Reaping the whirlwind of financial deregulation
by Dr Patricia RanaldCo-convenor, Australian Fair Trade and Investment Network
Conservative commentator Paul Sheehan wrote in the Sydney Morning Herald on March 31, 2008
“Most people seem unaware of how close we came to a catastrophic financial event this month, an event brought about by reckless greed on a reckless scale ...In June 2007 the Bank for International settlements, which acts as a central bank for the world's central banks, warned of the potential of a financial collapse not seen since the Great Depression in the 1930s...This month the system meltdown that the bank had warned about was almost triggered by the collapse of one of the world's leading merchant banks, Bear Stearns. When US federal regulators examined the bank's collapse, they were aghast... The bank was insolvent... the US Government guaranteed $30 billion of what would otherwise have been worthless mortgage-backed securities held by Bear Stearns. This averted the complete collapse of the bank and a catastrophic blow to confidence in the system”.
The impacts of the US subprime mortgage market crisis are being acknowledged even by conservatives, and continue to be felt through the global financial system. Banks and other financial institutions around the world have lost billions, there is a global credit squeeze, and share markets have fallen in value, wiping billions in value from pension and superannuation schemes. Governments have intervened to protect banks like Bear Stearns from collapse, ranging from guaranteeing the value of subprime mortgage securities, to the reluctant nationalization Northern Rock bank by the British government.
Subprime mortgage securities are based on housing loans made by banks to people who could not repay them, called in plain language “predatory lending.” How did the risks of these bad loans, made originally in the US, spread through the global system?
The answer lies in the progressive deregulation of national and global financial systems that has been vigorously promoted by neo-liberal economists, banks and other financial institutions, and enacted by governments, over the last two decades.
For example, regulation to prevent predatory lending existed in several key US states as late as 2004. Glenn Simpson, writing in the Wall St Journal on January 2, 2008, documented how US banks saw the combination of low interest rates and rising house prices as an opportunity to exploit “emerging markets” of low income people. The banks bet that rising house prices would cover the value of the loans even if the borrowers could not meet repayments. The only barrier was regulation against such predatory lending in states like California, Georgia and New Jersey. Simpson documents the banks' lobbying and huge donations to state legislators that succeeded in removing the regulation.
With the regulation removed, banks developed “NINJA” mortgages, (short for people with “no income, no job, no assets”) aimed at people in casual employment or on welfare payments. These loans had a low initial interest rate which low income people could just afford to pay. Hidden in the fine print was a sharp jump in rates after two or three years. These loans were known as “automatic resetting mortgages” or ARMs. The banks bet that the continued growth in house values would enable them to cover their costs if the borrowers could not pay when the interest rates rose.
These subprime mortgages were sold to low income people, not by the banks themselves, but by agents paid a commission for each sale, who had an interest in selling as many as possible, without pointing to the fine print about higher rates later. This was the second regulatory failure in the system. By 2007, the highest risk subprime mortgages were 14% of the total US mortgage market, with a further 10% of the market classified as risky. This meant there could be a massive downward impact on house prices when large scale defaults triggered the sale of millions of houses.
The original lending banks sold the mortgages on to other banks. This was not unusual.
What was new was that the banks then bundled together these high risk mortgages with other less risky mortgages into a Collateralised Debt Obligation (CDO) and in the third example of regulatory failure, sold them to a Special Investment Vehicle (SIV), often a separate company, but owned or guaranteed by the bank. The banks were passing the risk onto these subsidiary companies.
The SIVs borrowed funds to buy the CDOs, and convert them into securities, which were promoted and sold as investments with acceptable risks but high interest returns. In some cases, like Bear Stearns, these risky investments were used to leverage further risky investments, magnifying the original risk many times over. But the value of the securities and the ability to pay the interest to investors was still dependent on the value and risks of the original subprime mortgages.
Why were investors persuaded to buy these risky securities? The fourth example of regulatory failure rests with the ratings agencies like Moody's and Standard & Poors, which are supposed to provide reliable risk assessments for investors, ranging from triple A, low risk, through to triple B or C, very risky. The agencies gave these subprime mortgage securities low risk ratings, based on the false assumption that only a small percentage would result in defaults. And the deregulation of global financial markets meant these securities could be sold around the world.
And they were. Banks, local government and pension funds all over the world, including Australia, invested in these securities, based on the ratings given by the ratings agencies.
All of these regulatory failures came home to roost in 2007, when the higher interest rates kicked in on many sub-prime mortgages, leading to millions of defaults, flooding the US market with houses for sale. Millions of families were left homeless as their houses were sold, with many still in debt if the sale price was less than the value of the loan.
House prices fell alarmingly in the US, and the ratings agencies downgraded the value of the securities. An article in the Wall St Journal reprinted in The Australian on December 29, 2007, traced how this process led to huge bank losses. The investment bank Merril Lynch Special created a Special Investment Vehicle called Norma, which borrowed money to invest in subprime securities. The risk ratings of its subprime securities fell from triple A in early 2007 to triple B or C in November 2007, making them almost worthless. At least thirty other investment banks suffered the same fate, including Bear Stearns, which was bought by JP Morgan Chase after the US Federal Reserve Bank bailout described above.
Banks and investors in subprime mortgage securities have suffered direct losses and credit shortages around the world, leading usually sober financial commentators to refer to “contamination” of the global system, and to international agreements by central banks to provide guarantees to prevent collapses that could affect the global financial system.
The dramatic fall in US house prices has led to unemployment in the US building industry and its suppliers. This and the credit squeeze have contributed to a reduction in US growth and rising unemployment, which economists are now admitting is a recession in the world's largest economy. This is already having separate impacts on global product markets as US demand for imports falls.
In Australia, the effects have been less dramatic, but still serious. The Australian economy is still riding on the back of China's demand for minerals and energy. But Australian banks, including ANZ, Westpac, NAB and the Commonwealth have either experienced direct losses on investments in subprime securities, or been effected by the global credit squeeze. Australian investment company losses have included Basis Yield, RAMS, and Centro property trust. ABC Learning plunged in value and had to sell its US Childcare centres after subprime-affected US banks called in its debt. Following the global trend, all banks have become more cautious about any loans, leading to less credit availability and contributing to higher interest rates. With less money available to buy shares, Australian share markets have plunged in value, leading to losses for super schemes and retirement incomes.
Although Australia has a much lower level of subprime loans (called “low doc” loans here), Australia has a high level of overall consumer debt (including mortgages, credit cards and personal loans), which Sydney economist Steve Keen estimates at 156% of the gross domestic product. We are now seeing increases in mortgage defaults as interest rates rise, with rising levels of homelessness. Keen argues that this debt should be monitored and wound back, and that lenders should be regulated to prevent predatory lending of all kinds (see his paper Deeper in Debt: Australia's addiction to borrowed money, at www.cpd.org.au).
Central banks have spent billions guaranteeing securities to prevent the collapse of banks that could destroy confidence in the whole banking system. Some commentators have condemned such bailouts, arguing that banks should bear the consequences of their own folly. Although this reasoning might provide moral comfort for some, its practice in the 1930s led to a disastrous global depression.
The sober fact is that central banks, meaning ultimately governments, are still the lenders of last resort in the global system, despite decades of financial deregulation that has simply allowed what even conservative commentators like Paul Shehan are calling reckless greed on a reckless scale.
The reality is that we do need banks to provide credit for the economy to work, but that unregulated financial markets have failed. Given this fact, we should be demanding, not that banks be allowed to fail, but that they be compelled to behave responsibly to prevent failure. In other words, as Ambrose Evans-Pritchard, business editor of the London Daily Telegraph, put it, “it is time for states to act like states” (quoted by Shehan in Sydney Morning Herald, March 31, 2008).
There is now a serious public debate about what kind of regulation of the financial system is needed, both at global and national levels. This debate should include explicit recognition that financial institutions can cause enormous human damage. They should have a license to operate, and access to ultimate public guarantees, only if they act responsibly, with criminal prosecution if they fail to do so.
We need regulation to prevent predatory lending, licensing and regulation of mortgage brokers, legal obligations on banks to provide adequate capital reserves and full information to borrowers, regulation of mortgage securities, and regulation and accountability for ratings agencies to prevent misrepresentation of risk, with criminal penalties to ensure compliance.
More broadly, governments must fund consumer credit education, and address the need for secure low rental housing for low income earners, though both investment in public housing, support for housing cooperatives and encouragement of private investment in low income housing. The Howard Government blindly supported the mantra of financial deregulation and ignored calls and advice for public interest regulation in these areas.
The ALP federal government is considering what changes are needed to national financial regulation in the wake of the subprime crisis. It will take a lot of public pressure to roll back the rhetoric of deregulation and ensure that the ultimate public responsibility for the financial system is matched by robust public regulation to protect the public interest.
Source: Australian Options, Issue 53, Winter 2008, pp. 7-10