Subprime crisis : the overall picture
By Vincent Benard
In many aspects, the current financial meltdown that brought many banks and insurers to insolvency may be compared to the nuclear meltdown that affected the Chernobyl power plant. And whatever Big Government pundits may tell us endlessly – without real in-depth arguments – inappropriate state intrusions in the economy are as much responsible for the financial crisis as poor state management of nuclear facilities by USSR was for the Chernobyl disaster.
If the mechanisms of the so-called “Chinese syndrome” can be described as a process of ignition, amplification, and then propagation of atomic reactions, likewise, the current crisis is a story of state interventions in the economy, that ignited, amplified, and then propagated the meltdown from its original core to the whole financial system.
The main factor that ignited the current crisis is how politicians forced two state regulated enterprises, Fanny Mae and Freddie Mac, to refinance a growing part of unsecured loans to low and very low income families. In exchange, Fannie and Freddie were exempted from some accounting requirements generally expected from ordinary firms, allowing them to leverage too much credit compared to their equity, by an extensive use of off balance “special purpose vehicles.” All these operations were made under an implicit taxpayer provided safety net, as the statutory rules of the department of Housing and Urban Development made possible the nationalization of Fannie and Freddie in the case of bankruptcy.
These government provisions, coupled with a law mandating banks to find ways to originate loans to some high risk-profiled borrowers (the much discussed and controversial Community Reinvestment Act), reversed the usual prudential rules governing company CEOs: first, don’t fail, and then, make a profit. Due to their government backing, Fannie and Freddie only had to expand their volume of business, without too much consideration of the underlying risks. The purchase of so many bad loans by two state-backed giants encouraged reckless lending by banks and mortgage brokers to many risk-unaware families.
This behavior was greatly helped by Alan Greenspan’s decisions to lower and maintain very low interest rates in the early 2000s without consideration of the obvious asset bubble that was emerging in the housing sector. When credit is too cheap, borrowers tend to be less careful in their investments.
But these facts do not explain by themselves how big the housing bubble has become. The average Joe, in the mortgage broker’s office, was not as unsophisticated as generally described. He could lose his common sense and succumb to easy credit only because the brokers could show him impressive Case-Schiller index curves, which seemed to show that any housing investment could gain more and more value every year, making the purchaser richer even while he was sleeping. Without this apparent housing inflation, many people wouldn’t have jumped so recklessly onto the easy credit bandwagon.
But this housing inflation did not occur everywhere in the country. Some of the most dynamic metro areas, in terms of population growth, haven’t experienced any housing bubble. Recent Nobel Prize Paul Krugman, supported by several research papers, notably from academics like Ed Glaeser or Wendell Cox, explained it by land use regulations: when these regulations are flexible and tend to be respectful of the property rights of the land owner, housing bubbles cannot even get started. But when regulations allow the existing real estate owners to prevent farmland holders to build the houses required to satisfy all housing needs, housing prices start skyrocketing.
Housing mortgage debt owed by families grew from 4.8 to 10.5 trillion USD (from early 2000 to late 2007. But had every city in the USA had the same flexible land use regulations that they had in the fifties, and that still exist in fast growing areas like Houston or Atlanta, this exposure to risk would have been much lower, by 3 to 4 trillion. More borrowers would have qualified for the prime credit market and its less risky loans, since the lower price of the purchased homes would have resulted in better credit ratings. So, despite the bad lending practices mentioned above, the risk of a general collapse of the credit market would have been nearly equal to zero.
At this point, we just explained the roots of a mortgage crisis. What is still missing is the way it has spread throughout the financial system. Once again, bad laws are to blame.
First, this crisis shows how risky the bank’s business model, grounded on low equity and very high leveraging ratios, has become unsound in these time of high volatility of some assets. Some will blame banks for this, but you should be aware that before the creation of the FED in 1913, most banks’ business models were based on equity levels over 60%: the shift from a high equity to a low equity model comes first from tax policies which have, in nearly every country of the world, severely taxed capital gains, but encouraged debt by deducting the interest payment from the corporate tax base. The second reason is that central banks, as “last recourse lenders,” usually with a state’s warranty, have themselves favored this shift to a highly leveraged model: borrowing money was de facto a cheaper resource than raising capital to finance operations.
But of course, this doesn’t explain how a 10% default risk on a credit niche market (the subprimes), totaling less than 10% of the total housing debt (12 trillion at the end of 2007), itself less than one fifth of the total assets being exchanged on American financial markets, generated such turmoil.
The culprits must be sought within a set of rules named “Basel II,” and their declinations in local laws in most countries, aimed at regulating the activities of banks or insurance companies. In some cases, poorly designed accounting rules may have contributed, too.
Basel II rules — and the like — mandate banks and insurers to hold a diversified portfolio of assets aimed at providing them the liquidities they need to face hard times: for a bank, a major loss of customers; for insurers, a series of major disasters. These rules were supposed to “protect” investors from reckless diversification policies. So institutional investors were mandated to own only high quality bonds, or to value some kinds of assets, like stocks, with a weighting that de facto prevented their securities from handling such assets directly.
But banks and insurers needed the yields of “lower quality” bonds, or even stocks, to remain attractive to private investors. Otherwise they wouldn’t have been able to beat the performance of state labeled bonds, and thus wouldn’t bring any added value to their customers, forcing them out of the market.
So the late 80’s and the 90’s saw the onset of a huge market of “derivatives,” all based on the following principle: lower quality assets (like subprime based securities bonds) are put together in another security, which itself sells new bonds sliced into several “tranches.” The first slice, the “z-tranch,” is a very risky one, which is aimed at bringing a higher yield to unregulated investors as hedge funds but must absorb primarily the first percentages of any losses of the security. Other tranches bear a lower risk but serve a lower yield. The “cushion effect” of the high risk tranch allows the lower tranch bonds to receive an AAA rating from rating agencies, particularly if they are covered against credit default by a special derivative called a “credit default swap,” allowing lender and borrowers to reinsure themselves against defaults on their bonds. And there can be other “derivatives of derivatives” involved in these designs. In many cases, institutions issuing AAA tranches guaranteed the payment of the corresponding bonds.
So the current situation is that many institutional investors do not hold many real stocks or bonds in their portfolios. They mostly hold a majority of derivatives.
But all this incredibly complex financial engineering not only is extremely costly, but has one perverse effect: while reducing the probability of AAA tranches to default, it actually makes the amount of the risk higher in the event that losses are high enough to impact the AAA tranches. And all these complex designs of derivatives make it increasingly difficult to understand where the risks are located in complex securities mixing prime mortgages, subprime mortgages, and other kinds of credits. So when an AAA tranch is impacted by higher than forecast losses, nobody really knows what is the resulting worth of the best tranch if it has to be sold. Is it 95% of the nominal? 60%? Nobody seems able to value these bonds reliably.
So when the mortgage debtors began to be insolvent in a higher proportion than usual, the losses on subprimes derivatives began to exceed the “cushion” effect of Z-tranches. AAA bonds were impacted. Some holders of these bonds, forced to sell off in panic in order to get cash, couldn’t find purchasers, except some highly speculative funds that toughly negotiated the price.
But then, because of inflexible accounting laws, all institutions holding the same kind of toxic assets had to write down the values of these assets in their balance sheets, even if their treasury level didn’t force them to proceed to a fire sale of these assets. So they might have been declared virtually insolvent even if actually they were not. This affected their ability to borrow on short term liquidities markets, and thus led some of them ultimately to file for bankruptcy.
If no regulatory limitations had been placed on the assets that banks and insurers could hold, it is likely that they would not have found the use of exotic derivatives so attractive, and that early difficulties in subprime credits would have resulted in clear signals prompting securities managers to recompose their portfolios. Some investors’ failures could have occurred earlier, but would not have reached such proportions.
Big Government is the culprit
So, at the root of every mechanism identified as a catalyst of the current crisis, we can find a bad federal or local regulation.
Does this mean that private institutions have no moral and technical responsibility in the current mess? Certainly not. They’ve deliberately chosen to take advantage of these poisonous regulations instead of fighting them, even though some of the underlying risks were clearly identified. Many of them ifnored warnings issued by economists like Nouriel Roubini, or atypical politicians like Ron Paul, and preferred to listen to reassuring assessments of the soundness of the system written by star economists like Joseph Stiglitz. People don’t like dream breakers.
Competition to overturn bad regulations doesn’t exonerate financial private institutions from having failed to do so properly. Whatever conditions are created by the states, firms must act wisely. Many of them obviously did not. But in the ranking of responsibilities, states’ inaccurate and inordinate regulations obviously rank highest. Had its diverse regulations and interventions focused on principles (honesty in contracts, no concealment of malpractice, full disclosure of operations, respect of property rights) and court litigation; had they let private individuals or enterprises decide what was good for them without trying to curb their behaviors in particular directions, none of the elements that allowed this crisis would have been in place.
Government’s economic interventions in human interactions once again have proved counterproductive and finally wrought havoc. This should make people very careful about government claims that new interventions are necessary to solve the crisis and avoid the next one!
Vincent BENARD is the president of the Hayek Institute, a French speaking think tank based in France and Belgium – www.fahayek.org . The institute has published several tribunes advocating the free-market point of view on the current crisis. His personal blog is www.objectifliberte.fr