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Last night I attended the public lecture at the Sydney Institute entited ‘The World Financial Crisis How Did It Happen’. Speakers were Mark Johnson, former chairman Macquarie Bank, Timo Henckel, Research Fellow, Centre for Applied Macroeconomic Analysis, ANU and Dr. John Edwards, Chief Economist HSBC and formerly Economic Advisor to Paul Keating.

Mark Johnson
Mark Johnson spoke first, and most entertainingly. He started his speech by approvingly quoting US Federal Reserve Chairman Ben Bernanke who summed up the crisis by saying (to paraphrase) that the trigger was

‘the turn of the US housing cycle in 2006 with its associated cascading delinquency in sub-prime mortgages which was then itself triggered the collapse of the mountain of associated instruments and securities such as Mortgage Backed Securities, Collateral Debt Obligations and Credit Default Swaps all of which were funded by debt (borrowing). The securities were made to look more attractive than they really were due to improper US Underwriting standards and poor regulation of the financial industry.’

Johnson discussed how the US Credit Boom was funded by Global Current Account Imbalances i.e. The US borrowed while China (especially), Japan, Germany and OPEC loaned to the US by the purchase of US Government Securities (e.g Treasury Bonds). Successive US Administrations deliberately ran deficits as a response to challenges such as the Asian Financial Crisis, Y2K Bug, 9-11 and the DotCom bust.

Johnson said that Alan Greenspan and the US policy-makers had an over-confident ideological, (I would say quasi-religious) belief in the ‘Doctrine Of Efficient Markets’ i.e. that markets do not require regulation and automatically self-correct (NB Doctrine – see I told you it was a religious system) and so tolerated the growth of an unregulated ‘shadow banking sector’ which revelled in the cheap credit churned out by Washington, produced the weird securities mentioned above (MBS, CDO, CDS) and created the horrendous varieties of sub-prime mortgage which fuelled the melt-down.

Conventionally regulated banks were far from innocent however, also producing and trading in these instruments but moving them to ‘off-balance sheet vehicles’.

Such regulation that did exist was outmoded, confused (conflicting Federal-State laws) and politicized. The Financial sector lobbied for and got a repeal of the Glass-Steagall Act of 1933 which prevented Commercial Banks behaving like Investment Banks and vice-versa. After repeal of Glass-Steagall ‘everybody got into everybody ele’s business’ and the borrowing to deal in the ‘opaque’ MBS, CDO and CDS securities ran amok.

Greenspan later said that he watched the system collapse in ‘shocked disbelief’ so convinced was he that ‘free’ financial markets would self-correct. It is a brutal thing to see one’s most confident opinions shredded by reality.

US Rating agencies comprehensively failed the public and the world during this time. There were 37,000 AAA issues on the NYSE during 2007 most of which are now rated as Junk.

Opacity and the Liquidity Crisis

The meaning of ‘opaque’ in relation to the MBS and CDO securities is that third-parties cannot tell what they are composed of. Sub-Prime mortgages were bundles with good mortgages into MBS parcels which were then sold, combined with other MBS parcels -re-sold, sliced and diced some more and then re-sold again. The end result was a ‘mortgage porridge’ where no-one can tell which specific mortgages are where, or how many sub-prime mortgages you hold.

The opacity of MBS was of crucial importance because when the sub-primes started failing, lenders suddenly became very interested in knowing how many sub-prime mortgages say Bear Sterns, had parcelled up in their MBS. The answer was ‘We don’t know’ and so the lenders wouldn’t lend. This is where the ‘Liquidity Crisis’ came in and inter-bank lending dried up.

Timo Henckel

Timo Henckel took the podium and said that he essentially concurred with Mark Johnson’s view of the origins of the Global Financial Crisis, describing it as a ‘perfect storm’, a confluence of many factors, some of which taken by themselves were innocent or good in an isolated context.

He was specifically critical of the Ratings Agencies who, he said, acted as both ‘referee and player’ in the financial markets, pointing to their conflicts of interest. Dr. Henckel also pointed to outdated Accounting Rules as a contributer to the crisis as well grossly insufficient liquidity requirements, which the US Security and Exchange commission lowered to 33 to 1 (itself stupidly insufficient). According to the balance sheet of Lehmann Brithers their leverage ratio was 40 or 50 to one but their real position would have been far worse than that.

Dr. Henckel specifically mentioned the Community Reinvestment Act as amended in 1995 which he said (to paraphrase) ‘encouraged a loosening of lending standards, thus fuelling the sub-prime mortgage sector..’ I followed up on this point during question time.

Dr. Henckel’s most interesting points were those regarding the modelling of Financial Markets. As mentioned above, Greenspan and the policy-makers, indeed the consensus amongst economists today (prior to the crisis) was that Financial Markets were not different to any other market and function most efficiently when deregulated.

Henckel described the work of the economist, Hyman Minsky, who said that Financial Markets are a special case, characterised by very large ‘Information Assymetry’ which means that they are intrinsically unstable i.e volatile. In order to correctly regulate financial markets the correct model of their operation must be understood. The work of Minsky is now enjoying a renaissance. 🙂

John Edwards

John Edwards took a different perspective to the previous speakers. Instead of trying to assemble the fullest explanation possible, he tried to concentrate on the essential components.

For example, he said that Global Current Account deficit imbalances were not an essential factor in the explanation because interest rates could plausibly have been lower even if the whole world was not loaning to the USA to support their deficits.

Edwards was very critical of Greenspan and the regulators. He described the regulators as ‘irresponsibly negligent’. He noted that in inquiries into the crisis three seperate US Agencies claimed jurisdiction over regulation of Credit Default Swaps (CDS).

Edwards fingered the sub-prime mortgages as an indispensible part of the explanation, Greenspan (poor economic policy) and poor regulation. He noted that the adjustable-rate sub-prime mortgages products being peddled during the US Housing Bubble 1998-2006 could only be serviced in a phase of rising housing prices. As soon as that stops, defaults are inevitable.

On their own, however, sub-prime delinquencies would merely have decimated the US Housing Market as the bubble burst in 2006. What turned the whole show into a Global Crisis was the link between sub-prime mortgages and MBS/CDO securities. The collapse in these securites is what made Lehmann Brothers insolvent with cascading effects that now affect the entire world.

Edwards muted Henckel’s appraisal of the role of the Community ReInvestment Act, noting that it did not require or reward sub-prime loans. He may have also said, but did not, that the CRA actually mandates normal, prudential oversight but leaves the specifics of how loans should be structured to the expertise of the banks themselves.

Question Time

I directed a question to Dr. Henckel:
“Many people have fingered the CRA as the trigger to the crisis saying that the CRA caused large numbers of sub-prime loans to be held by poor (ethnic) minorities who then defaulted. I have read data that said that 60% of sub-prime loan defaults were held by middle-class and affluent borrowers. Is this true and how did they end up holding sub-prime loans ?”

Dr. Henckel replied:
“I would like to see that data. It does not correspond to data that I have.”

At the conclusion of the evening I handed Dr. Henckel a copy of my source which is the article The Community Reinvestment Act and the Recent Mortgage Crisis by US Federal Reserve Governor Randall S. Kroszner, December 3, 2008 .

Our analysis of the loan data found that about 60 percent of higher-priced loan originations went to middle- or higher-income borrowers or neighborhoods. Such borrowers are not the populations targeted by the CRA…Putting together these facts provides a striking result: Only 6 percent of all the higher-priced loans were extended by CRA-covered lenders to lower-income borrowers or neighborhoods in their CRA assessment areas…

In correspondence with Dr. Henckel, he said that he had misunderstood my question at the time and noted that ‘the sub-prime mortgage sector was concentrated in four states – Arizona, California, Florida and Michigan and indeed the majority of sub-prime mortgage holders there were white households.’

When I asked my question, the Sydney Institute audience let out a discontented murmur. I don’t think they were comfortable with the concept that the middle-class or affluent have contributed to this enormous problem. They were quite comfortable with the concept that poor minorities could have.

A Visit To The Institute

It was a good evening and very good value for $10 as a non-member. The talk was held on Level 61 of Governor Phillip Tower just behind Circular Quay, so there were panoramic views of the Harbour and the Botanic Gardens. Really stunning.

I would say there would have been about 200 people there, maybe more. We sat in rows in a big seminar room. Average age would have been maybe late 40’s or ealy 50’s. I went by myself but talked to a few people. Three worked in the Financial Industry, one was a retired man who has been a Sydeny Institute member for 3-4 years. He said the quality and number of speakers has been continually increasing. I didn’t notice any politico-celebs or IPA Members (I scanned the guest list) in the audience.

The line-up of speakers for this year is very good: Julia Gillard, Julie Bishop, Wayne Swan, Helen Coonan, Maxine McKew: and they have people with a leftist viewpoint e.g. Helen O’Neill (Refugee Advocate). Gerard Henderson should be congratulated for assembling a range of speakers that do not necessarily accord with his conservative viewpoint.

It went for two hours (80 mins talk, 40 mins questions) though the schedule for was 60 mins talk, 60 mins questions. Never mind, the speakers were very interesting. Gerard Henderson gave a very brief intro. and didn’t waste any time. No party pies or quiches afterwards (rats) but light refreshments are promised at future talks (see the Sydney Institute website).

So it makes for an good evening. I would recommend it. Come prepared with a good question and look enthusiastic and you’ll probably get a chance to ask it.

I am considering the following one for Senator Coonan, ‘Do you, like John Howard, consider the ABC to be the enemy of the Australian people’. Strewth. They’ll throw me out!

Example Of Sub-Prime Contagion
Here is an example of how Sub-Prime mortgages triggered failures in other securities.

The linked article describes how ‘Commercial Paper’ issued by investment and asset management companies e.g. Ottimo Funding, an affiliate of Aladdin Capital Management, an investment manager in Stamford, Connecticut was linked to sub-prime mortgages and hence how defaults in the latter flowed on to defaults in Commercial Paper.

Commercial Paper is a fancy term for an IOU. They were bought by pension funds, insurance companies, hedge funds and short-term money market funds. Commercial Paper became increasingly backed by sub-prime mortgages. In August 2007 more than one-third of all US Commercial Paper was backed by various forms of consumer debt such as residential mortgages, credit card receivables, car loans and other bonds.

The funds generated by Commercial Paper backed by sub-prime mortgages were used to buy…more sub-prime mortgages!

As sub-prime mortgages defaulted, the companies issuing Commercial Paper could not repay their debts to the Pension Funds etc. who became likewise compromised.

Blimey – its a house of cards!

Credit Default Swaps

Wikipedia has a good page on these. These operate like a form of Insurance where you pay a premium over time and get a payoff if a specified event occurs e.g. Lehmann Brothers go bankrupt or Sub-Prime Mortgage Parcel #1005 gets downgraded to Junk

You do not actually have to own any of the security (e..g Mortgage Parcel #1005) to be able to buy a CDS on it, so you can make money out of things you don’t own. Consequently the majority of the CDS market is a huge casino disconnected from the actual buying and selling of stock or bonds.

The role of CDS in the Financial meltdown was that

1) They introduced Systemic Risk into the Financial system which contributed to the ‘Liquidity Crisis’
2) They were responsible for the collapse of AIG

As Wikipedia explains on Systemic Risk, CDS and Liquidity:

imagine if a hypothetical mutual fund had bought some Washington Mutual corporate bonds in 2005 and decided to hedge their exposure by buying CDS protection from Lehman Brothers. After Lehman’s default, this protection was no longer active, and Washington Mutual’s sudden default only days later would have led to a massive loss on the bonds, a loss that should have been insured by the CDS. There was also fear that Lehman Brothers and AIG’s inability to pay out on CDS contracts would lead to the unraveling of complex interlinked chain of CDS transactions between financial institutions…

Some commentators have noted that because the total CDS exposure of a bank is not public knowledge, the fear that one could face large losses or possibly even default themselves was a contributing factor to the massive decrease in lending liquidity during September/October 2008.

Many thanks to Dr. Henckel for taking the time to enter into correspondence on his talk.

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