Financial Times

Is greed or stupidity the cause of the world's financial crisis ?

By Prof. Jagath Wickramasinghe

The current financial crisis which is brewing into a world economic recession is not caused by oil and food crisis as such, though it has sped up the intensity of the current crisis. It is too soon to expect the oil and food crisis to deteriorate into an economic recession as its supply side impact may take more time to materialize. Once it does, it will further exacerbate the current crisis creating a spiralling cascading effect of economic deceleration. Hence, short term economic prospects look very gloomy.

Some politicians like US President George W. Bush and other officials the world over and here in Sri Lanka assigned greed as the prime cause of this crisis. It may be so! Don't forget that the motor energizing capitalism or market economy is selfish interest which is reflected by this greed. Adam Smith, suppose to be the father of capitalism once said, "A group of capitalists rarely gather together under one roof without talk turning towards collusion against the public".

A broker looks at a terminal while trading at a stock brokerage firm in Mumbai. Indian shares fell 3.8 percent on Thursday to their lowest close in a week, caught in a broad global sell-off on fears of a deep U.S. recession. REUTERS.

Adam Smith believed that natural law would contain greed; he said "The ethical system developed by a natural process out of individual personal relationships … (Natural law) the individual will decide that certain actions are proper or improper by observing the reaction of others. A social consensus then develops, approving those patterns of behaviour that benefits both society and the individual…. Those involved in the competitive economic process … although they result from acquisitive self-interest of the individuals, which nevertheless fit together and make up a social-economic process of unconscious co-operation, which tend to maximize the… economic welfare of the entire society". But it did not happen that way!

America as far back as in 1933 enacted a piece of legislation called the Glass-Steagall Act which enforced the separation of banks by business types to avoid conflicts of interest. Under the act for example, a bank could not offer investment, commercial banking, and insurance services, however this act was replaced by Gramm-Leach-Billy Act of 1999 during the Clinton Administration. This replacement allowed the banks to engage on these activities simultaneously. This financial market deregulation that enabled Goldman Sachs and other investment banks to broker commodity contracts signed in early 1990's. After the new legislation the banks could work with mortgage origination companies to write loans to clients without proper collateral and then sell the loans to the investors. These loans were pooled together to create mortgage-backed-securities (MBS) and collateralized debt obligations.

It is generally believed that the root cause of this financial crisis was the sub-prime mortgages. Sub-prime lending is the practice of making loans to borrowers who do not qualify for market interest rates owing to various risk factors, such as inadequacy of their income, smallness of size of the down payment made, poor credit history, and employment status not up to the required level. Over the years mortgage lenders were happy to lend to people who couldn't afford their mortgage owing to such deficiencies. These lenders were able to charge higher interest rates and make more money on these sub-prime loans. If the borrowers default they seize the house put it back on the market. They were able to pass the risk off to mortgage insurers or package these mortgages as mortgage-backed securities (MBS), then the risk is passed on to the buyer of the securities.

One client said that when he told the real estate agent that he could not afford the monthly payment as it would double his monthly mortgage payment, he (agent) had said that he could go for 40 year mortgage with 5% down payment, which he would be repaying even in his seventies and had advised him to apply for more than what is needed so that he could have an emergency fund. Everything was great when houses were selling like hot cakes and their values go up monthly. Lenders made it easier to borrow money and the higher demand drove up house values. These higher values tempted the lender to lend out even bigger mortgages, and it also gave lender some protection from foreclosures. All this means more money for lenders, insurers, and investors.

This did not matter as much when the key interest rates were still high. But when the bottom dropped out of the US economy and the key interest rate dropped to 1% on government policy, the unregulated banking system went on a borrowing and lending spree.

Traditionally banks lent money to homeowners for their mortgage and retained the risk of default. This is called credit risk. However, the outcome of the financial innovations is that the banks can now sell rights to the mortgage payments the world over and related credit risk to investors through the securitization. Securitization is a structured finance process in which assets receivables or financial instruments are acquired, classified into pools, and offered as collateral for third party investment. In this case the securities the investors purchased are the mortgage backed securities (MBS) and collateralized debt obligations (CDO) this new system is known as "originate to distribute", the model is a risk broadening model, which would distribute risk to investors, with a series of consequential impacts.

The reasons for this financial crisis in US are varied and complex. Some of them include the inability of house owners to make their mortgage payments, poor judgment by the borrowers and/or lenders, speculation and overbuilding during the boom period, risky mortgage products, high personal and corporate debt levels, financial innovations that distributed and concealed default risks, central bank policies and lack of regulations. A combination of low interest rates and large inflow of foreign funds, mainly from China help create easy credit availability. The major contributory factor for increase home ownership rates and demand for homes in US was subprime borrowing between 1997 and 2006 American home prices shot up by 124%. The worst development was that some homeowners used the increased property value experienced in the housing bubble to refinance their homes with lower interest rates and took out second mortgages against added value to use funds for consumer spending. That is how this housing bubble fuelled consumption boom. The upshot of these developments was that US household debt shot up to 130% of their income from roughly 100% earlier in the decade.

Overbuilding during the boom as expected eventually led to surplus inventory of homes which resulted in declining home prices, beginning in 2006. The worst scenario was that easy credit and the expectation that home prices will continue to appreciate had encouraged many subprime borrowers to obtain adjustable rate mortgages (ARM) as they could not afford initial incentive payment. Once housing prices started declining in many parts of the US re-financing became more difficult. Many borrowers were unable to re-finance and began to default on their loans as their loans were reset to higher interest rates and payment amounts. An estimated 8.8 million homeowners in March 2006 have homes worth less than their mortgage. The increasing foreclosure rates and unwillingness of many borrowers to sell their homes at reduced market price have significantly increased the supply of housing inventory available. Nearly 4 million unsold existing homes were available for sale.

Another contributory factor was speculation in real estate. This depicted that nearly 40% of home purchases were not primary residences. According to Economist David Lereach, speculators left the market in 2006, which caused the investment sales to fall much faster than the primary market.
Traditionally homes had not been treated as investment like stocks; however this behaviour changed during the housing boom. One company estimated that as many as 85% of condominium properties purchased in Miami were for investment purposes.

The share of sub-prime mortgage to total originations was 5% in1994. This shot up to 20% in 2006. A study by Federal Reserve indicated that the difference in the interest rates in prime and sub-prime mortgages was 2.8 percentage points in 2001 and 1.3 percentage points in 2007. In addition to considering high risk borrowers, lenders have offered increasingly high risk loan options and incentives such as no income, no job, and no assets loans, known as Ninja loans. The banking industry had provided loans to undocumented immigrants too, viewing it as an untapped resource for growing their own revenue stream. The crisis deepened because the investors started mixing up sub-prime securities with the prime securities in the same stock; as a result when sub-prime value fell it had an impact on the prime securities too, consequently, the value of both tumbled together.

Credit Rating agencies too had contributed immensely towards deepening this crisis. Now they are under scrutiny for giving investment-grade ratings to securitization transactions.(CDOs) and (MBSs) based on sub-prime mortgage loans. This crisis has exposed defects in both credit rating procedure and the incentives model for credit rating agencies. The rating agencies evaluated the likelihood that the debt will be paid back and assigned a high ranking grading such as AAA, BBB. Anything below the ranking of BBB is treated as speculative. These high ratings encouraged the flow of investor funds, both foreign and local into these securities, which fueled finance and housing boom. This higher rating was justified by various credit enhancements including over-collateralization, credit default insurance and equity investor's willingness to bear the first losses.

There was conflict of interest as the rating agencies were paid by the firms that organize and sell the debt to investors, such as investment banks. Rating agencies lowered the credit rating on $1.9 trillion in MBS from 2007 third quarter and 2008 second quarter. This brought extra pressure to lower the value of their MBS. This in other words, demanded additional capital to maintain capital ratios; sometimes this involved in issuance of new shares of stock. That in turn contributed to reduce the value of existing shares.

The ratings downgrades pressured MBS and stock prices lower. Fraudulent acts connected with issue of mortgage, for instance, misrepresentation of loan application data, were rampant.

Underwriters, (who work for the actual banks who lent money not for brokers), determined if the risk of lending to a particular borrower under certain parameters is acceptable. These three types of risks are called three Cs; credit, capacity and collateral. However, with the recent automation of underwriting the scrutiny was lax and excessive underwriting of high-risk mortgage too contributed for his crisis.

Now even the President of US has realized that regulatory mechanism in the country is outdated. The cronies of former Presidents, for instance, Fannie Mae Corporation have pressurized the governments to ease credit requirements on loans, thereafter this resulted in agencies purchasing subprime loans.
Former vice president of Federal Reserve Bank of Dallas has stated that Fannie Mae and Freddie Mac were classic examples of crony capitalism. Government backed these cronies, mortgage giants returned part of profits to the polls, sometimes as campaign funds. This shows that cronyism which is a deterrent to development has been a bane not only in Sri Lanka.

Another factor that contributed to the rise in the home prices was lowering of interest rates earlier in the decade by the Federal Reserve to diminish the blow of the collapse of the bubble and combat the risk of deflation. The Federal Reserve Bank lowered interest rates from 6.5% to 1% between 2000 and 2003. The Bank believed that interest rates could be lowered safely primarily because the rate of inflation was low, disregarding other important factors. Apparently the central bank was relying on erroneous inflation data, according to President and CEO of Federal Reserve Bank of Dallas, Richard W. Fisher. He further said that interest rate policy was misguided by this erroneously low inflation data thus contributing to housing bubble. (Sri Lanka!)

The sky rocketing of price of oil from $20 a barrel to $147 over a very short period resulted in transferring hundreds of billions in wealth away from the working Americans as they had to pay nearly triple at the gas pump.

This with dropping housing equity only served to increase the default rate even further. Large sums of credit went to oil derivatives as the oil prices moved upwards depicting the movement of the scoreboard when Sanath Jayasuriya was batting in a one day match. With the tumbling of MBS values and resulting economic downturn a fear psychosis was developed about the future price of oil. As a result oil prices started plummeting and started oscillating creating further problems to speculators.

Due to unprecedented financial leverage what had magnified profits during the housing boom now draws large losses after the bust. The financial institutions and investors holding MBS suffered significant losses as a result of widespread and increasing payment defaults or mortgage asset devaluation, beginning in 2007 onwards. With the downgrading of MBS banks found themselves with unplanned for additional risk and debt on their balance sheets and were forced to raise equity. The financial institutions from around the world have now recognized sub-prime related losses and write down exceeding US $501 billion as of August 2008. The sub-prime crisis led to a series of other economic problems. Housing price drop left consumers with less wealth, which pressurized consumption to be cut down. Certain minority groups were worst affected as they held disproportionately a higher portion of MBSs. Home related crimes escalated. About 65000 jobs, mainly in the financial sector were lost.

No doubt the economic downfall the world over will adversely affect our exports, foreign remittances etc; our economy is more than 50% dependent on the foreign sector. More importantly what we should learn from this drama is to see that adequate protective measures are in operation in our financial sector and leverage to make such stupid decisions as were made in America by abusing the liberalization of the financial sector, is totally wadded. If the world's most developed country, both economically and technologically America, could not preempt an ensuing disaster until some of the giants came to the brink of collapsing, a developing country should be extra cautious.

However, along with the liberalization of the financial sector in US, I believe, we too here in Sri Lanka, liberalized the banking sector.

Banks were allowed to get onto other financial activities like insurance underwriting, investment, leasing etc. Going by the amount of advertisements appearing in the media, I believe, the exorbitant profits that are earned by our banking sector come more from these ancillary activities rather than from the core activity. The question is how reliable is our economic data.

There is no way that we can avoid the impact of world recession, but there are so many ways of minimizing the economic impact, if proper policies are selected. Let us learn a lesson from the stupid decisions made by American politicians and bureaucrats and be proactive.

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