Mystique of global crisis unravelled

Saturday February 14, 2009
Mystique of global crisis unravelled
What Are We To Do
By TAN SRI LIN SEE-YAN


Friends have been asking with increasing frequency why the biggest banks in the world are in such a sorry state of affairs. Was it because of a black swan? This refers to Hassim Taleb’s concept of an unlikely but not impossible catastrophe that no one ever seems to plan for, but that does not mean it does not exist.

Indeed, I have heard it quoted in a recent issue of Time that it is not just one black swan; it is a bunch of black swans that have hung out for a while and have since created this gigantic problem.

Twelve days ago, I had one of those rare opportunities to spend some quality time with Tun Mahathir Mohamad at a private brainstorming session with select experts (including some from abroad), and to participate in his Feb 4 strategy session on the global financial crisis.

Mahathir’s challenging query was simply this: Why did the US financial meltdown – not just its scale – happen so very swiftly (most were caught unawares), destroy so completely (US financial system in particular), and reduce so systemically (the efficacy of the global financial international mechanism)? How could subprime mortgages provoke such worldwide dislocation?

These are legitimate but very difficult questions to answer. I have since thought about it a lot. I shall now try to unravel, as best as I can, the mystique of this upheaval (which the Financial Times called, tongue-in-cheek, Asia’s Revenge), in so far as I have managed to string together the sometimes rather incoherent parts.

The big picture

Professor Charles P. Kindleberger’s classic book, Panics, Manias and Crashes: A History of Financial Crises, suggests that in history, financial crashes shared one trait – excessive expansion of credit which feeds on itself.

The current bubble is no different. The US Fed (Federal Reserve Board) kept interest rates too low and for too long.

George W. Bush became president following the dotcom bust in 2000. His tax cuts plus then-Fed chairman Alan Greenspan’s push on the monetary accelerator (in rapidly cutting interest rates) helped spur housing and consumer spending.

Even as the second tax cut became law in late May 2003 and with economic recovery beginning in earnest, the Fed funds rate was further cut to a mere 1% and kept there for a year. This stimulus worked well – indeed, too well.

Professor John Taylor of Stanford called this a monetary mistake. By pushing so much excess credit into the economy, the Fed created a consumption and housing mania that Wall Street took full advantage of, with many banks abandoning normal risk standards.

Taylor demonstrated this by comparing the actual Fed funds rate for this decade with what the rate would have been if the Fed stayed within the policy experience of the previous 20 years (see chart). This has now come to be known as the Taylor Rule for determining how central bank rates should be adjusted.

“This extra easy policy (the pink space) was responsible for accelerating the housing boom and thereby, ultimately leading to the housing bust,” he says. It was a party no one wanted to end, but it did nevertheless in 2008.

The system that failed

The banking business is based on trust; some may even call dealing with a bank an act of faith. Over the past decade in particular, the system that has evolved was underpinned by four articles of trust.

1. Trust in regulators (central banks, securities and exchange commissions, inspectorates), who apparently have done such a great job that it can be safely assumed the Western banking system is extraordinarily strong and much more advanced than a decade before. The track record of the crisis management skills of central banks and financial authorities is so well regarded, even the authorities are convinced that any glitches (big and small) can be readily contained. Indeed, the system always emerges stronger and more sustainable after a crisis.

2. Belief in the viability of modern capital markets, especially New York and London, which are always liquid and have become so deep and dependable that banks and investors can readily trade with confidence in debt securities. So much so that this has encouraged banks to let down their guard to arrogantly assume that risks can always be passed on. Indeed, in times of abundant liquidity, most have over-estimated the markets’ ability to assume risk.

3. Confidence in credit rating agencies (assumed wrongly by investors to be strictly regulated) as a reliable compass to guide investors through the workings of the complex jungle of derivative products which most don’t understand.

4. Trust in the intellectual capital and capital muscle of Wall Street based on the assumption that any “slicing and dicing” of debt into derivatives of all hues have made the financial system more resilient and more stable, supported by the banks’ ability to churn out so much profits in the process. This assumption that pain emanating from any potential default would be spread over millions of investors, rather than concentrated in particular banks (since these are off-balance sheet activities), is naive of course. The opacity of the derivative products left much to be desired. This shift from bank balance sheet to off-balance sheet realm of securitisation and derivatisation on Wall Street might not have been so bad if they actually worked to spread risk and encourage creative destruction, bringing the best minds to bear on resolving the underlying banking problems. Instead, they created a bubble, diverting capital to the least productive use and, worse of all, fed the pangs of greed.

A word about derivatives

They are what they sound like. Their worth is derived from a stock or a bond or a mortgage or a collection of them. The most common (and dangerous) is the credit default swap (or CDS) – a sort of insurance policy. A third party assumes the risk of the debt (say, mortgage) going into default. In exchange, the insurer receives payment (like a premium) from the issuer bank.

Created by whiz-kids from MIT and Cambridge for JP Morgan in 1994, they have since ballooned into a US$62 trillion market, before racheting down to US$55 trillion last September after American International Group (AIG) had defaulted on US$14bil of CDS (it held US$440bil).

Warren Buffett called them “financial weapons of mass destruction”. Since CDSs are privately negotiated between the parties, they are not regulated.

There are others such as CDOs (collateralised debt obligations), derivatives linked to corporate debt. These are essentially made for insurers, banks and others to invest in a diversified portfolio of enterprises without actually buying into their stocks and bonds. This market could be as large as US$6 trillion.

The entire derivatives market is very large. Latest estimates point to US$668 trillion (gross) or about 15 times the size of the world economy. Their underlying worth is about US$15 trillion, slightly larger than the US gross domestic product (GDP).

Relevant developments

The US banking system has evolved dramatically in the past 40 years. Consider the following changes that has since worked to significantly undermine the system:

● Forty years ago, 90% of all loans were backed by bank deposits. Today, it’s 60%.

● Regulators require lower capital on loans not backed by deposits. But the US Securities and Exchange Commission (SEC) removed in 2004 the leverage cap of 15 to one for investment banks (Bear Stearns, Lehman Brothers, Merrill Lynch, etc.) which allowed them to expand lending vigorously without raising capital.

● By then, regulatory separation between investment and ordinary banks was long removed, encouraging the likes of Bank of America and Citibank to move more and more of their lending to their investment arms. Leverage took off. By end-2007, 30:1 was not uncommon. Lehman’s leverage, when it collapsed, exceeded 40:1.

● Stock buybacks, especially those funded by borrowings (the impact: upped leverage and lowered capital) boosted profits.

● Adoption of sophisticated computer models with advanced risk management controls was intended to reduce capital requirement per loan.

● Regulatory and accounting changes (including mark-to-market rules) resulted in banks’ capital bases eroding much faster than expected.

All these meant that while US banks went on a lending spree so far this decade, their capital base had lagged behind, leaving the system vulnerable and in jeopardy of collapse (US$13.6 trillion in assets against US$820bil in tangible equity, or less than 7%, as at September last year).

Trust undermined

To be fair, the Bank for International Settlements (BIS) in Basel (the central banker’s bank) did express concern over the extraordinary bust of innovation as bankers implemented novel ways to slice and dice their loans (including the now controversial subprime mortgages), and then selling the resultant derivatives under the cover of prime names and high credit ratings to investors all over the world.

Despite many early warning signals (including by notables Professor Robert Shiller of Yale and Professor Nouriel Roubini of Columbia), the Fed appears convinced that these “deals” have changed the system in a fundamentally beneficial way.

No question that there was denial all round, even though the four articles of trust underpinning the system and supporting the credit boom had started to collapse since the summer of 2007, viz, two hedge funds linked to Bear Stearns got into heavy losses related to US subprime mortgages.

This led to a series of downgrades and raised doubts among investors. Soon, the European Central Bank injected substantial cash and the Fed embarked on emergency measures. By the year-end, banks started writing off losses and Britain had its first bank run in 140 years.

In the new year (2008), there were more writedowns and downgrades culminating in the nationalisation of Northern Rock and the collapse of Bear Sterns. And then, the big ones fell – Lehman, Fannie Mae and Freddie Mac, and then Merrill Lynch.

In the first half of last year, the financial system suffered US$476bil in credit losses and raised US$354bil in new capital. This was only the beginning.

The real problem

Basic trust has since crumbled and this has shaken faith in banking and finance. Western banks found themselves running out of capital in a way none of the regulators had imagined. The Fed initially estimated that subprime losses were unlikely to go beyond US$50bil to US$100bil – a fraction of the total capital of Western banks or assets held by global investment funds.

As it evolved, banks started hoarding cash and stopped lending to each other. Bankers lost faith in their ability to assess the health of other institutions – sometimes, even their own!

Then, a vicious deleveraging spiral got under way as banks scurried to improve their balance sheets – selling assets and cutting loans, especially to hedge funds.

All these started with eight years of cheap and plentiful money (liquidity). Sure, easy money provided the fuel. But it soon became evident the real problem in the banking system was not so much liquidity, but toxic assets and inadequate capital.

The regulators lost credibility; the US Securities and Exchange Commission’s relaxation of the leverage capital cap was a huge mistake.

It also became clear that the global capital markets, especially New York and London, were not what they seemed. They could not stay really liquid when required.

Neither did the ratings generate the confidence required of them. The agencies started downgrading even supposedly ultra-safe debt, causing prices to crumble. For example, in July, Merrill Lynch sold a portfolio of complex derivatives at 22% of its face value even though they were rated triple A. Investors lost faith in the ratings and stopped buying, thus created a funding crisis.

Worse still, banks that should have been better protected because of risk dispersion, also cracked. In the end, everything came back to haunt the banks with a vengeance.

Obiter dicta

More than a year into the credit crisis, America’s broken banks are eyesores. Banks are still struggling to respond to investor demands for larger capital cushions and an effective way out to rid themselves of toxic assets. The system did crack and banks remained fearful of their own solvency. Trust remains a rare commodity after eight years of easy money. This trust was broken when the underpinnings of 21st century finance turned out to be dangerously flawed. In a crisis born of greed and indiscipline in the face of the myth of a rational market – the markets know best, remember? – pity is in short supply.

To answer Mahathir

In an environment of easy money (Greenspan cut interest rates too far, too fast), banks, borrowers and investors lost their cool and self-discipline. In an environment where free markets ran amok, trust in the banking system (and its collaborators) was shattered as regulators let their guard down, and bankers let the pursuit of profits undermine the integrity of the system which they were charged to protect. Result: The entire system failed in the face of denial, indiscipline and greed.

● Former banker Dr Lin is a Harvard-educated economist who now spends time promoting the public interest.