E.B. Kasozi
15 September 2009
column
The unimaginable barely three years ago has come to pass. The large and mighty, show pieces of capitalism and an increasingly global economy have been brought to their knees and reduced to beggars before the taxpayer. Pensioners have lost lifetime savings while families have relocated into smaller houses as the white-collar recession bites. Banks, which assumed massive risk pre-crisis, became excessively risk averse and withheld credit to the real sector, creating a credit crunch and a recession that followed.
"Products that were developed to spread risk have instead spread contagion," lamented Gordon Brown, the UK Prime Minister during his address to the US congress on 3rd March 2009, referring to derivatives. The question is, why didn't somebody see this coming? Why did it get to this?
When historians finally put pen to paper, there will be as many causes pointed out, as there will be writers. Some analysts have narrowed the caused to sleepy regulators, gullible investors and greedy banks. Others have attributed the crisis to unsustainable imbalances, which were allowed currency for a long time. The households were over borrowed, the corporate equally over borrowed and the US run huge budget and current account deficits known as twin deficits. Other countries, particularly in Asia, run huge balance of payments surpluses, accumulated massive reserves and invested heavily in securities issued by governments that run huge fiscal deficits and mortgage securities that promised high levels of returns. The subprime loans defaults, to many the cause of the crisis, may well have been the last straw which broke the camel's back, the spark which ignited the fire. The reality is that the crisis was caused by multiple failures. We will examine one by one.
Failure of a fundamental governance principle:
Separation of ownership and management is one of the pillars of corporate governance. However, over the last ten years or so, this pillar has been shaken to its foundation and found amazingly wanting. We have witness's unimaginable management failure, precipitated by competitive pressures and sheer greed.
For ages, it was taken for granted that management would always put the company's survival at the forefront. Management could be trusted with ensuring that the company was not at risk and that company failure was an insignificant risk. However, in a situation where management is driven by short-term individual or personal gains, it is logical to run the company as hard as possible with heightened probability of wrecking it as long as this serves the personal interest well. No wonder that in the case of the American insurance company AIG, bonuses were paid out even when the company was kept afloat by taxpayer's money, much to the chagrin of the Obama administration and the American public. Further, managers participated in the upside, i.e., when the company made profits, but left the shareholders to pick the bill when the company performed badly. This asymmetric management interest is likely to remain a point of contention, with logic dictating equal management share in the profits and losses of the company, never mind the difficulty of operationalising the dictates of logic.
Whether shareholders, as owners of a company, can effectively control managers as agents is also questionable. Strong regulation and audit may help, but the crisis has shown that management run companies for individual gains, demanding hefty compensation packages including golden parachutes when the very existence of the companies was under threat. Carports retort that limits on executive compensation constrain the hiring quality talent. This is one reason that banks which benefited from the stimulus package money known as TARP have advanced for paying the money back so they can operate free of such constraints. The point is that shareholders' interests took back seats and management personal interest took precedence.
Failure of risk management
Managing risks is part of everyday life and certainly part of managing a business entity. It is the ability to manage risks that translates a good business proposal into a successful one. In agriculture for example, there is always the risk that the rains may fail or that the coffee wilts disease attacks the coffee trees and the farmer fails to realise the expected output.
Banking is no exception. There is always the risk that a borrower fails to pay back the funds borrowed, or fails to pay in time. Although better known, particularly in Uganda, for lending activities, banks carry out many other activities, including trading in currency markets and investing in financial assets such as bonds. They also invest or trade in assets whose prices depend on prices of other assets. These are known as derivatives, because they are priced off other assets.
Naturally, banks want to know how much risk they are taking. In order to answer the question of how much risk, risk management, particularly in banks and the more sophisticated of the financial corporates, has become increasingly quantitative and specifically statistical. As complexity of operations grew, banks figured out a way of measuring risk associated with the complex assets held or traded. They reckoned that the real world was too complex to analyse. They therefore simplified the real world by identifying a few of the factors that determine e.g., the exchange rate, assume the others away (or assert that they are insignificant or would not move ) and put the few factors together in order to forecast future exchange rate, stock or interest rate direction. These techniques are known as models and are widely used in finance, economics and social sciences in general. Models are an attempt to simplify reality. Unfortunately, the reality is never simple. The variable that is assumed away may matter more than the variable that is kept in the model. Secondly, the assumptions are not always right. During the current crisis, models were found to assume that house prices would continue rising!! No body imagined a falling house prices situation because it was out of the ordinary!!
One such model or technique, widely used by banks is value at risk (VaR). This model purportedly tells management how much an institution could lose, in a day, week or month, on the investments made. It goes further to give the likelihood of loosing that amount of money and a confidence level number.
The appeal of this approach is the ability to reduce risk to a number in money terms that a bank could lose in a given period. It is indeed a very powerful tool. A bank may adjust this figure by taking less risky bets or, in non-markets language, make less risky investments.
VaR has gained wide acceptance. Initially sold by J.P. Morgan as a proprietary product, it was span off and sold under the name Riskmetrics. VaR grewn to levels where it became the mainstay of risk measurement and management in banks. Unfortunately, VaR does not handle credit risk very well and does not handle situation of market breakdown where fair market values no longer exist. It is also backward looking drawing from past experience to tell the future. The reality is that history does not always repeat itself!
The failure of risk management has been deeply humiliating to major finance houses. Some finance houses had VaR numbers that were far lower than what they lost during the crisis. For example, Q4 2007, Merryl Lynch's VaR at 99% confidence level was $69mn. They announced a $10bn write down or loss when the crisis broke. When the dust finally settles, risk management technology will certainly undergo major changes. Model prescriptions will certainly be read or viewed with a pinch of salt.
Failure of Regulation and Supervision
One of the major failures in the area of regulation and supervision was to allow co existence of the regulated and the unregulated. On one hand were banks, subjected to stringent conditions to ensure that they remained strong, solvent, and liquid with deposit insurance and a high level of transparency standards. All these were imposed on the banks to ensure that confidence in the banking system was sustained. These stringent conditions, however well intentioned, came with costs and restrictions which banks sought to circumvent. The regulated therefore set up special purpose vehicles or PSVs which operated like banks but were not burdened by costs which come with regulation and supervision. The insurance sector was no exception. In the case of the American insurance company AIG, the Financial Services Products SPV was a good example. The vehicle engaged in activities that main stream AIG could not engage in including exposure to the subprime mortgage sector. It is the financial services products that finally brought AIG to its knees.
The point is that the segregation between the regulated and the unregulated created disparities in the cost structures amongst institutions, which favoured the unregulated against the regulated, at least, in the short run. The problem is that the unregulated interact with and therefore affect the regulated and the entire financial system. In addition finance houses which set up special purpose vehicles quickly realised that the SPVs were not off balance sheet after all when the crisis set in.
A second area of regulatory failure was with respect to regulation and supervision of institutions with international reach. Financial institutions are increasingly international with operations in the home countries and other countries. In spite of the international character of institutions, regulation remained national, carried out by regulatory and supervisory authorities, which did not have the full picture of the entity as whole. In the case of Iceland, the banks expanded to a level well above the capacity of the Iceland authorities to support them.
There are certainly other areas of regulatory failure. If CEO of a major finance company, sensed danger and chose to underweight a sector or a market when others remained and returned hefty profits compared to his, he probably would loose his job. Extended downwards to a dealer, if he or she sensed the impending dangers and sold the assets off, this would hurt company profits and there would be no bonus for the individual. Besides, the extent to which an individual dealer could withdrawal from a market or a particular category of investments was limited, since overall strategies such as asset allocation are typically determined at a high level, leaving him with limited room to dump assets that finally turned toxic. These are the excesses the regulator and supervisor are supposed to moderate! The individuals and corporates are driven by greed and fear and are not able to place due consideration on overall sector health. The issue of blind faith in markets, that markets constitute the collective wisdom of a myriads of participants, who take into account all available information and are therefore better informed than the individuals and the regulators. After all, those who make the wrong choices are punished while those who make the correct choices are rewarded. In addition, there was the belief that what was good for wall street was necessarily good for main street, good for the ordinary people. The arguments for stronger regulation, particularly in the US, were pushed aside in favour of greater market freedom. This mindset influenced regulation and supervision giving reign to soft supervision. More specifically, why didn't someone look into the quality of loans that were packaged onto bonds and presented to the market as highly rated? Why didn't somebody question the excessive level of borrowing at the household, the government and national levels? In the US, why was it possible for Mr Benard Madof to dupe investors with the promise of phenomenal returns for twenty years, when the relationship between risk and return is a fundamental principle in finance? In 1992, a clean report of Madof's operations was issued when his funds under management totalled $400mn. At the time his scheme collapsed, the fund stood at a whooping $65bn! Whistle blowers were simply ignored. Apparently, in this whole debacle, no body wanted to spoil the party!
Failure of the origination and distribute arrangement (model)
This is how the system worked. Sub prime loans, meaning less than prime and therefore poor quality were extended, the claims or assets so created packaged into bonds or securities, rated and sold to investors. Those who created the loans had no interest in whether the loans performed or that they were sustainable. Determination of whether the borrower would be able to service the loans was not the focus of attention. There have since been press reports of fraud, where cashflows or incomes were grossly exaggerated with borrowers ending up with loan that they could hardly service. One creative originator in the US even used churches as the channel to push the loans, with congregations praising the Lord for the blessing. Further, the structures were so complex that investors could not see through to the underlying loans. Investors simply based their decisions on credit ratings and did not fully understand the asset they were acquiring nor the magnitude of risk they were assuming. There was an obvious disconnect between the risk investors assumed and the reward for the risk assumed. This fundamental flaw was allowed to prevail, with the benefit of hindsight, for an unbelievably long time.
Failure of rating agencies.
Rating agencies provide independent credit opinions on borrowers and issuers. Typically, ratings provide the lender or investors with information on the possibility or likelihood that the borrower or issuer may be unable or unwilling to service or retire debt. The principle point against credit rating agencies or CRA's is that they, as independent providers of credit information on institutions and financial systems did not recognise and failed to raise red flags about the enormous imbalances and potentially harmful practices that existed in financial institutions. Investors were not warned.
Secondly, instead of simply rating issues, they were deeply involved in packaging loans into securities to suite certain ratings. Further that the credit rating model as exists today is fundamentally flawed. Credit rating agencies issue credit opinions to markets for use by investors.
However because of the tremendous growth in information technology and information flow, they could not restrict access of ratings and collect fees from consumers of rating information. Ratings are freely available to market participants and are increasingly a public good. The rating agencies figured out a smart way around the problem. They turned to issuers who they charge for rating opinions. This approach may have weakened the CRAs and prevented them from performing such an important role for markets to the expected or desirable level. Given the importance of rating information, and the role rating agencies play, alternative arrangements ought to be explored. For example, rating services may be paid for by agencies like the IMF and information made available to investors, with the cost recovered from market participants through points like the exchanges and brokerages.
Asset Valuation and Accounting Standards
Financial assets have a value at the time they are bought, based on the price paid to acquire them. In order to measure, manage risk and write books of accounts, assets are valued even if the holder has no intention to sell them for as long as they are held. There are essentially three valuations; the intrinsic value or IV which is estimated using valuation techniques or models, the fair market value or FMV which is the value at which a security may be bought or sold in the market by a willing buyer or seller under normal market conditions and the Fire Sale Value or FSV which is the value at which a distressed seller may sell a security. Under normal market conditions, the difference between these valuations is negligible. Distressed sellers are accorded the benefit of selling their securities at going market prices. However, under market stressed conditions, a big difference between these valuations appears. Willing buyers and willing sellers conditions no longer obtain, market prices collapse towards zero and there is a big divergence between Fire Sale Value and intrinsic value.
At the same time, accounting standards and risk management models require that assets be valued at going market prices. Marking-to-market, as this is commonly known, requires that the assets be stated in the books of accounts at market prices. The requirement is that a fall in value be followed by write-downs in the banks balance sheet and the losses posted to the profit and loss account, an account which shows the profit or loss performance of a company. Losses are deducted or charged to the capital of a company. Under crisis situations, huge drops in value results into capital erosions to cover the losses incurred on the assets. This is the situation in which banks that were found exposed to assets backed by sub-prime loans found themselves as the assets, which came to be known as toxic assets, fell in value. There are suggestions to change accounting standards in order to deal with situations of market collapse. Clearly, this requirement exacerbated the crisis as banks wrote down assets to the extent of eroding their capital. This affected all major finance houses depending on the extent of their exposure to toxic assets and the mortgage market in general. However, it is well known in markets that whatever comes down normally up and whatever goes up eventually comes down. That accounting has remained oblivious to this fundamental fact is a question for the accounting profession to answer. Risk management, which employ market prices in their models will also have to agree methods of dealing with market collapse situations.
Obviously, other reasons for the crisis may surface as the crisis unfolds. One question is striking, where was the body of knowledge and enormous capacity developed in the area of financial stability when mayhem threatened to break? Can humankind tell the future in financial markets and economics in general even in this era of the highly touted sophisticated models? All said and done, soul searching will be the order of the day over the next two, three years. Where do we go from here? There will certainly be changes in the regulatory regime, institutions such as IMF will focus more on financial stability, there will be country-specific initiatives in financial stability, co-ordination among regulatory agencies to mention but a few.
Prof Simon Johnson of Sloan School of Management, Havard University summed up the key elements of the crisis eloquently. There was "large inflows of foreign capital, torrid credit growth, excessive leverage, an asset price bubble, asset price collapse and financial catastrophe." Frankly, it is a tall order to add to such eloquence.
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