Tuesday, September 25, 2007

Throw The Book At Sub-Prime Criminals

Source : The Business Times, September 25, 2007

At the heart of the current financial turmoil is simple, old-fashioned fraud

In the wilderness: Governments around the world should implement a '3R' framework of retribution, regulation and re-engineering of the financial system to deal with the credit crunch and prevent similar crises from occurring

IMAGINE local farmers growing a crop quickly by intentionally using hazardous fertilisers and selling the produce to well-reputed international grocery chains. The food safety authorities are aware of the malpractice, but turn a blind eye to it.

In their labs, the grocery chains identify the dangerous substances, too. Nevertheless they dry the produce and sell it in attractively branded packages with quality approval seals to trusting shoppers around the globe. Several consumers die, others require medical treatment at the expense of taxpayers. Would you cry 'foul play' and demand remedial action?

The current financial turmoil, which costs investors around the world dearly and spills over into the real economy, is portrayed as a very complex phenomenon. But this noise hides a simple inconvenient truth: At its heart is old-fashioned fraud, as simple as the farmers' ruse and distributors' conspiracy in the crime.

Here is the ploy: Banks rapidly grow their loan books by granting mortgages even to borrowers who cannot afford them. They swiftly sell these risky loans to other financial intermediaries and thus clean their balance sheets. The intermediaries repackage them as 'collateralized debt obligations' (CDOs), adorn the securities with high credit ratings, and thus hide the junky nature of the underlying assets.

Then, they sell myriad slices of what essentially is a black box to investors around the globe who are lured by high interest rates and put blind faith both in the sellers' brands and credit ratings. Central banks look the other way.

In a pyramid scheme, a steady flow of new CDOs help finance the interest payments to the investors. The Pandora's Box is opened when the mortgage holders start to default and the equivalent of a run on banks is triggered.

Liquidity is drained from the system, since banks refuse to lend even to other financial institutions and investors scramble to escape from the trap. Market insiders again profit, this time from well-informed bets against the junk loans.

Financial institutions at the brink of collapse are rescued with taxpayers' money. Central banks around the world succumb to pressures to cut interest rates, which fuels global inflation. The financial problems spread into the real economy and unleash a vicious circle: The credit squeeze dampens investment in the housing sector and results in layoffs. Distressed consumers spend less and default on other loans, prompting banks to tighten credit further.

Afterwards, market insiders laconically state that, as a rule of thumb, some financial product innovations will falter. They share their joy over the fact that by now, the world has come to understand the simple truth they have always known, but never shared: CDOs cannot be priced!

Governments around the world should implement a '3R' framework of retribution, regulation and re-engineering to deal with the crisis and prevent similar developments.

In the short term, authorities must stop talking about unfortunate 'mistakes' and use the term 'crime' instead. The masterminds of the financial time-bombs and their accomplices - such as certain credit rating agencies - should be prosecuted mercilessly. Destroying the life savings of pensioners and other investors is a serious offence, especially in countries with ageing populations and insufficient retirement provisions.

Like drug trafficking, it undermines the fundament of society and thus deserves the harshest sentences that courts have at their disposal. Those criminals and their employers, rather than taxpayers, should pay for the damage using the cash they horded.

Criminal convictions and significant compensation payouts will help deter similar crimes.

In the medium term, governments must tighten regulation in certain financial arenas. As for other legal subjects, compliance must be mandatory, not just voluntary.

Mortgage features, such as low downpayments and deferred debt-service, should be scrutinised to protect financially naive consumers. Hedge funds must be closely supervised, too.

Besides, the authorities must lift the veil hiding the dubious practices of credit rating agencies and regulate them, too. To eliminate their monopoly power, which leads to abuse, national governments should consider setting up their own credit rating agencies.

The authorities also need to regulate securities more tightly. They must keep a watchful eye on financial 'innovations', including off-balance sheet investment vehicles tied to asset-backed commercial paper, which often are old tricks in new disguises.

Collapse

A stricter penal code needs to be introduced to deal with financial high crime.

In the long term, the financial system must be changed fundamentally to decrease the likelihood of collapse. Most importantly, countries around the world should move from a market-driven system to a bank-centred financial architecture that puts firm limits on 'securitization'.

In the past, national banks operating in a regulated environment proved capable of financing rapid and sustainable economic development. They can serve as models for the future. For example, Germany's astonishing recovery after WWII was facilitated by strong relationships between banks and industry.

They helped the credit institutions gain first-hand information about the prospects of their clients and thus price loans efficiently. Through membership in the supervisory boards of borrowers, bankers even could influence their strategies. There was no incentive for either banks or their clients to cheat on each other since they interacted continuously.

Besides, banks kept their loans on the balance sheet and had to attract savings to finance them. With direct responsibility for the results of their lending and limited financing options, they were motivated to allocate scarce resources to the best uses, which involved extending credit prudently.

Since they kept assets and liabilities on one balance sheet, it was easy to match maturities and risks. This limited the risk of illiquidity. Depositors, shareholders and regulators could understand a bank's risk profile better than now, since it did not offload risky assets into black holes in global markets.

Intelligent financial supervision and well-informed, prudent lending practices ensured that in contrast to what happened in Japan and China, German banks did not accumulate significant amounts of bad debt in the past.

Countries around the world, especially those with large underfunded 'sunset populations', cannot afford to leave the future of their citizens to the vagaries of markets that are cornered by fraudulent ring leaders with insider knowledge, who pose as emperors in new clothes.

The 3R framework will help governments regain control over the financial system and create a solid fundament for future generations.

The writer is a former professor at Peking University and McKinsey & Co Management Consultant. He is a global leadership expert at the National University of Singapore (NUS) Business School and the author of 'The Art of Chinese Management'. He can be reached at schlevogt@schlevogt.com.

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