Sub-Prime: Six Lessons, And Counting

Source : The Business Times, March 7, 2008

The more things change, the more they stay the same - the US fiasco has thrown up mostly old lessons to be re-learned.

EVERY financial crisis has its lessons. Most of them are old lessons which need to be relearned. Here are six (and still counting) from the United States sub-prime crisis:

1. Financial innovation is not always innovative, nor benign

Many of the so-called financial innovations at the root of the sub-prime crisis have been seen before, in previous crises. For example, the securitisation of credit (the packaging of loans and other financial assets into marketable securities) and the ‘originate and distribute’ model (whereby financial institutions create various financial instruments and then distribute them to investors) were in evidence during the run-up to the great stockmarket crash on Wall Street in 1929. At that time, banks originated and ingeniously repackaged highly speculative loans and marketed them through their own networks.

Similarly, in the run-up to the current crisis, financial institutions creatively sliced up sub-prime mortgages and packaged them into ‘collateralised debt obligations’ (CDOs), which ultimately found their way into the portfolios of investors around the world, including many large banks.

Many other features of the sub-prime crisis - the use of leverage, the opaqueness of investment instruments and their multi-layered structures - evoke, likewise, a sense of deja vu.

Amid boom times, the lessons of the past are not always remembered. As one of the sharpest observers of financial crashes through history, late economist John Kenneth Galbraith pointed out: ‘In the world of high and confident finance, little is ever really new. The controlling fact is not the tendency to brilliant invention; the controlling fact is the shortness of the public memory, especially when it contends with a euphoric desire to forget.’

2. Gatekeepers tend to be behind the curve

In the sub-prime crisis, the main ‘gatekeepers’ can be said to have been the credit rating agencies. They were unable to spot the excesses when it really mattered. This again is not new. It also happened before the crash of 1929, when credit raters were too liberal with their seals of approval and were unable to anticipate the sharp drop in bond values or the defaults that were to come.

More recently, we saw during the Asian financial crisis of 1997 how many Asian economies enjoyed high sovereign ratings prior to the crisis, even on the eve of the crisis itself. But once the crisis hit and the rating blunders became obvious, the credit raters overcompensated in the opposite direction, subjecting Asian economies to downgrades of extreme severity - which made the crisis worse.

Rating agencies were again caught flatfooted by the collapse in 1999 of US energy giant Enron - which they had also rated highly. US Senator Joseph Lieberman, whose Senate committee held the first public hearings on Enron, described the credit raters as ‘dismally lax’. ‘They didn’t ask probing questions and generally accepted at face value whatever Enron’s officials chose to tell them,’ he said.

Similarly in the sub-prime crisis, most CDOs - despite being highly opaque - were rated AAA (the highest rating, which explains their popularity among investors). After the soundness of CDOs and other mortgage-related bonds became obviously suspect, their ratings were furiously downgraded. Remarkably, the bond insurers who insured CDOs were also given AAA ratings. When the insurers’ exposure to these toxic instruments became clear, the rating agencies threatened to downgrade the bond insurers as well. But if this happens (and it already has, in a few cases), the latter’s business model - and, indeed, very survival - is threatened, because few entities would want to be insured by a insurer that is less than financially sound.

At least when it comes to their ratings of the bond insurers, the credit rating agencies can be said to have been not just behind the curve, but asleep on the job. As Professor Nouriel Roubini of New York University (and one of the first to raise the alarm about the sub-prime crisis) put it: ‘Any business that needs a triple-A rating to remain in business doesn’t deserve a triple-A rating in the first place.’

3. Self regulation does not work

Prior to the sub-prime crisis, US financial markets relied heavily on self-regulation, even for highly leveraged entities such as hedge funds and private equity funds. Financial institutions have been free to ‘innovate’, including to create highly complex and opaque instruments and various ‘off-balance sheet’ vehicles like conduits and ’structured investment vehicles’ or SIVs (which are in fact driven precisely by the desire to avoid regulatory requirements, such as minimum capital and liquidity standards). A number of ‘innovative’ loans (such as ‘liar loans’ which did not need any income verification and ‘piggyback loans’, which involved no downpayments) also became common.

Self regulation was also de rigueur in the run-up to previous crises. Before the Asian crisis, for instance, regulation of banks was either light or not enforced, which enabled such excesses as lending based on relationships rather than creditworthiness to flourish and unregulated entities like finance companies to operate with wanton disregard for risk. The years before the 1929 stockmarket crash were likewise attended by extremely lax regulations on financial institutions which led to the proliferation of all manner of wondrous investment schemes and structures.

Each crisis has been followed by regulatory catch-up, as the lesson is re-learned that voluntary codes of conduct and self-regulation is no regulation without vigilant official surveillance, at a minimum. Also, that some rules are needed to protect investors and financial institutions - ultimately, from themselves - and to guard against systemic risk.

4. Consumer spending can be artificial

Much of the US economic boom since 2002, in particular, has been driven by consumer spending, which accounts for more than 70 per cent of US GDP. The exuberance of the American consumer has been considered a litmus test of the health of the US economy. However, much of consumer spending was financed not out of savings but out of debt, in an era of super-low interest rates. It was also inflated by rising home prices: consumers with mortgages were able to draw ‘cash out’ by refinancing, often repeatedly; the bigger the mortgage, the more the home could be used as an ATM. The high ratings given to mortgage-backed securities which the banks peddled to investors fuelled ever more generous terms on mortgages, further inflating the home -equity-financed consumer spending binge.

A lesson: beware of debt-financed consumption as a sustainable driver of economic growth, and/or financial markets - all the more so if the debt is based on rising home prices.

5. You can bet against the Fed

There’s a popular saying in the markets: ‘Never bet against the Fed.’ Some of the events of the sub-prime crisis prove that this is not always true. Throughout 2006 and most of 2007, the US Federal Reserve’s assessments of the risks facing the US economy and financial markets - particularly the assertion that the US sub-prime crisis would be ‘contained’ - were way off the mark. Anybody who bet otherwise (and some did) and went short in the markets would have done well. Also, repeated interest rate cuts by the Fed (by 2.25 percentage points in the last six months) have failed to lift either the US economy or the stock markets. Part of the reason is that the Fed cannot do much in the short term to help troubled banks recapitalise. Its rate cuts also cannot directly resolve the problems facing non-depository financial institutions like hedge funds, investment banks and off-balance sheet entities like SIVs.

Whether the Fed’s rate cuts can avert a US recession during the current crisis also remains to be seen. On some previous occasions (most recently, the period following the dotcom bust of 2001), they were unable to do so.

6. When in trouble, bankers embrace socialism

The often spectacular gains that bankers make during boom times accrue to shareholders, employees and, above all, top bank executives. But in terrible times, such as now in the US, losses are, more often than not, sought to be dumped on governments - in other words, on taxpayers.

In the current crisis, the most prominent case so far has been the nationalisation of the British bank Northern Rock, for whose imprudence British taxpayers will end up paying tens of billions of pounds. In the US, while there have been no comparably overt bailouts (although we could yet see some), banks have been getting low-cost loans from the Fed and other government agencies, using collateral of questionable value. There are also various bank-supported plans afoot to expand the guarantees provided by US federal agencies for mortgage refinancings by delinquent borrowers.

At the end of the day, the final tab picked up by the US government to pay for the banks’ recklessness could well end up being several times as large as the approximately US$150 billion spent on the bailouts of the US savings and loan (S&L) institutions during the last significant banking crisis - the S&L crisis of the 1990s.

Similar bailouts have taken place over and over in the history of the banking industry, going back decades. As Martin Wolf, chief economics commentator of the Financial Times, put it recently: ‘No industry has a comparable talent for privatising gains and socialising losses.’