DHRITIMAN DUTTA (200101057) PAF Assignment I

Questions
1. If you were in Rajani’s position, what would you do or advise him to do
and why? Is there any future need of securitization in banking, in
corporate finance and investing? Explain.
If I were in Rajani’s place, I would still keep the option of securitizing the
markets, because securitization is a process by which a company pools all
the different financial assets/debts to form a consolidated financial hub,
which is issued to investors, either via cash flows or via assets themselves.
Although securitization suffered an unprecedented strike in the financial
crises, Rajani should march on confidence for still implementing
securitization. The need of securitizing is stressed on the fact that it is an
effective measure of protecting and practicing the governmental laws of the
land.
If the financial market is lucrative, the risk can be shared to achieve an
optimal fund allocation system. But, if there exists a risk diversification, the
moral hazard in the financial system is aggravated. As was seen of the
subprime crisis, by transferring generated risks through a continuous
securitization, investors are addicted to adapt a ‘gain profit’ behavior, which
inevitably produces a lot of immoral prejudice. Moreover, risk
diversification leads to the accumulation of a risk(s) inside the financial
system. Meanwhile, different mortgages have different characteristics and
the analysis of information also requires upkeep, due to disclosure of any
internal information, so that the assessment of earnings and risks become
extremely difficult. Nevertheless, securitization is still a structured product
that cannot be replaced by a financial market.

2. Based on the four-crisis mentioned in the case, what are the indicators of
the impending financial crisis? Were there some common characteristics
to the four types of crisis?
Ans. The four crises had a few specific indicators to their own downfall,
which are namely:
a) Asian Financial Crisis:
 They had too high a foreign debt to domestic debt ratio.
 Their excess leverage ratio caused murmurs in the real estate
department, and when Thailand Baht dropped its value, with
reference to the US Dollar, the government had no choice but to
depreciate the currency, leading to its falling asset prices.
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 Involvement of the IMF caused further pandemonium as the
sanctioned $40 billion demanded lowering of governmental
spending, further destabilizing the foreign debt madness.
Condoning bank failures worsened the crisis overall.

b) Long Term Capital Management:

 Investors were exploiting loan arbitrage.
 Borrowers of more than $124.5 billion assets worth $129 billion, in
complex financial statements.
 South East Asian financial crisis precipitated the Russian markets,
and hence when LTCM invested their money into the Russian
markets in forms of bonds and bills, they faced a crisis of large
value.

c) Technology Equity Bubble:

 Stock price increase, and an available venture capital funding
caused potential investors to overlook the conventional
performance metrics of the entire system (P/E ratio) and invest in
technological advancements.
 Fast tracking of stock valuations of dot-com companies caused low
interest rates causing large borrowings. Business models of
building on net loss to build potential market shares skyrocketed,
underlined by venture capital and initial public offerings.
 With the advent of the interest rates increase in 2000, by the US
Federal Reserve, the economy slowed down and the bubble burst.

d) 2007-2009 Financial Crisis:

 As Federal Reserve increased the interest rates and tightened the
credit records of the common man, the sub-prime mortgages/loans
started to get affected.
 Low teaser interest rates caused a lot of potential buyers to invest
in the housing and real estate business. This further resulted in
fraudulent activities when they were driven by greed to lean into
volume sales instead of quality sales.
 After the dot-com bubble, all banks having been bailed out by the
govt, they were of the belief that they would be bailed out
henceforth. Thus, they started investing in riskier assets.
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Common indicators were mostly unstable interest rates, and the meddling of the
Government into the financial markets to restore order, by passing of
impractical financial laws, exacerbated the crises.
3. What are the likely new regulations for the financial services sector and
what are their likely consequences on financial services sector and
products?
Most common reforms to be implemented will include a basic structure as
follows:
 Impairing the assets initially. Banks to be recapitalized, including a lot of
sustained space for liquidity levels.
 Capital building and dynamic provisioning of the funds can break the
pro-cyclicality issues.
 Governments can play a proactive role in devising a better financial
system, under the lines of the IMF, and not ask them to simply barge in
and undertake reform.
 Finally, dividing the assets on the levels of price, trading policy and
security can drive growth for the financial service sector.
These few simple approaches can:
 Prevent excess leverage from developing.
 Reduce counterparty risks.
 Reduce mismatches in interest rates domestically and foreign.
 Improve the liquidity management systems.
 Make the banks and the instruments used for transactions more
transparent.
 Reduce systemic risks in the policy management causing a valid
network approach for things to track the market and develop a risk
aversion model for extreme cases.

4. Are complex financial instruments like derivatives bad for the society?
A financial instrument chalks out the guidelines and presents the information
necessary for any investment to hold. It is of utmost importance to society to
adhere to banking and transaction norms. For a short crisp answer, it is a
good element for the society. More often than we would want to believe, it is
the investor who remains at fault for not tallying the instrument, or for
overlooking policy details while making a transaction. Mostly, financial
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instruments are in the form of cash, but when the transaction requires, a
derivative is also made to adhere to both party’s wishes.
A derivative is a special type of instrument which possesses value according
to the changing interest rates, or to credit risk and foreign exchange rates.
This is just a piece of information which educates the society of the
prevailing conditions of the financial market. On its own, it stands neutrally
in composition, it is not complex; only when there is governmental
interference, or too much liquidity imposed by the banks, do they cause
instability of the financial markets. The only risk that comes into play in that
regard, is that of counterparty risk, one which arises when a party defaults on
the legally binding contract, due to domestic country financial marketing
rules.