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By Jonathan Catalán, on 22 November 11
There have been many books attempting to find and explain the causes of the ongoing financial crisis. Authors have approached the issue from all sorts of ideological perspectives and with different sets of evidence. Most of these works are lacking, incomplete, or even flat-out wrong. Many of them do not even care for the facts, instead using vague generalizations to justify the application of broad economic theories. There has not, until recently, really been a meticulous analysis of the mechanics of the causes of the Great Recession, despite the enormous interest displayed by the economics profession in the subject.
This lacuna has been filled by Jeffrey Friedman, editor of Critical Review, and Wladimir Kraus, in their recently published book: Engineering the Financial Crisis. The authors make the purpose of their study evident from the very beginning. They shed themselves of any ideological priors which may have otherwise impaired their analysis, even going as far as to disprove a number of general theories from either side of the spectrum (insufficient regulation versus insufficient economic freedom), and task themselves simply with accumulating, analyzing, and interpreting the evidence. The data they look at has to do with the regulations which governed the financial institutions that presided over the network of financial instruments which suddenly lost the bulk of their value. The question they ask is a simple one: based on the facts, was the recession caused by under-regulation or was it something in the regulation itself which may have influenced the ways banks invested?
Friedman and Kraus give reason to believe that it was the latter — perverse regulations — which gave way to the great contraction which took place between 2007 and 2009. Looking through the relevant legislature which dictates the laws governing the banking industry, the authors find that it was this regulatory web which led banks to invest in the specific financial assets that would soon after be deemed nearly worthless.
Friedman and Kraus emphasize the importance of the fact that the banking industry had no idea — what they call “radical ignorance” — about just what kind of quagmire they were investing themselves into. They use evidence to illustrate the fact that, predominately speaking, the bankers, regulators, politicians, and other major actors in this crisis had absolutely no idea of the relevant potential for a recession to occur, let alone that the highly rated assets they invested into would soon become relatively valueless.
We can see now the broad thesis of Engineering the Financial Crisis. Bankers did not buy large amounts of soon-to-be “toxics assets” because the risk had been externalized to the taxpayer. [1] Neither is their any evidence suggesting that bankers purposefully ignored high risk in favor of pursuing high profits. The majority of assets purchased were actually AAA rated, and because of this the risk-load they carried, as perceived at the time of purchase, was relatively low. What manipulated the relevant price signals which funneled investment into the housing market were regulations which rewarded these type of investments. To a lesser extent, the authors also point at government programmes which pushed for house ownership and the relatively low rates of interest on new loans which made borrowing seemingly more affordable.
Leading up to the crisis, bankers were generally very risk sensitive, preferring assets with lower revenue returns. Roughly 93 percent of mortgage bonds held by U.S. Commercial banks were AAA-rated mortgage backed securities (both private label [PLMBS] and agency rated [MBS]), and almost another 7 percent were AAA-rated collectivized debt obligations (CDO). [2] Missing from this collection of assets were any mortgage bonds rated less than AAA, which were usually the bonds which the highest rate of return.
Most commercial banks in the United States were also above their legal capital reserve minimum on the eve of the financial crisis — the twenty largest banks held capital levels averaging 11.7 percent, where the legal minimum was 10 percent of a bank’s total assets (as dictated by the Federal law, whereas the Basel I accords had set it at 8 percent). More specifically, if one only accounts for “Tier 1” capital [3] banks retained a capital cushion of 50 percent, even while federal law required a minimum of 5%. In other words, most banks opted to retain a substantial capital cushion, where one would expect a bank interested in maximizing profit (while ignoring risk) to push the boundaries of its legal requirements. [4]
The issue, then, was not about bankers with low risk aversion, seeking high profits by investing mostly in high-risk assets. The evidence suggests quite the contrary. U.S. commercial banks invested in what were perceived as low-risk, low-return assets, and on top of this held higher than required capital cushions. Also going out the window is the “too big to fail” theory, or any other case that argues that it was risk externalization which created an incentive for an over-concentration of investment into the mortgage market. Simply put, there was a high aversion to risk during the years leading up to the crisis.
Friedman’s and Kraus’ explanation of what caused the crisis can be divided into two parts: what caused the over-concentration of investment into mortgage-backed securities and why these securities, which by 2008 had lost the majority of their value, had been rated so highly by the major rating agencies. The strength of their book is found in its accounting of the first — what led to the pattern of investment that characterized U.S. commercial bank assets prior to the recession.
Because different types of investments generally have different degrees of risk, a capital requirement minimum that encompasses all assets is illogical. Rather, it makes more sense to create different capital reserve requirements for different sorts of investments, based on the general perceived riskiness of the different types. The Basel I accord was an attempt to correct the issues of a homogenous treatment of assets by creating different categories and attaching a capital reserve minimum to each category. Higher risk assets, therefore, were categorized into higher “risk buckets” and required a greater capital cushion. In other words, the greater the risk the asset carried, the more it cost the banks to protect against, by reducing the amount of capital available to invest.
The issue, as explained by Friedman and Kraus, is that these regulations led to “regulatory arbitrage”. For example, a bank could invest into mortgage bonds with a risk-weight of 50 percent, then re-sell these bonds to a government sponsored enterprise (such as Freddie Mac and Fannie Mae), and buy them back as an agency bond. These agency bonds were risk-weighted at 20 percent, effectively reducing the capital cushion necessary to back the asset, even though the composition of the asset remained exactly the same. The Basel regulations made it more expensive to issue business loans than home loans, creating a financial incentive to issue more home loans. Basel I created incentives for banks to make certain types of loans and then securitize them.
A further boon to securitization came with the adoption of the Recourse Rule, which borrowed the Basel II accord’s method of rating privately issued securitized assets by risk. This system caused banks to increase investment in AAA-rated securitized mortgage bonds, especially since the risk-weight of unsecuritized mortgages remained at 50 percent (as dictated by Basel I). It remained cheaper to invest in mortgages, rather than other types of loans to consumers and businessmen, and then banks could further increase profitability by securitizing these mortgages and releasing part of their capital reserves for further investments. This explains the concentration of investment in mortgage backed securities.
We see a pattern between 2001 and 2007 of an increase in housing loans and investment into mortgage backed securities. We know that at the time these types of investments being made were being pooled into buckets which were considered generally less risky than other forms of investment. It was not an issue, therefore, of carrying on more risk. In fact, this pattern of investment was created out of the fact that the regulations incentivized purchase of less risky assets. The problem which led to the financial collapse, therefore, deals exclusively with the fact that these assets carried more risk than was originally perceived by the regulators (and banks). In fact, the collapse of the subprime mortgage market came as a total surprise, both for the bankers and the regulators.
It was not just the architecture of the impending financial collapse that the regulatory web was responsible for, but also the magnification of the disaster. Thanks to the capital reserve minima, many banks faced insolvency even though the circumstances did not really call for it. In order to remain legally solvent, U.S. banks are forced to maintain a certain capital reserve minimum. As the crisis unfolded, bonds which had been previously rated at AAA were suddenly downgraded, raising the necessary capital reserve minima for each risk-bucket. In other words, as ratings fell for different types of bonds, banks were suddenly forced to raise new capital to cover their loss.
Furthermore, regulations forced banks to mark-to-market their assets to reveal their “true value”. This process was not done on an individual basis; rather, different bonds were lumped together and them marked-to-market as a group. So, even individual bonds which may have not actually lost value were readjusted on a bank’s balance sheet as assets that were suddenly worth less than had been perceived prior to the crisis. It was on the basis of these new market values that a bank’s solvency was judged. The issue is that by late 2009 many of these same bonds had recuperated much of their value, and so a bank that had been legally insolvent in early 2008 may not have been two years later. In other words, many banks were forced into insolvency that could have survived the crisis, and other banks had to radically contract outstanding liabilities in order to remain solvent.
The consequence of these regulatory restrictions was a giant credit contraction — much larger than was actually necessary. And, of course, the monetary contraction only worsened the situation, as it reduced the financial viability of the various investments that depended on this credit.
Friedman and Kraus blame the inadequate rating of mortgage bonds on the cartelization of the major rating agencies — Moody’s, Standard & Poor’s (S&P), and Fitch. Basel II and the Recourse Rule had effectively tied their capital reserve requirements to the ratings provided by these three agencies. It was these three rating agencies that had been classified as Nationally Recognized Statistical Rating Organizations by the Securities and Exchange Commission (SEC) in 1975, and the various regulations that relied on risk ratings depended exclusively on this cartel. None of the three “nationally recognized” rating agencies, furthermore, had accounted for the possibility of a nationwide hosing crisis leading up to 2008.
There were private rating agencies, though, that had recognized the potential for crisis. According to Friedman and Kraus one such company was First Pacific Advisors, which sold its $1.85 billion investment in mortgage-backed bonds in late 2005.
Friedman’s and Kraus’ analysis hinges on the notion that what was ultimately at fault were these rating agencies. Had they been more accurate in their risk assessments then banks would not have malinvested in so many mortgage-backed bonds. But, why had the banks relied exclusively on the risk-assessment provided by the three “nationally recognized” agencies? Were these banks not aware of the risk assessments being made by private investment companies?
Perhaps the authors put too much weight on the notion that it was this cartelization of the rating agencies which made possible the crisis, and that had there been more competition in this industry the recession may have been less destructive than it turned out to be. But, Friedman and Kraus do not make clear exactly how many private agencies had foreseen the crisis. Few investors sold off their mortgage-backed bonds in anticipation of a market crash. Indeed, the majority of investors were still fairly confident in the strength of the housing market.
Here is where the explanation of the crisis becomes more detached from the data. Friedman and Kraus leave room for further interpretation, since their explanation for why the different bonds were assessed as they were comes off as inadequate (or, at least, incomplete). Understandably, they are looking to separate themselves from ideology — even though the book’s conclusions are extremely pro-market — and thus avoid applying far-reaching theories to the evidence they were able to collect
However, that there is still room for further interpretation is not necessarily a bad thing. As far as their analysis on the impact of regulations on the housing boom and the consequent financial crisis goes, it is difficult to refute. That there is still room for the application of theory means that their empirical findings can easily be assimilated into grander explanations of the financial crisis.
For the task it sets out to accomplish, Engineering the Financial Crisis is undoubtedly one of the best books written yet on the causes of the Great Recession. Jeffrey Friedman and Wladimir Kraus painstakingly dig through the data to provide a solid picture of why there was such an overconcentration of investment in the mortgage market. The evidence clearly shows that it was the web of regulation on the banking industry that shaped the structure of banking investment by favoring certain investments over others. The entire system collapsed when it turned out that these regulations had depended on agency assessments that had totally miscalculated the risk these favoured assets carried. Thus, banks had loaded themselves up with mortgage backed bonds, completely unaware of the fact that these bonds would soon be relatively valueless. It was not the market which caused the crisis, rather the distortions to the market that were created by government intervention.
[1] That banks did not buy mortgage-backed securities and other similar assets because the bankers knew that there was no risk for them is a very specific claim, and it does not include many banking practices which are undertaken because of risk externalization (such as the extent of fiduciary expansion, which in our present banking system is a product of its cartelization under the Federal Reserve System).
[2] Friedman and Kraus 2011, p. 42 (table 1.3).
[3] Basel I divides bank capital by the type of asset, Type I being the safest pool. Type I is composed of “funds received from sales of common equity shares and from retained earnings.” Ibid., p. 40.
[4] A capital reserve basically allows banks to take losses, since it gives it a cushion of assets it can capitalize on to make up for net losses (before liabilities exceed assets).
By John Phelan, on 9 November 11
A common interpretation of the credit crunch and ensuing global turmoil is that it was all down to unregulated or under-regulated financial institutions and markets. As a result, one of the most commonly advanced solutions is for more and/or better regulation. Indeed, this call is about as close as we get to a firm demand from the presently fashionable ‘occupy’ protests.
There are many things wrong with this view. First, the underlying causes of the recent boom and bust could be found, as so often, in monetary disturbances. In comparison to the damage wrought by a deluge of credit, any regulatory deficiencies are just hundreds and thousands atop a cake that was always going to turn out pretty sour.
Secondly, nothing says ‘profit opportunity’ to financial institutions quite like some new financial regulation. To give just one of countless examples, the Eurodollar market sprang into life thanks to attempts like Regulation Q to impose limits on interest rates. The financial innovators will only ever be one step behind the regulators for as long as it takes them to read the regulation. Then they streak ahead.
And thirdly, it is a mistake to think that financial markets were notably under-regulated. After redesigning British financial regulation almost from scratch, the Labour government never ceased tinkering with it. As Terry Arthur and Philip Booth wrote recently (PDF)
To obtain permission to carry out regulated activities an organisation must meet certain qualifying conditions. These include having adequate resources (financial resources as well as internal systems and procedures). The conditions are laid out in the FSA’s Integrated Handbook…Regulation is bureaucratic in the extreme. It is no longer possible to determine the number of pages in the handbook, but an indication is given by the following example. There are ten main sections in the book. One of those main sections…is that on ‘Listing, prospectus and disclosure’. This contains three subsections which have between nine and 23 sub-subsections each. Taking one of those sub-subsections, under the ‘Listing rules’, there are six sub-sub-subsections
Fortunately we can look at the economic impact of regulation worldwide with the release by the International Finance Corporation of the World Bank of its annual ‘Doing Business’ report which compares regulatory environments and the ease of doing business across countries. The reports message is unequivocal; regulation is mostly bad and those calling for more of it are calling for economic suicide.
A report on the report by The Economist picked out some notably egregious examples
A typical company in Congo with a gross profit margin of 20% faces a tax bill equivalent to 340% of profits…How long, for example, does it take to register a company? In New Zealand it takes one day and costs 0.4% of the local annual income per head. In Congo it takes 65 days, involves ten steps and costs 551% of income per head…Other procedures the IFC measures include registering a property (which takes one day in Portugal, 513 in Kiribati); obtaining a construction permit (five steps in Denmark, 51 in Russia); enforcing a simple contract through the courts (150 days in Singapore, 1,420 in India); and winding up an insolvent firm (creditors in Japan recover 92.7 cents on the dollar, those in Chad get nothing at all)…A young entrepreneur in Liberia who builds a new warehouse must wait on average 586 days to connect it to the power grid. In Ukraine it takes 274 days; in Germany only 17. Guess which of these countries has a thriving manufacturing sector?”
The chart below illustrates the point
Source: ‘Doing Business 2010′ (PDF) and International Monetary Fund ‘World Economic Outlook Database’ – Puerto Rico, Palau, the Marshall Islands, Micronesia and West Bank and Gaza are omitted for lack of a comparable data point
We see that while a light regulatory environment is not a guarantee of wealth, it is a necessary precondition. Not surprisingly, The Economist sees a causal relationship
Cutting red tape makes countries richer, if the 873 peer-reviewed articles and 2,332 working papers that use the “Doing Business” data are anything to go by. A study in Mexico found that simplified municipal licensing led to a 5% increase in the number of registered companies and a 2.2% increase in jobs. It also lowered prices for consumers. Bankruptcy reform in Brazil caused the cost of credit to fall by 22%. Countries with flexible labour rules saw real output rise by 17.8% more than those with rigid ones”
Calls for more regulation are both pointless and dangerous; pointless in that it won’t solve the undoubted problems in our present economic system and dangerous in that it could end up making us even worse off. More regulation is not the answer.
Related articles
By David Howden, on 7 November 11
One significant issue arising in the crisis has been the size of some European underground economies. Politicians seek measures to increase public revenues as public budgets come under strain. As large segments of European, and especially southern European, economies are hidden in the underground, large amounts of otherwise taxable incomes are likewise hidden.
Chapter 4 my new edited collection, Institutions in Crisis: European Perspectives on the Recession, grapples with the issue of these underground economies. With over a quarter of Greek economic activity only unofficially undertaken, we see that in some countries the issue is significant. Indeed, the average underground economy for the PIGS (the PIIGS excluding Ireland) is 21.7 percent of GDP, almost three times the size of America’s, and double that of Germany’s.
Two important questions must be answered. First, what explains the size of these underground economies? Second, how can we integrate them into the official economy?
There are two general reasons why economic activity seeks to be underground rather than official. On the one hand high, tax rates prohibit otherwise mutually beneficial economic activities from occurring. Movements into the underground try to evade these taxes and thus allow trades to be made (for those of you who can remember your first-year economics class, this is a way to reduce those triangular deadweight losses of taxation). On the other hand, regulations add a potentially complex and costly web of rules that entrepreneurs must abide by. In some cases it is only possible, or at least easier, for a firm to operate in the underground instead of the official regulation-abiding economy.
When looking at the general range of underground economies in Europe it does not take long to discern which effect is stronger. Europe is well known for its plethora of taxes, as well as its high marginal tax rates, but there is no clear relationship between taxes and the size of the underground economy. High tax Scandinavian countries, for example, seem to enjoy relatively small undergrounds. Some southern European countries, Spain for example, have relatively low tax rates and large undergrounds.
The answer lies in the distinction between different interventions that Murray Rothbard made in this economic treatise, Man, Economy and State. Binary interventions are those where one party becomes subordinate to the intervener in the transaction. Labor taxes, for example, cause a firm to hire labor at a different price than it originally would have, and under the constraints placed on it by the government imposing the tax. Triangular interventions, in distinction, are those that place both parties to a transaction subordinate to the intervener simultaneously. Testing requirements on drugs subordinate both drug producers and consumers to the government imposing the regulation – no transaction can take place regardless of the desires of the relevant parties.
Northern European countries, despite their high tax rates (a form of binary intervention) enjoy relatively low levels of triangular interventions. Low levels of simple regulations make entrepreneurial undertakings relatively pain free. Business owners can comprehend the binary interventions as an additional cost of business, and proceed cognizant of the fact that they face a minimal level of complex and uncertain regulatory burdens. Consequently, there is not much reason to operate in the unofficial section of the economy. (Keep in mind that although one can save on taxes by doing so, there are costs – the lack of a clearly defined and enforceable rule of law being the foremost.)
Southern European countries, in distinction, are well known for the bureaucratic boondoggles they are. Triangular interventions abound. Complex and uncertain labor laws make firing (and subsequently, hiring) employees a costly or impossible ordeal. Unable to navigate the regulatory burdens endemic in these economies, entrepreneurs hide in the underground. By saving on the expense of the difficulties of complying with complex regulations, entrepreneurs are able to outweigh the added costs by working in less official conditions.
As this problem is most acute in the PIGS countries, it has become an issue as politicians search for means to bolster government revenues. By reallocating economic activity to the official sector, taxes will be able to be collected and government coffers replenished. Calls for more frequent auditing and increased fines have come to the fore. Such solutions are misplaced at best, and will exacerbate the problem at worst.
Increased audits and fines for the “guilty” will doubtlessly decrease the size of the underground economies. This added risk and cost of underground business will incentivize some entrepreneurs to withdraw, or at least curtail, such economic activity. It is doubtful that this will translate into increased official economic activity. Entrepreneurs in the underground are there because the conditions in the official economy are not conducive to business. High taxes and complex regulatory structures drove them out in the first place. Without a change to either of these two facets (primarily the latter), we should not expect any increase in official economic activity.
In my book I spell out one additional reason why EU politicians should not be overly keen on minimizing the size of their underground economies. As unemployment rates have increased, the various undergrounds have been able to cushion part of the blow. Working conditions in the underground economies are certainly not as desirable as in the official one, but the unemployed have few choices. Lacking growing employment opportunities in the official economy, a lack that I stress is caused by excessive and uncertain regulatory burdens, removing the underground options available will only serve to further impoverish the burgeoning unemployed masses.
By Steven Baker MP, on 1 June 11
From Deception of Government Intervention (1964) – an essay in Mises’ anthology Economic Freedom and Interventionism – we learn how governments adopted “the third way”:
Faced with the tremendous challenge of totalitarianism, the ruling parties of the West do not venture to preserve the system of free enterprise that gave to their nations the highest standard of living ever attained in history. They ignore the fact that conditions for all citizens of the United States and those other countries which have not put too many obstacles in the way of free enterprise are much more favorable than conditions for the inhabitants of the totalitarian countries. They think that it is necessary to abandon the market economy and to adopt a middle-of-the-road policy that is supposed to avoid the alleged deficiencies of the capitalistic economy. They aim at a system which, as they see it, is as far from socialism as it is from capitalism and which is better than either of those two. By direct intervention of the government, they want to remove what they consider unsatisfactory in the market economy.
Such a policy of government interference with the market phenomena was already recommended by Marx and Engels in the Communist Manifesto. But the authors of the Communist Manifesto considered the ten groups of interventionist measures they suggested as measures to bring about step-by-step full socialism. However, in our time the government spokesmen and the politicians of the left recommend the same measures as a method, even as the only method, to salvage capitalism.
In the aftermath of the financial crisis, we are now going down a road towards ‘judgement-based’ regulation of financial firms in an attempt to salvage capitalism.
It is proposed that firms will be supervised by what amount to shadow management teams of disinterested, public-spirited individuals more able to reach sound views than firms’ own management teams: they shall possess “the optimal experience and technical ability”.
Quite where these mythical philosopher kings are to be found, I do not know. Presumably, financial firms and regulators already hire the best people available. And the notion that the best people will work for the regulator despite inevitably higher rewards in the firms themselves is silly.
Financial firms will find their business subject to the day-to-day judgement of government officials. To think that those officials will be more capable than the institutions’ traders and managers is a fantasy. The outcome will be, as it has been, a surprise financial catastrophe as regulators fail to foresee the future and, since they are bound to converge on “best practice”, fail as one.
A free society is not one based on constant official interference with business. It is one based on cooperation, choice, competition, profit & loss, predictable rules fixed well in advance and exit from the market: that is, property, contract and the classical rule of law.
Rather than resort to fantastic ideas about the effectiveness of government interference with market phenomena, we would do better to reapply the principles of a free society. Financial institutions should be no exception, for government intervention caused the crisis [1,2].
Postscript: Marx and Engels’ ten measures are available here.
By Toby Baxendale, on 29 December 10
Dalibor Roháč of the Legatum Institute and Matthew Sinclair of the Taxpayers’ Alliance have jointly authored a report on the risks of new global financial regulations:
Around the world politicians and officials are advancing major new regulations of the financial services industry. Those regulations are a response to a major financial crisis, but real care needs to be taken to ensure that they help avoid future crises, and won’t precipitate or exacerbate crises instead.
…
- The increased internationalisation of financial regulation risks amplifying future global booms and busts. Global regulations lead to global crises as organisations are encouraged to hold similar assets and respond in similar ways when things go wrong. As a result, the new regulation could increase the systemic risk to the world economy.
- Attempts to focus regulation on the institutions that contribute the most to systemic risk carry their own risks. If institutions understand that they are seen as “too big to fail” then that will encourage excessive risk taking.
- Despite attempts to address the issue, the Basel regulations may still be procyclical, imposing more onerous requirements on institutions at times when the system is in trouble.
- Some measures proposed, like attacks on tax havens and hedge funds, are motivated by other agendas and do not actually address the problems that led to the financial crisis.
- There is an important debate over whether or not effective “macro-prudential” regulatory policy is possible. However, the policies introduced since the financial crisis do not live up to that standard. Some of the measures announced are disingenuous political posturing while others continue existing mistakes partly responsible for the problems we are facing today. It is entirely possible that the new regulations being implemented could hurt established financial centres like the City of London while increasing the frequency and strength of global financial crises.
Download the full report (PDF).
The Taxpayers’ Alliance announcement is here:
By Gordon Kerr, on 19 November 10
Britain and the Eurozone hover on the Brink of Banking and Monetary Collapse. Our response? More Regulation.
The European Central Bank’s head, Jean Claude Trichet, appears to have realised what a mistake he made in single-handedly engineering the bailout of Greece only six months ago.
As I pointed out at the time this was simply a massive transfer of wealth from taxpayers to banks, funds and other investors in Greek Government bonds. Those smart and wealthy investors are now banking these profits very rapidly as we can observe by noting the rises in credit default swap prices.
Yesterday M. Trichet announced plans to raise Euro interest rates and decrease long term support for the banking system. It will be interesting to see if and by how much rates are raised since the Spanish banking system will probably collapse if Euro rates rise by even 1 per cent.
Why will this happen? It was a poorly reported consequence of the bailout two years ago that a significant consequence of forcing rates to zero is to inflate asset prices. Both effects are forced and hence, to use the popular term of the decade, unsustainable. The crash that we are about to experience will be far greater than that which would have occurred if the ordinary rules of capitalism had been allowed to operate in 2008. Sanity could have been restored to the banking system had governments stayed out of the mess. Liquidations would have led to changed business models and the appreciation by consumers of banking products that governments cannot protect them from losing money.
And what has the UK Government’s response been during this joyous week, which has already been widely reported as a good time to bury bad news?
In addition to pledging that we will donate several billion to the Irish cause, it has been announced that those who make their living by selling us mortgage products must take a course in mortgage loans.
This is yet another example of what Kevin Dowd has labelled “sham regulation”. The presence of an accreditation mark on an IFA’s business card is intended to imply that the consumer should trust his mortgage advice and sign up for the loan he recommends.
Let me recommend that sellers and buyers of these products take a very short education by reading and understanding the rest of this article. If enough of you lobby the FSA, these few words might even be adopted as the new FSA official mortgage education qualification.
When considering mortgage loan offers there are only two relevant criteria:
a) The length of the fixed interest period;
b) The all-in cost of the loan.
I would mention a third, but much less important point: break costs. Borrowers’ circumstances may deteriorate and the consumer should be aware of the costs of defaulting or switching lenders during the fixed period. Simply ask and compare.
Let us consider point a). Why do I focus on fixed rate loans, when historically in the UK and today in many countries like Spain floating rate loans were / are much more common? The answer is simple. The financial risk of a home purchase is usually considered to comprise only the risk of up or down variance in the house’s value after purchase. This assessment only applies to houses bought for cash. If a loan is required the consumer should quickly decide whether he wishes i) to take this amount of risk or ii) twice this risk.
Buying a house and borrowing on a floating rate basis amounts to taking roughly twice the house price risk because if rates rise not only do house prices usually fall but of course your payments rise as well. Therefore borrowers who wish to expose themselves to one times the risk of the house price variance should borrow on a fixed rate basis.
Point b) the all-in cost, can be calculated by entering all payments into either an Excel spreadsheet or even some calculators. All fees at inception and redemption should be included. Then press the “Net Present Value” button and compare the offers. (For the less financially savvy reader, NPV is simply a way of expressing a stream of payments over time as a cost today. For example, if the interest rate is 5% you would be indifferent as to a choice between paying £100 away today or £105 in one year’s time).
That is the end of the mortgage loan training course. Set out above is a universal guide. No other criteria matter – least of all the identity of the lender, unless you take a floating rate loan and expose yourself to being gamed by the bank. Many lenders brazenly jack up the rates they apply to loyal customers and offer “discounts” to new borrowers. These banks rely on lethargic consumers not to refinance quickly. This risk is almost impossible to assess in advance and is another reason to fix your rate for as long as possible.
It would be wonderful if the FSA’s official course were to comprise no more than the above few paragraphs, but sadly I fear the actual course will be replete with mumbo jumbo and simply constitute yet another barrier to entry into the financial services business. Mortgage industry hucksters will thus receive state support for their present modus operandi, namely the maintenance of the pretence that, like a Savile Row suit, you are a very special customer and need an expert, like me, to tailor a loan to your specific requirements.
By Gordon Kerr, on 4 November 10
Consider two points:
- Last Week Mervyn King said in a now famous speech in Manhattan that of all the banking systems it is possible to have, our present system is the worst.
- In 2002 Warren Buffet coined the phrase “Derivatives are the Financial Weapons of Mass Destruction”.
I am not sure if the Sage of Omaha was conversant with all the regulatory aspects of derivatives, but I choose this enormous component of the international banking system to explain that our system is incapable of regulation and certain to fail again.
In principle, there is no difference between the regulatory capital charge applied to a risk held by a bank in derivative format from any other format, for example, loan format. Where the system has failed the taxpayer is in the accounting and regulatory treatment of risks that are bought and sold by a bank for profit on its trading book.
Let me draw a parallel with the business of my local second hand car dealer, Barnet Motors. The car dealer’s very simple business model is to buy a second hand Ford Mondeo from Peter for, say, £10,000 and sell it on to Paul for say £11,000, recording in its accounts the £1000 gross profit (before expenses) of the trade.
Consider how banks record purchases and sales of many kinds of risks in derivative format. Banks operate two books, a banking book and a trading book. The destructive arbitrage I am about to outline occurs entirely within the bank’s trading book.
Let us take a simple example of something that went very publicly wrong in the bubble leading to the crash of 2008 – banks buying and selling sub-prime mortgage risk in derivative format.
The parallel with the car dealer is on its face reasonable. The bank buys the asset (writes protection on a portfolio of sub-prime mortgages) in credit derivative format. Step 2, it sells the asset by purchasing a matching credit derivative from, say, AIG’s bank.
The accountants and regulators treat the asset as bought and sold and the margin in the middle is treated as profit earned today by the bank.
However there is a crucial difference between the derivative trade and the second hand car trade: nobody has paid for the derivative. There are indeed flows of annual premium income in favour of each writer of protection, but the recognition of the sale on trading book enables essentially all of the buy/ sell premium differential to be recognised by the bank as profit up front. But tinkering with this rule would not prevent the derivative asteroid about to hit the banking system. The problem is far greater, as we noted in 2008. When the bank was called to pay out on its derivative by the protection buyer, it discovered that AIG had assumed so much of this risk that the counterparty to whom our bank had “sold” the risk was insolvent.
This explains why banks choose to put so much business through their derivative trading books. They did not need to trade in the derivative, they could have bought and sold the underlying sub-prime bonds. The reason for the volume of business being put through the derivative trading book is primarily the “easy ride” of this unreasonably soft treatment of a matching derivative as equivalent to a sale, which in turn implies bank profits which subsequently prove to be illusory.
And therein we can see the absolute impossibility of regulating derivatives – the rules assume no linkage, no correlation between the probability of a default of the underlying assets (the mortgages) and the probability of default of the counterparty to whom the risk of default has been supposedly sold, but who has not paid for or collateralised the exposure.
As ever, this is a simplification of complex rules and hair splitters will point to commercial future collateralisation requirements, but as we saw in 2008 and in the other major banking crises throughout my career, these tweaks never protect the banks and their prime stakeholders, depositors and taxpayers.
What, you might ask, if our regulators asked how much of various risks AIG held? In practice it is impossible for regulators to monitor such matters and the trend towards confidentiality is on the increase, not the decrease. There will never be global banking regulation; there will always be a regime that allows AIG to operate in the future in precisely the way it did in the past. The only solution is a fundamental reform of the present banking system.
And so we have proved that the banking system in its present format is incapable of regulation.
By Toby Baxendale, on 5 October 10
In April, I reviewed Jimmy Stewart is Dead by Laurence Kotlikoff.
Yesterday, Jerry O’Driscoll posted a review of his own:
Chapter 1 of the book is titled “It’s a Horrible Mess,” and in it Laurence Kotlikoff, a professor of economics at Boston University, reminds the reader of the breadth, depth, and horror of the global financial crisis. It is a cure for the dispassionate observer of events, an indictment that would send all but those with ice water in their veins to sign up for the Tea Party Express. The book is a particularly well-written account of the crisis that begins in housing finance, spreads throughout the financial system, and then throughout the real economy. The crisis hit in tsunami-like waves beginning in 2007 and continued into 2009.
In Kotlikoff’s words, “We thought we had well-functioning banking and insurance companies with competent directors, world-class managers, responsible regulators, and incorruptible rating companies. But overnight, we it learned it was a sham.”
O’Driscoll thinks the Achilles heel of Kotlikoff’s proposals is their reliance on a financial regulator:
Kotlikoff excels at detailing the failings of the existing regulatory structure, but does not explain why his proposed system would work any better. If the regulators at the FFA face the same incentives as do those at the SEC (and the rest of Washington’s alphabet soup panoply of regulators), then we should expect the same outcome.
Government regulation, no matter the industry, typically fails for two reasons. First, there is the Hayekian knowledge problem. The information needed for effective regulation is dispersed across firms, the industry, and even the economy. There is no effective means for marshaling and centralizing the information within the agency.
Second, regulators are routinely captured by the industry they regulate. Through frequent interaction with members of the industry, regulators come to identify with the industry’s interests over the public’s. The revolving door between industry and government exacerbates that problem.
Even so, he concludes:
There is a great deal to recommend this book. First, there is Kotlikoff’s recounting of the crisis itself. Second, there is sense of the manifest injustice of a system in which bad actors get to gamble with other people’s money. Third, there is the challenge to do something radical to reform a system that is radically dysfunctional.
Read the whole review.
By Steven Baker MP, on 30 August 10
Via Bank plans to cap risky mortgages – Telegraph:
Mortgage lending would be “capped” to stop borrowers taking out risky loans under radical Bank of England plans to prevent a repeat of the credit crisis, a senior official has disclosed.
But why did borrowers wish to borrow so much, so riskily? And why did lenders wish to lend so much, at such risk?
In the first place, credit has been too cheap for too long. Low interest rates are bound to encourage people to borrow more and save less. Therefore, people saved less and borrowed more. This was the result of the Bank of England’s decisions.
House prices kept rising because people kept borrowing and pumping money into housing. Housing was excluded from the Bank’s measure of inflation, so rates stayed low.
The appearance of inevitable and uninterrupted house price rises gave the impression that we were in a new era within which the old rules did not apply: borrowing caps could be raised to excessively risky levels and borrowers could rely on price increases to deal with the capital.
Lenders used models which fundamentally understated risk. For example, markets do not behave within the Gaussian or “normal” distribution: extreme events happen more often than a normal distribution predicts. Furthermore, the risk of mortgage default correlates across similar mortgages when the economic environment changes. Still, the models said risks were lower than they were, so more credit could be extended.
Since the lenders were neither, on the whole, mutuals or partnerships with open-ended liabilities and since the employees making the decisions shared only in the upside, there was insufficient motivation to manage to the true level of risk.
Moreover, securitisation of mortgage pools and so forth palmed off the risk onto hapless investors who probably trusted the risk models and the market environment created by excessively cheap credit. And, “Hey, look at the returns!” The personal touch was missing from the relationships between borrowers, ultimate lenders and intermediaries, further corrupting the system.
Of course when the pantomime ended, the taxpayer was forced to pick up the bill. And still bonuses were paid in bailed-out banks!
Now, having created the boom with cheap credit and moral hazard, the Bank plans, not to fix the root problems, but to pile intervention upon intervention…
There is much else to be said, for which I recommend The Alchemists of Loss and Money, Bank Credit, and Economic Cycles. However, on the face of it, the Bank’s present proposals merely extend the infantilisation of the financial services sector.
Later this week, I will indicate ten serious plans for financial reform.
By Tom Clougherty, on 21 April 10
The BBC reports that the IMF has unveiled its interim proposals on a new international tax on the financial sector, ahead of a meeting of finance ministers this weekend.
In fact, the IMF’s paper suggests two new taxes. The first, a ‘financial stability contribution’ would be levied on all financial institutions, initially at a flat rate, to help cover the ‘fiscal cost of any future government support to the sector’. The second, is a ‘financial activities tax’, which would be levied ‘on the sum of the profits and remuneration of financial institutions’.
The first point to be made is that justifying these taxes on the grounds that the proceeds will help governments deal with future crises is a straightforward con. The proceeds of the first tax could either ‘accumulate in a fund to facilitate the resolution of weak institutions or be paid into general revenue’ say the IMF, but you don’t need to be psychic to work out which of those is more likely – governments will just spend the money on current expenditure, as they always do. The second tax doesn’t even come with an either/or fig leaf – proceeds will go into general revenue, for governments to spend as they see fit.
So it is pretty clear that what we have here isn’t so much a policy to ensure financial stability, but rather to bail out profligate governments. Moreover, this could in itself worsen financial instability by making fiscal policy even more pro-cyclical (revenues would be highest during financial booms), and exacerbating boom and bust cycles.
There are other problems too. For example, the idea of compulsory ‘insurance’ against failure for banks (this is the direction the ‘financial stability contribution’ moves us in) is likely to make moral hazard – already a major issue – an even more severe problem. Even now, government guarantees to banks are largely implicit, but the IMF’s tax proposal would make them explicit. Indeed, the ‘financial stability contribution’ is not just an overt indication that irresponsible banks will be bailed out – it could easily be read as creating an obligation that they must be bailed out. And that’s hardly a way to encourage less risk-taking.
It is also problematic that these taxes will be applied to all financial institutions (including insurers, hedge funds and so on), most of which had little to do with the financial crisis. They are thus likely to damage the wider financial economy, without actually doing anything much to deal with the real offenders.
Which brings me neatly to the most depressing aspect of these proposals: the complete lack of understanding they exhibit about the actual causes of the financial crisis – loose monetary policy, ramped up by unrestrained fractional reserve banking, and amplified by fiscal incontinence. The saddest thing is that the world’s financial system desperately does need reform. Without a radically new approach to controlling the money supply and taming the credit cycle, history is doomed to repeat itself. But the IMF’s proposals do not even qualify as a step in the right direction.
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