bankrupt and had to be rescued by the UK government, it had a very risky financial model. It was using overnight borrowing to lend thirty years for mortgages, which is very risky, you know. And more conservative banks such as HSBC, etcetera, were using deposit funds, which are stable, to fund mortgages. And the market was penalizing the more conservative banks, and it was rewarding Northern Rock. It was saying, yes, Northern Rock is the way to go, ’cause shareholders were getting more returns, the bank people working there were getting more bonuses. So there is a lot of pressure when you’re in the game to—.
JAY: So it’s no longer about how much money will we make five years from now, ten years from now. How much are we going to make this second? Within three seconds how much money can we make?
KAPOOR: In the culture we live in, where there is a quarterly forecast and there’s a song and dance everywhere about it if you exceed the quarterly forecast by a cent, hey, then your share price goes up. And it’s gone down to shorter and shorter durations, from, you know, ten-year, fifteen-, thirty-year investment horizon to five years, to one year, to now just a quarterly one. So this is unfortunately the way—and this is something we seriously need to reform in the long term. Otherwise—now, the thing is, you know, everybody is dancing, everybody’s doing this leverage game. But when the music stops, somebody will be left standing, as they are in the game. It doesn’t matter to the individuals which get round the seat, but if this person left standing—as Lehman was—fails, it generates negative footprint on other banks. The financial system is different, ’cause, you know, if there are four grocery stores around your house, one of them fails, it’s good for business for the other ones. If there are four banks around your house, one of them fails, it’s bad for the other banks. And that’s where the regulator and the government steps in. So individually every bank, every banker is doing the right thing, what is rational for them given their incentive systems, but collectively it’s disastrous.
JAY: So in the next segment of our interview, let’s talk about what’s been done. Has it really going to fix the situation, or are we just setting up a new game?
JAY: Like, if we just put the chairs back and we’re starting—has the music just started all over again? So please join us as we discuss musical chairs on The Real News with Sony Kapoor.
Please note that TRNN transcripts are typed from a recording of the program; The Real News Network cannot guarantee their complete accuracy.