Events in the US financial sector are unfurling dramatically. Or should I say unraveling? And it appears that there is more to unfurl. To understand the US financial sector at the moment we need to understand the chain of money, finance, debt, risk and trust which interlinks homebuyers, retail lenders, investment banks, financial insurers, speculators, hedge funds and credit ratings agencies.
The sub-prime crisis has been widely reported for a year now. But how on earth could the average “Joe” bring down the global credit ratings system? The answer is he didn’t. He is just the “fall guy”, along with the “low documentation” sub-prime retail lenders. They are the fall guys because they’re involved at the periphery, and some media spin seeks to divert attention away from the real problem and its causes. If the system was working properly no home borrowers could break the system. So what’s gone wrong?
Sure: it isn’t really smart to give home loans without any deposit to so-called “Ninja’s” – those with no income, no job and no assets. So it is fair to direct some of the blame in the direction of the retailers and the borrowers. They should have known better. They may well have known better.
But maybe the lenders weren’t completely silly. Especially if they could off-load the future loan risk onto other parties before the risk materialized, and be rewarded for opening those loans without being accountable for the subsequent performance of those loans.
And it would be equally unfair to claim those borrowing to buy homes were stupid. Accommodation in a nice “home of your own” for a year or two on an unrepayable loan works out way better than renting. There’s no landlord, and you’re even free to treat the property as you wish. After the introductory low interest rate period expires: simply send the keys back to the bank and walk away. And even return to apply for another sub-prime loan, if the lender ignores your credit rating, which they did in the first place.
But what is a credit rating? Well, we’ll get onto that later.
This is how the system operates. I can’t choose the word “works”, because something is not working the way it should. Home buyers, some with no income or deposit, take out a mortgage from a retail lender. The retail lender bundles mortgages together into mortgage backed securities, which they sell to other banking entities further along the chain. The investment banks have very clever young business graduates with no experience of a crash. But they do have mathematical models. They statistically predict mortgage failure rates embedded in those mortgage backed securities. They then slice and dice and reassemble tranches of those securities to create structured investment vehicles (SIVs) and collateralized debt obligations (CDOs) which have a blend of good, intermediate and risky mortgages. The theory is that there’d be enough good mortgages to cover the chances of default by the bad ones. Those CDOs would then be sold to shire councils, local municipalities, superannuation funds and other investors around the world, from Norway to Australia. When I was young I was taught that mathematics can be used as an abstract representation of reality. But for these guys mathematics is reality, not a model of reality.
Now, that class of end investor is required to invest only in “AAA” rated investments, to protect their stakeholders against bad investment decisions. Trust is transferred to the credit ratings agencies. Using their mathematical models to forecast loan default rates and projected house prices, the investment banks were able to convince the ratings agencies to assign “AAA” ratings to those investment products. They would also use credit default swaps and other derivative instruments to insure those assets, to further protect against risk. Effectively they would forego a small amount of income to buy insurance in the form of derivatives from third parties, who would guarantee the performance of those CDO and SIV assets.
The money generated from selling those assets would then be ploughed back into the system as new loans to more home buyers, completing the circular flow of money and leveraging up the amount of debt and money to many times the original loan amounts. With all that money available, borrowing remained easy. They were throwing money at anyone who wanted a loan. “Don’t have a deposit? No problem, we’ll lend you the deposit!” And so the money circle continued, grew, and spiraled up, inflating house prices and creating the housing bubble. While it worked, everyone involved was a winner. On paper, at least.
But when things spiral up into leveraged bubbles, the collapse is usually as big as the rise. You can’t create wealth out of thin air. Those who bought houses near the top now find their mortgages upside down. If they’re not being foreclosed upon, many are simply walking away. So now, not all loan repayments are flowing back through to the end investors. This triggers insurance, and calls into question the credit ratings.
The sub-prime part of the problem has not really even got under way yet. I understand that there are many more loan defaults to come than have happened so far. This is because many of the problem loans are so calls “ARM” loans – adjustable rate mortgage loans. They have a fixed term low interest rate honeymoon period, after which the interest rate resets upwards to the market rate. Most ARM loans are still on their honeymoon low rate, and are yet to be adjusted upwards. So we probably haven’t yet seen the peak in loan defaults.
The Fed’s dramatic cuts in interest rates doesn’t really fix this because they can only influence the short end of the yield curve. Home loans are based on longer term interest rates.
But home loan defaults shouldn’t affect those CDOs and SIVs because they have insurance facilities in place, and they have (or at least they had) “AAA” ratings. Everyone should be protected, and the problem should be covered. So what’s the problem?
Well, insurers earn premium income by taking on risk, in this case the risk that those investment products might fail. Credit default swaps and other derivative instruments earn income by taking on risk. But it was difficult to see exactly what the risk was in some of those investments. In a sense it was hidden in the mathematics, and the maths was wrong. It was never possible in the first place to accurately quantify the risk. And besides, they had a “AAA” rating, so on balance they were probably all OK.
Now, this is where the game has been taken up to the next level. Just about anyone can write off-market financial instruments to earn premium income. Speculators and investors came into the scene opening all sorts of derivative positions to generate income by taking on risk. Because its all off-market, its largely unregulated.
Let’s imagine a group of people living in a street. Some of them notice that one of their neighbours is looking gravely ill. They each take out multiple life insurance policies on their sick neighbour down the road, hoping to cash in if he dies. They’re all betting against the insurance company that he’s going to die. The insurance companies go along with it, because it generates and amplifies premium income. And besides, they’ve done the maths.
But let’s say he’s displaying numerous medical certificates in front of his house which prove that he is one of the healthiest people alive. He’s not ill: this guy’s got a “AAA” bill of health. So then more neighbours emerge, and because there’s no real regulation in this street, they start writing life insurance policies over this guy: left, right and centre, to anyone who wants them. This generates bucket loads of premium income. It doesn’t matter that some of them won’t be able to pay out the life insurance if the poor ill neighbour dies. All they care about is collecting premium, the future is too far away. He’s not going to die anyway. His health is triple A.
Back in the real world of finance, in some cases the value of the insurance written over some investment products has been ten times the value of the investments in existence. Not only were insurers writing those derivatives, but also a whole lot of other participants. Those derivatives and insurance instruments have themselves been massively leveraged. And that insurance is over debt which itself has been massively leveraged. And because it’s all in an off market unregulated environment, there is no clear way to ensure that the counter-parties meet their obligations. It is like building a number of large houses of cards balanced up on top of a single house of cards.
Such a system might hang together if the bets aren’t too large and there aren’t too many failures – as long as most of the insured mortgage backed investment products remain healthy. But they were never healthy in the first place. When you’ve leveraged up the insurance, it only needs a few failures to create serious problems for the insurers. The health of the underlying assets they insured was not visible. (Well, actually it should have been visible. How can anyone write a loan for 100% of the asset without requiring any deposit or sufficient cash flow? Can the basic laws of financial discipline be changed to suit the instant gratification consumer economy?) Their health was hidden by the complex way in which risk, money, liability and obligations were sliced, diced, tranched and redistributed around all the interlinked chain of parties. The chain of financial transactions is so complex that obligations and liabilities are not really knowable, let alone clearly defined. The credit worthiness of those investments is now only as good as the credit worthiness of the insurer counterparty, and because the value of this whole game has been inflated so wildly out of proportion, into the trillions of dollars, the investment assets themselves have destroyed the creditworthiness of some of the insurers.
There is the real prospect that more risk has materialized than the insurers can afford to cover. And it is big.
Some of those “AAA” rated investment products have been downgraded not just one or two notches, but by over ten notches from “AAA” to junk, in the space of 12 hours: overnight. That requires the municipalities and other investors to sell them because those assets now don’t comply with their investment requirements to hold AAA. But there is no demand for them so sales are at a massive discount to their face value, if they can be sold at all. And the value of the mortgages and housing collateral which underpin those investments has also fallen. If the recent announcement by the National Australia Bank is anything to go by, it seems like these CDOs could be worth only around 20 cents in the dollar. Of their $1.2B in holdings, NAB has written off about one billion dollars worth.
This is a bit of a worry. In putting a market price on these CDOs and related investments, the financial institutions have been finally wrenched from the comfort of their mathematical models into reality. Merrills offloaded some of their CDOs and related investments at 22c in the dollar. How could the NAB have unquestioning faith in a AAA rating without doing some basic analysis of their own?
And this brings us to the heart of the problem. One should be able to trust credit ratings. No one can trust a credit rating anymore. How can an asset have a AAA rating one day, and overnight find it ranked with junk bonds? That’s why the interbank lending system has seized up. Banks are very reluctant to lend to one another because they just can’t assess risk with confidence, so they just don’t know how creditworthy their borrowers might be, including other banks – their fellow peers. It’s not so much a sub-prime crisis. It’s a crisis of trust at the most fundamental level in the entire financial system itself – not just in the US, but globally. If you can’t trust a credit rating, you can’t lend. You can neither know to whom, nor how. And you can’t borrow.
Injection of liquidity is a difficult way to restore trust. Much of the bail out money and new equity injections will end up in the hands of lawyers who will need years to unravel this tangled mess of liabilities. About the only market sector I’d like to be in for the long term in the US would be corporate litigation.
This is no small problem. This is not about the problems of a single insurance company. It is not a problem confined only to sub-prime mortgages, although much of the financial media continues to spin it this way.
One of the more perceptive commentators in this field currently is Sam Wylie, of the Melbourne Business School. I first saw his articles in the Australian Financial Review in early April, 2008, when he clearly identified the problems. Wylie sets out essentially three contributing problems.
Firstly, he argues that the ratings agencies have become the de-facto gatekeepers of the capital markets. Regulation of the credit markets has in effect been handed to private ratings agency companies, who control the issue of capital based on their risk assessment of assets.
Secondly, in the 1990s commercial banks were again permitted to act as investment banks, and to underwrite more risky sub-prime backed securities. Commercial banks’ balance sheets now hold low grade assets and greater risk.
The third problem is that the underlying bargain between banks and government has been breached. Traditionally banks would be prudent, and the government would act as lender of last resort. But relaxation of regulations and the lack of transparency of those derivatives have allowed the banks to be less prudent. The derivatives markets have become so large, complex and opaque that no one can really determine the value of those derivatives listed as assets. Those “over the counter” derivatives have no standardized, regulated or open market, unlike exchange traded derivatives. Yet the notional value of those derivatives has been allowed to explode completely out of control to about US$500 trillion. I can’t even imagine how big that is. But I do know that the hundreds of billions of dollars which the western central banks have already injected to delay the outcome is huge by historical scales. But that’s not a drop in the ocean compared to the size of the problem. The potential problem is bigger than all the western central banks combined.
Much of this injected liquidity effectively can’t be removed. So a side effect of the cure will be compounded inflation, especially in the US. That’s one reason why commodity prices are being inflated so rapidly. But that’s the subject of a separate discussion.
The US Federal Reserve is aware of the size of the problem. That’s why they appear to have been panicked into abandoning their efforts to control inflation. There is no easy solution. In fact there might be no solution. There’s really nothing they can do. Injecting liquidity only helps in the short term, and delays the full effects of the problem.
Should the Fed have allowed Bear Stearns to collapse? It was not a commercial bank. The Fed was not obliged to act as lender of last resort. Should it have allowed the invisible hand of the market to determine which entities survive and which fail? It’s a trade off between manipulating market confidence and perception, and allowing the market to cleanse itself of bad practice. No matter what the Fed chooses to do, the costs will be large, and felt around the world. The only difference will be whether the effects will be significant and soon, or even larger and later.
By propping up those entities who hold dodgy assets, the US Federal government has effectively signalled that it is prepared to support all the banks and insurers involved, not just the commercial banks. It now appears that they’re going to somehow support the whole interlinked chain through the investment banks to the financial insurers. They can’t afford to let the insurance companies go broke, because the whole system will then collapse. That is a massive undertaking by the US taxpayer, which ultimately will put more downward pressure on the US dollar.
But in doing so, are they inviting more of the same? Could bad practice now be encouraged and amplified? Does anything prevent the continued money circle of CDOs, SIVs, credit default swaps and other off market derivatives? It takes time to change the rules. Obviously there needs to be a thorough and carefully thought through overhaul of not only financial regulation, but the whole system. But you can never change the rules in haste without making things worse. So the environment remains the same for now. By propping up those entities in the interim and accepting risky assets as collateral the US Fed only invites more of the same merry-go-round problem.
But what really needs to be restored is trust.
How can you restore confidence in credit ratings? How long will that take, if it can be done at all? Can you restore trust by unleashing liquidity? That would require many trillions of dollars. It sounds to me a bit like trying to restore trust by transferring mistrust away, and into the underlying fiat currencies. Are they really going to prop up the whole chain from the lenders, through the investment banks to the financial insurers?
And even the ratings agencies?
Copyright © 2008 Nils Marchant.
This is an edited transcript of the paper first delivered at the Options21 market briefings during the 27th – 30th of July, 2008.