The subprime crisis has exacerbated by toppling down of several leading investment banks (Bear Stearns, Lehman Brothers), nationalised GSEs (Government Sponsored Enterprises, such as Fannie & Freddie), bailed out AIG in the US, and the contagious effects are sweeping around the world, leaving no Anglo-Saxon countries unscathed, precipitating deleterious effects to the world’s economy. What are the real causes of the crisis? How can we put our world economy in better shape “tomorrow” is what this article concerns the title that I choose “in future tense”.
The causes of subprime crisis
In a nutshell, the economic cataclysm riveting our attention is the result of no regulatory supervision of unbridled financial products proliferation, no stress test under the worst case scenarios how they impact the financial world. The result is an array of unexamined financial products had already out of the factory’s door creating upheaval. The laisser-faire approach was evidenced by risk assessment units assigning low risk grade to high risk structured products, underestimating the complications of the chain effects the product attributes carry.
The financial world is busy making money sloshing around by pooling monies rather than taking a hard look at the downside that augmenting the pernicious effects. According to a report unfurls, “in 2006, of the $3 trillion in loans extended to all mortgage borrowers that year, $615 billion were subprime, $475 billion were alt-A, and 395 billion were jumbo ARMs. An incredible $250 billion in the riskiest stated-income, no down payment subprime ARM loans were originated.”1 This is how the crisis cascades: Speculation in housing market resulted overbuilding. When the markets were whittled away by plethora of housing supplies and high interest rate, refinancing became more difficult, the markets flailed at the blink of an abyss and the contagious unraveled.
The colossal failure is also the result of no mechanism to perform continuing monitoring and evaluation of level of cash reserve capacity to correspond with disparate risks the financial institutions are assuming. Especially those involved in high leveraging businesses, for example Hedge funds that require continuing re-evaluation of risks, because the higher leverage you go, the more liquidity risk you are assuming (margin call, redemption and other liquidity shocks), so the requirements for deeper cash reserve capacity to absorb liquidity shock is sine quo non.
It is palpable that the existing framework of governance does not match the sophistication of the products proliferated. In the wake of the financial woes deepened, those reining at the helm petrified and came to their sense how that iffy structured products’ obscurity weare causing snafus. (For example, how to account for a hodgepodge of different category of risks in an arcane structured products. They also assumed securitisation diversified away risk, in fact the risk is concentrated, Misjudge risk is just a reminiscent of the Long Term Capital Management saga) If you cannot ascertain risk and value of a bunch of gobbledygook at the very beginning, certainly it will continue to be obfuscating even till the time facing call. It is culpable that investment banks and hedge funds ignored credit risks, asset price risk, counter party risk and liquidity risk they were assuming.
Another factor exacerbated the crisis is greed. There are still people disavow and singing the song of how greed is humming the engine of capitalist system; greed had no bearing on current crisis and what was at fault was stupidity. Some renowned economics professors joined the chorus. What they failed to see is people are always blinded and get lulled into false sense due to greed, and stupidity ensues. The most egregious example is the market is awash with easy monies blinded some of the venal Americans. They became intermediaries borrowing cheaply and raked in profit from excessive housing speculation, flipping multiple housing assets to get rich quick; In the same vein, loose lending standards exacerbated bubbles fermenting (ignoring standard lending best practices), and when bubble burst, orgy of speculation spread to commodity market pushed up commodity price and food price causing disarray are good examples of how greed had blinded them to the systemic consequences entail.
The effective regulatory control is through chastening, by hiking transaction costs to tamper the evil inside not to take calculated risks. It is the foresight of not letting things gets out of hand that matters. Think of the total costs to clean up the systems by nationalising the banks and buying bad loans of the ailing banks. Foresight is derived from a panel of finance professionals with diverse financial background in an open culture environment rather than gained from a venerated person’s expertise to call the shot and expected him to be on target every time.
Through slice and dice, structured products moved money fast making large and small investment banks so eager to earn transaction fees, commission and lending spreads to chalk up record earnings, they were blinded by the mercenary lure and ignoring increasing risks. It was their big bonuses tied to financial results that counted. This greed we learnt during the tech bubbles, and soon it was evanescent and now is back to haunt us demanding us to pay more for the lesson.
There is no conspiracy, as the US is the hardest hit by the crisis. The unruly financial crisis broke out in a rash in September pulverised global investment banks, inflating public debts, vitiating further the US financial position. In the short term, banks and business communities are facing severe liquidity problems as mutual trust and transparency are simply lacking. This cautious behaviour is a defensive routine and is normal in a sense it is part and parcel of self-protection due to lack of transparency. And partly undercapitalisation of the troubled banks needs to infuse new equity, and also need funds for deleveraging.
Deleveraging is not the cause, it is the markets turn to defensive behaviour, though it precipitates the fall in house price and mortgage loan security and exacerbates the malign vicious cycle. Deleveraging is the institution survival mode, it is a process that financial institutions unwind their gearing and revert to economic reality. Especially when deleveraging becomes a trend at the backdrop of global slowdown, unwinding is a process to keep balancing. It is during this phase the market consolidates. Deleveraging will slow when the market hit the bottom because once the pressure of house price eases, there will be no further downside.
Is 700 billion rescue bill a panacea?
The simple answer to the question is depending on the objective and what you want to achieve? At best, there is limitation the role the treasury can play; the newly minted bill gives unprecedented power to the treasury carte blanche in the rescue efforts. Buying bad loan and ailing assets are performing the role of an investment bank. It is extremely rare for the Treasury to step into the role of the investment banker. And make no mistake; their actions are hemmed in by the congress and the tax-payers. What is more, there is risk involved because the market may decline further, and expose tax-payer’s monies into bigger risk.
There are two scenarios in my perspectives to explicate the Treasury’s rescue:
The first is there is not much meat left and tremendous inherent risk shun away prospective buyers. In private corporate finance sector, it is exceedingly rare not to have throng of experienced blood hounds earnestly chasing for opportunities in a gummed up credit market. One answer is the risks involved are not adequately compensated. And if no one or very few in the private sector perform this role, the treasury cannot fudge the matter and becomes the last resort to clean up the credit woes and assume the risk.
The second scenario is the market is under severe liquidity strain. Even the Fed early this year introduced Primary Dealers Credit Facility (PDCF), Term Securities Lending Facility (TSLF), and Term Auction Facility (TAF). The Fed also went all length to inject liquidity into the markets several times. Certainly these auspices helped, but palliative and fleeting. These aids came with conditions attached restricted the use to shoehorn firm’s drying liquidity due to institutions own capacity. Undercapitalisation is foreseeable due to massive write-down pushing the institutions close to precipice. The aids did not hit the nail on the head. A huge blizzard is eminent on the horizon. In other words, the market is thirst of liquidity, and each is more parochial to take care of one’s own yard and averted from buying troubled assets. It is lamenting that this hard to ingratiate task is fallen on the treasury. Who else besides the treasury is in the capacity to clean the shambles?
Apart from assuming risks that is unquantifiable, the major contribution of buying ailing assets and bad loans is to give bank with a clean slate, a fresh footing and that is important. Without that the suspicion will remain, and there are many clogs choking the financial system. There is no basis for recovery.
Buying mortgage back securities, residential mortgage and other assets is dicey due to inherent unforeseen downside risks in a declining market. Nobody can guarantee the asset managers can buy at the lowest price because the market continues declining. And the value is changing all the time especially under poor external economic environment.
I am amused about fair value accounting was shot down in this credit crunch. The moot point claimed mark to market was inimical and would jeopardise the worsening balance sheet, because all banks were to recognise losses at the same time, impairing their capital, and triggering fire sales of assets, which in turn drove down prices and valuation even more. They said during the market crisis, there were simply no market prices that made objective sense. During financial turmoil, chances are some companies are no longer a going concern; break up value seems more appropriate. Investor wants information reflects intrinsic value of the company, even value changes rapidly in myriad situations. If asset’s value is grossly undervalued, there will be arbitrage opportunities to prop up price even is an illiquid asset. It is preposterous that when the market is booming, you are in favour of mark to market, and now the market decline, you discard and shelf the standard. Accounting standard is just a tool, why politicised and resort to ferocious lobbying? No wonder the accounting profession is so fragile that always face the threat of acquiesce to people’s manipulation- ask to produce the figure they want. Wart and all, transparency is promoting the market, why work the other way round?
Transparency is also promoting trust, improving credulity. At this juncture, trust in between banks is diminishing; mutual lending in between bank is becoming more difficult, 2 and not knowing the other borrowing party will bankrupt tomorrow ploughing the seeds of distrust. Skittish depositors scurry to withdraw monies in trepidation. Panicky hedge funds pull out cash. Bankers are nervous that borrowers who look good today may not turn out to be so solid. Banks also borrow short term to fund long term assets find themselves in a fix and worry that short term loan may not forthcoming . Flight for safety is common response. The resulting impacts are Bank cash reserves are quickly depleting, lending activities are slowing. Borrowing rate is skyrocketing, these will severely impede rolling of business activities, and the economy is slowing fast.
The remedies to improve transparency are to first set up a special audit squad to segregate banks assets between non-performing with the performing one. The treasury will provide back to back guarantee to the performing net assets of the surviving banks. Banks are required to disclose at daily clearance the aggregate lending and borrowing activities, and it is the obligation of the borrowing bank to disclose at time of borrowing that they are within guarantee limit, so to put the prospective lenders at ease. Once these guarantees and transparency are in place, banks will start mutual lending. Once this is kick-start, the normal banking activities will start rolling, investors’ confidence will resume.
It makes no sense to prop up the property market to stop the fermenting vicious cycle caused by deleveraging. It is pyrrhic, wasting tax-payers monies, and achieving zero effects because the overhangs of housing supplies are yet to clear. Propping up market can only achieve temporary respite and cannot chasten declining market force. It is all about timing. The tactic is to buy time. Restructure short term loan to longer term to match assets with liabilities will alleviate part of the liquidity problems. If the property market has already hit the trough and will be reviving next year according to Alan Greenspan’s recent observation, deferring some problems now and they will gradually unwind and becomes peripheral in a rising market. Of course, some problems still need immediate attention. Deferment does not mean policy maker can shrug off their responsibility to skip reform. One constructive approach would be to look for alternative temporary use of those overhangs until such time that the economy back on its own footing that may alleviate the downward pressures.
Central bank nationalisation or direct lending will not solve undercapitalisation problems. For direct lending, on Balance Sheet, the rescued bank on the one hand, is to shun high gearing by deleveraging; on the other hand, the bank re-gears through the amount borrowing from Central Bank lending, so, it is back to square one.
From the central Bank perspective, nationalised all ailing banks is arduous, making the Treasury tantamount to running banking business, a welter of managing and controlling problems stem from the tremendous amount of chores to supervise and monitor these banks and the resources used are simply not making the option economical. Nationalised bank not only profligates a huge extra budget that may further worsening behemoth fiscal budget deficit (There are two ways out, either borrow to the hilt or print dollar even faster), All hell breaks loose, there also encompasses equity problem (Does the biggest always get bailed out?), a moral hazard problem (Wrongdoers are not punished, and basked on government’s bail out, moral virtue is nebulous); it is also desultory (the unspoken reproach is how about Bear Stearns and Lehman Brothers, were their demises at the wrong time?) Tax payers are disenchanted and malaise of congress turns on the money spigot. They are seething at using their monies to cleaning the mayhem originated by the Wall Street’s malfeasance. It is nefarious. Now GM appears to be wonky, does the Treasury also nationalise GM? It is inconceivable. There will be too many casualties down the road and there is limit a country and its Treasury can do.; and political risk involved too.
The advisable way is: sovereign wealth funds are a straw worth crutching. Those leading banks with good grade need not be too staid and circumspect of foreign threat and become intransigent; the crux is to extensively diversify foreign funds in manageable chunks and offering restricted rights, making each fund a small proportion of total shares; so that no funds are in dominant position or holding substantial share interests. Second, if the bank is raising redeemable preference shares, they can sweeten the deal by paying good rate of dividend and transfer banking skills in volition. I think it is easy to mesmerise suitors vying for subscription. Preference shares being dole out are deemed part of equity. This brings down or maintains the efforts of low gearing measurably, and the upside is being able to redeem preference shares when the bank recuperates.
If recession falls, what is next move?
I am paranoid the way how people interpret GDP figures. Many accustom to direct quantitative interpretation as a way of projecting economic picture; for example, two consecutive quarters of falling of GDP as recession. I cannot more agree with the well-founded view in the article -“Redefining Recession” (“The Economist” 13th September 2008 edition) that I share their contention. My instinct viscerally tells me always to read the GDP figure in context. Many a time, the duff figure is skewed by unbalanced components in GDP. The picture is always distorted. The typical controversy is whether we are in recession now. Man in the street insisted the economy in recession. However, those swear by the ironclad rules interpreting the subliminal GDP message as: “the economy is debilitating, growth is at its slowest, we are on the verge of recession”, I think such contention is vacuous, because definition is man-made. What is the difference between 0.5% growth and no growth? The people in Main Street are just indifferent. They are twitchy and stew the pressures of downturn on their lives, whether official recession heralded.
If the credit crunch causes the world slips into recession, what would be the response? Central bankers around the world in cahoots have made coordinated efforts to cut interest rate recently to calm the antsy markets and allay worries. To recuperate, there are disparities among approaches to tackle recession. Cutting interest rate and showering with easy monies are ostensibly to creating a stimulating environment for money use, a typical monetary approach. I find during the time when economic activities are declining, easy monies does not cut the mustard to revive the economy because aggregate demand is simply absent. How about invoke Keynesian models resort to pump prime or adopting fiscal policy tax cut, which way is better?
I am neutral with all the approaches. But I think during the economy declining, on the back of debilitating private sector activities, slow in capital spending, rising unemployment, weakening consumer confidence, government spending is the main source to keep the economy continues its momentum. Tax cut helps very little either. In developed or developing countries, large part of tax payers come from middle and upper income groups, a few percentage points tax relief may increase their disposable income but will not rush them for spending spree. The correlation between tax cut and spending is not that strong. It is vaunted to say tax cut as a reviving tool.
Neither is pump prime approach a solution to reviving economy. We use to equate pump prime with infrastructure spending. It is hyperbole resort to pump prime for the spill-over multiplying effects to jumpstart the economy at full pelt. Infrastructure spending is beneficial for developing countries, such as China, India. After all, for China, large part of their GDP accounts for public spending in infrastructure. How about developed countries? Government still can upgrade or maintain public infrastructure that are in tatters. But John Maynard Keynes does not live our times, we need not to dogmatically applying infrastructure spending doctrine and we should upend the notion innovatively.
Even I downplay the spillover effects; I am enamored of revving up public spending to fill the void of private sector spending in a strategic way. Policy maker can do two things steadfastly:
First: Maintenance spending: to maintain economic momentum by spending on promoting economic activities representing major economic components and upkeep of tattered infrastructure for developed countries.
Second, forward looking spending, I recommend spending on renewable energy R & D. I foresee (It is conjecture) after the economy recovered, the business cycle will become shorter and more volatile. Indelible high fuel price and food price of the present cycle due to supplies shortage, increase demand and market speculation will continue to haunt us. To iron out hitches that obstructing future economic growth, policy maker should not be impervious, proactively assuage supply tension and protect future economic health by speeding up the alternative use of energy supply. In the same vein, increase the productivity of agricultural activities to cover supply shortage. To resolve supply constraint, monies spend on research for substitutes of some materials used to tame commodities price such as steel, metal etc. It is imperative to spend on new and affordable health care business model for health care systems and also new inventions to cater for aging population are high on the card in future economic developments. Government with foresight will tackle these problems of strategic nature.
Notes:
1. Financial shock by Mark Zandi (Financial times) page 43
2. A sigh of relief, as of the completion of this writing, there were changes took place in the international arena, first, central bankers offered joint guarantees to the bank, to break the deadlock of mutual lending. Countries in Europe and US also nationalised banks. According to the paper, US Treasury will buy preference shares in the banks. The latest news also broke out the money market ease sharply, and expecting the interbank dollar costs to decline further.
