It started in the 1970s and 1980s, the deregulation of the financial system, with America leading the way. Add to that a wave of financial innovation, with New York investment banks in the lead, and then moving quickly elsewhere, financial deregulation was all the rage.
First came Securitization and Derivatives in the 1970s, with the innovative Salomon Brothers in New York. Then followed in the 1980s, risk transfer products, first with Credit Derivatives (CDs), and later Collaterized Debt Obligations (CDOs) and its cousin Collaterized Loan Obligations (CLOs), with variations of these products creating a multitude of products. All these products opened the door to substantial abuses.
The central bank role became more limited, mainly involving itself with setting interest rates and monitoring the economy. Even the role of supervising the banking system for most jurisdictions was transferred to other regulatory authorities. Central banks abstained themselves from any function relating to the monitoring or regulation of asset bubbles, such as in equities or property.
Martin Wolf, the chief economic writer for the Financial Times says that over 100 significant banking crises have occurred during the past three decades, which doesn’t say much for financial stability. The biggest crises were in America, with the savings and loan disasters of the 1980s, the commercial property crisis of the early 1990s, and now the subprime and securitised-credit crisis of 2007-08.
There were at least two other crises. One of these was the financial market crash in 1987, and the collapse of Long Term Capital Management in 1998. In all these crises, greed and manipulation were at work. The greed and manipulation is even more rampant in the subprime and securitised-credit crisis currently in progress, which is by far the worst financial disaster since the Great Depression.
The credit crunch is still very much in evidence. Since early August, banks have been reluctant to lend to each other. Many of the private equity deals, which were all the rage one and two years ago are going sour, and those deals still underway are largely underwater.
The banks have lost heavily, as they largely deserved to, because greed gripped them too tightly. Having been forced into writing down large volumes of assets, they will still need further equity injections. But when that time comes, more and more equity may be harder to get.
The sovereign wealth funds as white knights are on a losing proposition, and they are beginning to realise that. The new wisdom is that investing in US and European banks doesn’t make much sense, compared to placing their money directly into productive companies in raw materials, and in innovative technology.
The investment bankers deserve heaps of blame for originating masses of CDOs stuffed with subprime mortgage debt, and their companions, the marketers for selling these toxic securities. After buying subprime mortgages, the bankers proceeded to bundle them with other loans into supposed gilt-edged residential mortgage backed securities (RMBS).
The mortgage brokers who were more predators than good guys, as agents of residential customers to secure mortgage loans from financial institutions were consumed by the financial rewards, totally indifferent to whether their customers would be able to service the loans.
Too many of the residential borrowers were refinancing their homes beyond levels they couldn’t afford, tricked by the mortgage brokers into covering short-term emergencies. Only 11 per cent of the subprime loans were to first home homeowners. A study by the Centre for Responsible Lending said that over 61 per cent of the subprime borrowers, who were on teaser rates on adjustable rate mortgages would have qualified for a conventional prime rate loan.
Two other groups deserve substantial blame. The rating agencies-Moody’s, Standard and Poor’s (S&P), and Fitch endorsed too many of the doubtful securities, which ended up sour. The magnitude of defaults was largely the result of the rating agencies persisting in using faulty models to base their confirmation of the soundness of the securities.
Given their monopoly position, the raters need to smarten their act. The only good news is that a fourth rating agency which has been operating for some time, the tiny Egan-Jones, has recently been given the green light to operate as an official rating agency.
The other faulty parties are the monoline insurers, incorrectly given a triple A rating, given the size of the securities they were insuring against their small capital base. They should never have been allowed to insure complex structured debt, which was beyond their skill base in understanding the potential for rapid failure.
Currently, the FBI is investigating 14 companies for possible accounting fraud and other crimes related to the subprime lending crisis. The chief of the FBI’s economic crimes isn’t identifying the companies, only saying that the cases involved “valuation-type stuff.” Three of the firms Goldman Sachs, Morgan Stanley and Bear Stearns have reported that regulatory agencies are looking at investment products linked to home loans.
Other regulatory agencies including state agencies are investigating aspects of the loan abuses and manipulations. But isn’t it a bit too late to show concern. It’s like bolting the stable door after the horse has bolted. Why let the horse out in the first place.
