May 2009


David Hale

The Rudd essay & the global financial crisis (Part III)

David Hale. © Time & Life Pictures - Getty Images.

The current global recession will be a more defining event than any other business cycle since the 1930s. As Prime Minister Kevin Rudd noted in his February essay, "This crisis has become one of the greatest assaults on global economic stability to have occurred in three-quarters of a century." The downturn will have far-reaching implications because it was unnecessary. In 2006 and 2007, the world economy achieved an unprecedented level of prosperity, growing at an average of 5%. There were 120 countries with growth rates exceeding 4%, and growth was negative only in political outcasts, such as Zimbabwe, North Korea and Somalia. The large increase in the output of developing countries also helped to restrain inflation, so central banks did not have to impose highly restrictive monetary policies in order to contain inflationary pressure. There was monetary tightening in many countries during 2006 and 2007, but it was finetuning. No central bank was attempting to drive its economy into a recession.

The downturn resulted from the collapse of the residential real-estate market in the US, and its potential impact on the solvency of major financial institutions. A year ago, the International Monetary Fund estimated that the losses on American lending would be US$965 billion. It has since hiked this estimate three times. In October, it rose to $1.4 trillion. In January, to $2.2 trillion. The IMF has now increased it again, to $2.7 trillion. The loss for banks alone will be $1.6 trillion. Such a loss is potentially devastating, because the total equity capital of the American banking system is only $1.3 trillion. During the past 18 months, American banks have written off $955 billion of bad debt. It is far from clear how they will be able to cope with such large losses. During the first nine months of 2008, banks raised nearly $400 billion of capital from private investors to replenish their balance sheets, but after the Lehman Brothers bankruptcy the private market for bank capital closed. During the past six months, banks have raised a further $650 billion from governments in the US, the UK, Germany and the Benelux countries. If the new IMF forecast is correct, the American government may have to provide another $1.5 to $2 trillion of capital.

How did the world come to such a perilous impasse? There were three major factors which drove the American property boom at the heart of the crisis, and then magnified the crisis globally.

The first was excess global liquidity, resulting from the large current-account surpluses of the developing countries. During the period 2004 to 2008, the developing countries had an aggregate current-account surplus of more than US$2.5 trillion. In 2008 alone, it was nearly $800 billion. These large surpluses helped to depress global bond yields, a decline that in turn depressed mortgage rates and encouraged property inflation in many countries. It also helped to increase the risk appetite of fund managers for new financial products. Wall Street provided these products by securitising a large volume of American mortgages and selling them as structured-debt products.

The second factor nurturing the crisis was the American obsession with homeownership. Since the days of Herbert Hoover, the goal of all American administrations has been to promote a rising level of homeownership. During the 1930s, Congress created new major intermediaries, such as Fannie Mae, to promote mortgage lending. In 1977, it enacted a law compelling banks to provide more credit for low- and moderate-income residents. During the past decade, the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac expanded their lending for sub-prime and Alt-A mortgages to US$1.6 trillion. This helped to promote a boom which was already starting due to record low interest rates and steadily rising home prices. Congress supported the action because it was anxious to promote homeownership. The result was a surge of lending to households without any verification of income or ability to service the loan. The homeownership rate rose from 65% in 1995 to 69% in 2005, but millions of people obtained mortgages without any capacity to repay them.

The third factor which turned the American property boom into a global financial crisis was securitisation. The securitisation process encouraged banks to make loans that they knew to be high risk because they could sell them to an investment bank, which would then convert them into a structured-debt product. Securitisation undermined any incentive for banks and other intermediaries to protect their credit quality. The credit-rating agencies then facilitated this process by giving high credit ratings to structured-debt products. At the peak, three years ago, there were 64,000 securities - including collateralised debt obligations (CDOs) - with AAA credit ratings, compared to only 12 public companies on the world's stock exchanges with such high ratings. The rating agencies encouraged the CDO boom: the fees on such products were three times as high as the fees on conventional bond ratings. Ironically, one of the companies with an AAA rating was AIG, whose financial engineers exploited the high rating to turn the company into a hedge fund by issuing nearly US$500 billion of credit-default swaps against the CDOs with significant exposure to sub-prime mortgages.

Kevin Rudd's essay was correct to criticise the banks, the ratings agencies and other players in the securitisation process for selling high-risk securities to investors all over the world. What he neglected to mention was the role which GSEs played in driving the sub-prime boom. Congress promoted the boom in high-risk lending by failing to adequately regulate the GSEs.

The loan losses now occurring in the American financial system are going to produce profound changes in the behaviour of private-sector financial institutions, without any need for regulatory change. There has been a significant tightening of credit standards for all forms of loans since 2007. The reputation of credit-rating agencies has been devastated. There is still a market for their services, but Wall Street now understands that an AAA rating does not mean the same thing across different asset classes. In March, Britain's Financial Services Authority issued a major report on how the financial crisis should change regulation in London. The FSA suggested that banks should hold more capital and reduce their leverage. It was also critical of banks' risk-management practices, and argued that regulators would have to play a more intrusive role in the future, guarding against highly speculative behaviour.

The US Treasury has announced its own regulatory changes. It is asking Congress for the power to supervise more directly non-bank intermediaries, such as insurance companies. It is also expected that the Federal Reserve will play a greater role in supervising the financial system. In the past, the Federal Reserve was responsible for supervising the banks, and the Securities and Exchange Commission regulated Wall Street. As a consequence of the crisis that followed the Lehman Brothers failure, Wall Street's two remaining investment banks, Goldman Sachs and Morgan Stanley, announced they would become commercial banks; the traditional distinction between commercial banks and investment banks has, therefore, broken down.

Switzerland, a major financial centre, has also been affected by the crisis. Its central bank announced last year that it wants to reduce the leverage ratios of its major banks to 20. Before the crisis began, the giant Swiss company UBS had been leveraged 57 times, and had a balance sheet larger than Switzerland's GDP.

The crisis has had a major, and still evolving, effect on economic policy. Central banks everywhere have slashed interest rates. The Federal Reserve cut its core lending rate to nearly zero in December. Governments are pursuing more stimulative fiscal policies. The G20 countries agreed at their recent London meeting to expand the resources of the IMF by US$750 billion, to help provide new lending to developing countries.

It would be incorrect to blame the current crisis solely on private-sector greed. The sins of Wall Street and the banks are serious and well known. But Wall Street and the banks did not act alone. The banks were subject to supervision by the central banks, and regulatory officials failed to recognise the errors in risk management by private-sector lenders. They did not perceive the lending excesses in the system until the markets began to seize up. The American property-lending boom was magnified by the GSEs seeking to promote homeownership while also making a profit, and sub-prime lending would not have gotten so out of control without the help of government intermediaries. Australia did not experience a property boom as destabilising as America's because its banks had more prudent lending policies, and there were no GSEs promoting low-income lending.

The challenge for governments in the future will not be simply to increase regulation. It will be to regulate effectively. There was a major failure of risk management during the first decade of the twenty-first century. Both bankers and regulators will be able to avoid future crises only if they can develop better checks and balances to enhance the management of risk.

© David Hale 2009.

Cover: May 2009
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