A primer on subprime (5 of 5): Who’s to blame?

Culprits as I see it:

1) Greed by everyone in the chain: The people who took out loans they really shouldn’t have, the bank officers helping to falsify loan information to meet their performance targets, the CEOs out to make their big bonuses, shareholders hungry for profit growth, ratings agencies focused on fee income, investors looking for a free lunch ….

Borrowers were encouraged to over-state their income to qualify for bigger loans; or even to qualify for loans in the first place as banks rushed to hand out credit. A senior officer at Washington Mutual, one of the failed US banks said, "At WaMu it wasn't about the quality of the loans; it was about the numbers … They didn't care if we were giving loans to people that didn't qualify. Instead, it was how many loans did you guys fund."

They were facilitated by a false sense of security after years of benign economic conditions. Over-optimistic assumptions were built into financial models. Bankers and ratings agencies conveniently assumed recent low default rates were sustainable in the long-term. Those who argued against were told, “This time it’s different”.

Some senior bankers knew it was a house of cards – remember former Citigroup boss Chuck Prince saying, “As long as the music is playing, you’ve got to get up and dance?” But bank bosses were under pressure to show profit growth. Banks competed fiercely to lend, and often dispensed with the usual covenants meant to secure such credits – ie the “cov-light” loan. Ratings agencies gave unwarranted AAA ratings.

2) The market failure was facilitated by regulatory failure. Alan Greenspan’s Federal Reserve refused to deflate the mortgage bubble. He argued that markets had efficiently found ways to diversify the risks. But regulators failed to look deeply enough into the institutions that had supposedly took on the risks. The risks appeared to have been off-loaded, but really weren’t as the insurers were not well capitalised. It turned out that even large AAA-rated firms like AIG were over-extended and could not pay up when defaults rose.

Quite frankly though, I don't think the soul-searching is worth much. History is useful if only we would learn from it. And yes, for a while, lending standards will be tighter, banks will focus on risks and regulators will be stricter.

But as the good times roll again, politicians and businessmen will push for relaxed standards. Risk managers don’t earn revenue. Loan salesmen do. We'll again hear “This time it's different. We've learnt our lessons.” We shall see.

A primer on subprime (4 of 5): What we can do

It's a given Malaysians will suffer too in this global slowdown. Anyone suggesting Malaysia will be unaffected is living in dreamland. All of us – government, businesses and employees – have to contribute to mitigate the pain:

1. Government in the next few months has to spend to cushion the local economy and protect society's poorest;
2. In the longer-term economic policy has to be reevaluated to attract investment, both local and foreign;
3. Businesses and employees must use the breathing space afforded by the government handouts to improve efficiency and productivity.
   

Like most things, these are easier said than done. Unfortunately, government fiscal options are limited. We had already been running Budget deficits for the past 12 years, through the good times. In fact, the deficit for this year, 2008, will hit 4.8%, higher than the 3.6% initially forecast, even with record high oil and crude palm oil prices. Next year, in 2009, there will be a lot less government revenue with oil prices down by more than half and lower corporate and income tax collections.

Fortunately, and ironically, there has been plenty of fat in the system. Most would agree that there is tremendous leakage when the Barisan government spends money. Cut out the fat, and spend what we have on projects with the maximum impact on the local economy – so small scale grassroots projects please. Mega projects with high foreign input costs should be carried out only if truly necessary.

Besides the short-term spending, the Barisan Nasional government must reconsider its economic policies. The government has been increasing its role in the economy over the years. The federal budget has increased 57% over the last three years! That is not healthy. Sustainable economic growth is always private sector-led.

The amount of capital investments in Malaysia is very low poor. We were the only Asean nation to record net capital outflows last year . And if foreign exchange rates are any indicator, we are considered a worse risk than Thailand, where quite literally there was blood in the streets. The ringgit has depreciated against the baht in the past year.

Now is the time to ask the hard questions and implement the solutions. Why is investment lagging in Malaysia? Why has the perception of our country deteriorated so much? We were once seen as close to Singapore in terms of stability and prospects; we are now compared with lesser peers.

Create a conducive environment for private sector investment. And don't just focus on the foreigners. Remember the locals too. There are many Malaysian millionaires and billionaires with cash to spare. What will it take to get them to put it back into the Malaysian economy?

As for what businesses and individuals can do, Tan Sri Ramon Navaratnam said, “Be lean and mean.” Time was short and he was closing the discussion at the open forum on The Global Financial Crisis and its Implications on Malaysia. Elaborating on his behalf, we should all be looking at ourselves and asking how we earn our income. No-one owes us a living, and in my working life, my guiding philosophy was “My employer must consider me good value.” That's the only way to job security, no matter what you do. If you're a businessman, it's “My customer must find me good value.” I'm not saying cut prices – there is a difference in price and value, which can be the subject of another blog – I'm suggesting there's also substantial room for customer service, productivity and efficiency improvement in Malaysia.

For those lucky enough to have spare cash, I personally believe this is a buying opportunity . Traditional financial theory says markets are efficient. My experience is that markets are made up of people. These people may be smart, may be very highly qualified, may be very intelligent but they are humans with very human emotions. There will be periods of euphoria and periods of pessimism.

We are entering a period of pessimism. I had drinks with a friend recently. He used to be a happy punter in the stock market. Conversation turned to personal portfolios and I recommended a stock at 1.5x P/E. His first reaction – what will earnings be next year? I said, even if earnings go down by half, the stock would be at 3x P/E. But still he wasn’t convinced – and this was a guy happily buying in the bull market when P/Es were well in the teens or 20s.

It won't be an easy ride. Warren Buffet last month said, "…. the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary … ..…… Let me be clear on one point: I can’t predict the short-term movements of the stock market.”

But he added, “…fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now..”

The plunge in share prices has been indiscriminate. Prices of shares in good, and bad, companies are cheap. Hunker down for tough times, do your homework, find companies you’re comfortable with and put your spare cash in the stock market. “Be fearful when others are greedy, and be greedy when others are fearful.”

It will be hard to maintain equanimity in the coming months. News flow will be more negative than positive. Tan Sri Ramon at the forum reminded us that economic cycles come and go. He's seen 6 in his lifetime. We will survive this; the good times will roll again, and I’m sure we’ll see another crisis after that.

Finally, on Sunday: Who's to blame?

The End of Wall Street's Boom

Here's an excerpt from an article on www.portfolio.com, by Michael Lewis, whose Liar's Poker was one of my inspirations:

When a Wall Street firm helped him get into a trade that seemed perfect in every way, he said to the salesman, “I appreciate this, but I just want to know one thing: How are you going to screw me?”

Heh heh heh, c’mon. We’d never do that, the trader started to say, but Moses was politely insistent: We both know that unadulterated good things like this trade don’t just happen between little hedge funds and big Wall Street firms. I’ll do it, but only after you explain to me how you are going to screw me. And the salesman explained how he was going to screw him. And Moses did the trade.

Read more.

A primer on subprime (2 of 5): Why governments had to bail out the banks

The virtuous cycle was trundling along. The economy was doing well (thanks to consumers spending on borrowed money), asset (house) prices kept increasing which meant default rates hit all-time lows as even the sub-prime borrowers were able to either flip their houses or service their loans at the low rates. The low default rates made financial institutions even more confident and they offered increasingly attractive loans to consumers.

At the peak, banks offered “No money down” mortgages and arrangements such as ARMs (Adjustable Rate Mortgages). ARMs allowed borrowers to pay very low interest rates for periods of two to three years. After that, market rates would be charged and principal repayments also started, but borrowers were convinced that by that time property prices would be higher. They would just sell their property, repay what was necessary and still reap a healthy profit.

Some alarm bells were raised. Some pundits suggested mortgages were increasingly being offered to people who couldn’t afford them. But regulators, lead by Alan Greenspan, said markets had found new ways of dealing with and pricing risks and there was no systemic problem (ie individual institutions that took on too much risk may go under, but the entire financial system was robust)

With hindsight, Greenspan was proven hugely wrong at enormous cost to the taxpayer. All good things must come to an end, eventually.

There are only so many people and so many potential housebuyers. After years of scraping the bottom-of-the barrel for the marginal borrower, to the point where lenders closed one eye as borrowers over-stated their incomes so they could go for bigger mortgages, there were no more new borrowers to be found. No new borrowers meant reduced demand for properties, which meant asset prices started to fall.

The house of cards started unravelling. Default rates on the CDOs turned out to be higher than expected. Even AAA-rated CDOs turned sour. Not surprising – considering the mortgages on which these CDOs were based were given to consumers with poor credit histories or to consumers who could not afford them.

Wait! Weren’t some CDOs backed by credit default swaps (CDS)? The CDSs turned out to be not worth the paper they were printed on. The institutions that were supposed to pay-up were woefully under-capitalised!

The problem was made even worse by the absence of open markets for these CDOs. These were traded over-the-counter with valuations based on complex mathematical models. But investors had lost faith in the assumptions going into the models so values could not be determined with certainty.

Also, it turned out that the banks were also liable for some of these CDOs. To entice investors to take the CDOs, the banks had agreed to buy back at least some of these if default rates turned out to be higher than expected. No-one expected the default rates to be that high, but when they hit that level, the banks had to buy back, incurring losses.

This lead to inter-bank credit markets freezing. Any bank, on any particular day, could be a net borrower in the inter-bank market. It is not bad management, it is just a matter of cash flow. For example, a company the bank had already approved a huge loan to draws down that day. The bank knows another borrower is due to repay tomorrow, but in the meantime, it has to borrow today to cover the gap. Tomorrow, when a loan is repaid, it may become a net lender in the inter-bank market.

But the inter-bank market froze. Banks became reluctant to lend to each other as they could not tell if the other bank would still exist tomorrow. Imagine if you were the bank lending to Bear Stearns or Lehman the day before they went under!

Initially the US Federal Reserve and the European Central Bank tried to restore the inter-bank market by making funds available for banks to borrow on more favourable terms and cutting interest rates. This did not help: 1) Banks were unwilling to take Federal funds because it would indicate weakness; and 2) cutting interest rates did not help because it did not address the core issue – banks were unwilling to lend to each other at any price.

The financial problem was turning into a real economy problem. Because banks could not tap the inter-bank market to cover short-term cash shortfalls, every bank wanted to be net cash. They started cutting back on loans to companies and individuals. In turn, companies and individuals would also want to hoard cash. The curtailing of credit facilities threatened the foundations of the economy – business activity would slow leading to job losses, bankruptcies and recession.

British Prime Minister Gordon Brown in the end got it right. Contrary to his long-held views, he extended government backing to the banks. This led to a flood of central banks around the world, including Malaysia, to guarantee deposits. With government guarantees, banks became willing to lend to each other again and credit markets were restored.

Next on Saturday: Brace for tough times

Open forum on global financial crisis and Malaysia

On Wednesday evening I participated in an open forum on The Global Financial Crisis and its Implications on Malaysia, organised at Universiti Malaya by the Centre of Public Policy Studies. The 5 member panel of Datuks, Drs and one Encik (me :-) had a very good 2 hour dialogue with members of the public, very ably moderated by Tan Sri Ramon Navaratnam. The Nut Graph was there …

A primer on subprime (1 of 5): On CDOs, SPVs and CDSs

I prepared this in anticipation of a forum that ultimately did not materialise. It’s not so topical now, but better late than never ….

The roots of our current crisis are in the US housing and consumer-credit boom. This was fuelled by the Wall Street innovation called CDOs – Collateralised Debt Obligations.

The amount that any financial institution can lend is constrained by the capital it has. Historically, banks kept the mortgages on their balance sheets – these are their assets on which they earn interest income. Against these mortgages, they had to keep a certain level of capital aside to insulate against defaults.

Then, Wall Street invented special purpose vehicles (SPVs) just to buy and pool thousands and thousands of mortgages together. These SPVs raised the money to buy the mortgages by issuing their own securities – the CDOs. Banks were happy to sell their mortgages to the SPVs because it freed up their capital to make new loans.

Basic financial/statistical theory is that it is hard or impossible to predict if any single mortgage will default. But if you have a pool of, say 10,000 separate mortgages, you can be reasonably sure that, say, 98% will be fine and 2% will default. So the SPVs issued CDOs with varying risk levels. If you had a senior CDO, you got paid before everyone else. Of course you also received a lower interest rate than another investor buying a junior CDO, which would suffer first if the default rates were higher than expected, but that interest rate was still more compelling than other alternatives.

Wall Street and the SPVs managed to convince the credit ratings agencies (like Moody’s and Standard and Poors) that the more senior of these CDOs deserved AAA credit-ratings, suggesting they were very safe for pension funds and insurance companies to invest in. And on top of that, a new market in credit derivatives (CDS – credit default swaps) allowed buyers of CDOs to purchase insurance against default.

Markets were working like a dream. Banks rushed to give as many mortgages as possible. Millions of poor Americans who were hitherto considered poor credit risks (sub-prime) became new homeowners, millions of existing homeowners got to upgrade and others were able to “unlock home equity” ie take a mortgage on the rising value of their houses to spend as they wished.

Banks’ profits went up from the mortgages they generated. They didn’t care about the risks because these mortgages would quickly be sold to SPVs. The SPVs had no problems selling the CDOs to investors. Investors were happy because they got higher interest rates on the CDOs, at apparently little incremental risk. Even the junior CDOs did well. Everyone was happy. Investors made high returns and financial institutions and CEOs reaped billions in profits and millions in bonuses.

Then the gears jammed ….

Next (on Wed): Why governments had to bail out the banks