Lessons in Greed, Gullibility and Ignorance

The recent global financial meltdown began in America and spread far beyond its borders. It produced a crisis of confidence in how money is extended and invested in financial markets by individuals and financial institutions: primarily banks, other mortgage lenders, insurance companies, investment banks, pension funds and hedge funds. Central banks, regulators, rating agencies, analysts and accountants as well as the media failed to properly carry out their responsibilities. Had they examined, monitored, reported and rated the performance of financial institutions more thoroughly and promptly, the crisis would have been averted or at least substantially reduced. In particular, they failed to detect funding difficulties caused by inadequate deposit bases.

It was inevitable that financial institutions would become victims of catastrophic events because their high risk activities were unsustainable. The unwritten strategy of many financial institutions was to follow the leader and join the rush. The blame for this mindless approach can be laid squarely at the feet of CEOs and directors.

Their duty of care had long been abandoned in favour of growth, profits and bonuses as the events of the past two years have shown. Many banks, including investment banks, had over-indulged in the high risk American sub-prime mortgage market. The glut of unsold houses and countless delinquent borrowers, many of whom had vacated their premises, transformed sought-after assets into write-offs, driving banks and other financial institutions into insolvency or near insolvency and into seeking government support.

The financial mess began when Wall Street’s investment banks discovered that quick profits could be found in America’s Main Street residential mortgage loans, including sub-prime loans. They devised ingenious complex financial products such as credit default swaps and collateralised debt obligations (CDOs) in which sub-primes found a home.

Stop greedThere is no greater misnomer than the term "sub-prime loans". There is nothing even close to "prime" about these high risk assets; certainly not loans based on one hundred per cent or more of the value of the homes of weak residential borrowers, many of whom were granted an interest-free  period. Borrowers with poor credit histories are less likely to meet their obligations. Lenders were aware of this, but continued to approve them because they knew they could avoid the inevitable default consequences. They utilised a structured finance process to securitise their risky loans and offer them as collateral for the issuance of bonds for third-party investments or for other deals. These "liar"or "teaser" loans were bundled in with other interest bearing debt such as car loans and credit cards, and even in some cases, very risky post September 11 aircraft leases. These assets became known as collateralised debt obligations or CDOs.

Investors seemed unbothered by a lack of information and understanding of the risks. They were more interested in the investment return. Thus asset laden risky loans were removed from the originators’ books and transformed into popular marketable assets.  

Bernard Madoff’s $50 billion Ponzi scheme is further proof that investors failed to conduct due diligence. No one seemed to know or care how Madoff made money. His business was being audited by a firm of four people and not one of the big name accounting firms. 

Credit rating agencies (CRAs), the once highly regarded establishments which assign credit ratings for issuers of certain types of debt obligations as well as debt instruments, were hired to evaluate CDOs to attract investors. Not surprisingly, the CRAs came up with satisfactory appraisals. There were no loan-by-loan reviews of a borrower’s creditworthiness and no appraisals of the lenders’ strategies, policies and procedures to determine the quality of the process which produced the loans. CDOs were arranged in tranches or layers, graded and priced according to risk; the highest risk carried the top return and the least risky, the lowest.

In July 2008, the Securities and Exchange Commission (SEC) released its report on three credit rating agencies – Fitch, Moody’s and Standard & Poor’s – concerning their rating practices of residential mortgage-backed securities (RMBS) and CDOs. This was not the first time that CRAs have attracted unfavourable attention. They were criticized for acting too slowly in the Russian and Asian crises and for failing to downgrade Enron and WorldCom more promptly.

The SEC’s report found:

  • the growth and complexity CRAs’ RMBS and CDO deals since 2002 had increased putting some CRAs under stress.
  • no written procedures for rating RMBS and CDO deals
  • conflicts of interest.

Above all else, risk arises from unknowns and there were plenty of unknowns about hedge funds. Hedge funds which are also investment funds are supposed to guard investors against volatility and risk. Yet they are themselves risky in that they are highly geared – sometimes up to six or seven times their net worth. They operate secretly and without constraint, undertaking significant risks to exploit discrepancies in currency, equity and commodity markets and wherever and whenever else they think they can make a buck. This did not bother investors, many of whom failed to critically evaluate these enigmatic entities.

US based hedge funds generally target high net worth individuals, i.e. those with a net worth over $US5 million and an annual income of $US200,000. They, along with other investors, rushed into securitized markets and gorged on highly risky and incomprehensible investments. Some may have known what they were doing, but many others didn’t. If the downsides had been known and spelled out to investors, it is unlikely they would have become as heavily involved in high risk schemes that were on shaky grounds and destined to fail. If the income stream of CDOs had been examined and questioned more
carefully, investors as well as lenders would have been more mindful of
the dangers and this may have affected their investment decisions. Instead, they were apparently unmindful of the disastrous and entirely predictable outcomes that lay ahead.

The infant CDO market was another area disregarded or glossed over by CRAs, lenders and investors. While there are primary and secondary markets for stocks, bonds and cars, no established secondary market existed for CDOs. CDO lenders, particularly, should have been cognisant of this shortcoming and its implications. It was only in July 2007, as the market tightened, that they became aware of problems with their security. As the CDO values fell, margin calls began to be made. Those who borrowed had a choice of either topping up the loan with other acceptable securities or selling. Those who borrowed and chose to sell discovered that the proceeds were often insufficient to repay the loan.

While there may be sympathy for some investors, there are no excuses for banks and other lenders who employ experienced skilled personnel to extend credit on the basis of a borrower’s ability to service the loan in accordance with its contractual terms. A lender’s responsibility is to steer its customers away from high risk transactions. They are supposed to know the risks in the transactions they are financing. If they don’t, then they shouldn’t lend, because profits are rarely realized on bad loans.

It could be argued that low interest rates were the principal cause of sub-prime loan failures as well as CDOs because it attracted many would-be borrowers, some creditworthy and many not. Higher interest rate loans would have dampened demand especially from weaker borrowers. However, in previous times when interest rates were low, the level of bad loans was well within acceptable limits: about 0.5 per cent of the total outstandings.

The defaults that banks, other lenders and investors have suffered have more to do with easy credit than cheap credit. This is especially evident in the CDO loan agreements of structured investment vehicles, many of which could be described as covenant light; for example, a standard adverse development clause accelerating repayment was often omitted. Another broken lending principle was that sub-prime borrowers were frequently given higher loan amounts that they could safely service. This was the case with one well known American bank which offered almost double the size of a mortgage loan for a home purchase.

When the low interest rate period on ‘teaser loans’ ended, it inevitably led to sub-prime loan defaults. Since CDOs contained a high level of sub-prime loans, cash flows began to deteriorate, affecting the entity’s ability to meet its financial obligations. Predictably, a flight of capital ensued, sparking fears of a liquidity crisis in several countries, making mortgage refinancing more difficult and prompting central bank action. Billions of dollars of loans awaiting syndication were warehoused and may still be in inventory. The result? The global financial fallout rocked Wall Street and many investments banks were left with large losses.

A changing and volatile world requires that our guardians of money be
more vigilant of potential threats, not just here, but also abroad.
They should keep up to date with the activities of non-bank financial
institutions. It is no longer sufficient for regulators to audit bank
loans. Lending processes and operations must also be inspected. There
must be more transparency and better monitoring by regulators, and
better investor risk analysis and management. Regulators should
benchmark good bank lending practice and construct regulations which
will protect banks from themselves. These should be reviewed annually.  

The financial crisis came as a surprise to Alan Greenspan, the former chairman of Federal Reserve System, the US central bank. It shouldn’t have, if the Fed had been properly monitoring its turf. The problem was that the Fed, as well as other central banks, had not adjusted its thinking on what their turf is or should be. Barriers, in a globalised digital world, are disappearing. Money markets and new products are emerging. Regulators must catch up.

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