Sunday, September 26, 2010

Another worse GFC is coming

Without a Nobel Prize in Economics, or even a degree in it, how can I make this assertion:
There will be another GFC, and it will be worse than 2007, and make it confidently?

Because we didn't see the last one coming nor did the controls to prevent such disasters, work.

The 2007 GFC was initiated by the inevitable, predictable collapse of the US "sub-prime" mortgage market. ["sub-prime" is disingenuous double-speak for 'very risky' or 'junk'. People buying houses with this money couldn't afford to pay it back, the lenders knew it and still loaned them money and resold the debt as quickly as they could, collecting a tidy profit along the way.]

We saw this before at the end of the 1980's with the rise and collapse of "Junk Bonds".

Why weren't "sub-prime" mortgages a problem, or even a market, before 2000?
Because of the economic slow-down when the "Dot Boom" turned to the "Dot Bust", the US reacted to prevent a recession.

The US Federal Reserve, with the backing of the US Government and Central Banks around the world, dropped interest rates to near zero on US Government Bonds, the benchmark "risk-free" investment. That created the conditions for the next "market bubble".

There are two points in there that need to be unpacked from that:
  • "Zero" interest rates are not numerically "0.0", they take inflation into account.
    If inflation is at 3% and you're getting 3% interest, your wealth increases by NIL over the course of a year. You can buy exactly the same number of burgers or cars at the start and end of the year.
  • Economic Theory for judging the proper return from investments is based on the Risk/Reward principle.  Higher Risk translates into higher Reward (or interest rates).
    But compared to what? The equations that describe the valuation of financial "instruments" assume a baseline or benchmark: the "risk-free" rate that everything else is compared to.
    Which is the Government Bond rate. If the Government can't pay interest when due or redeem its bonds, you have bigger problems.
How did a reasonable and well-proven response to an economic slow-down convert into a massive "Market Bubble"? The usual suspects of "Fear and Greed", the same drivers of the 1980's Junk Bond bubble and all before it.

With "safe" investments offering no returns, investors looked for other avenues to get good returns: this was the environment which created a bubble in just 10 years.

There were/are a number of special conditions in the USA that created this particular scheme. Be clear: the same investors and the same money would've chased any of the other myriad schemes possible.

The peculiarities of the markets in the USA:
  • Mortgagees can walk away from their debt with impunity. Banks, not borrowers, bear the risk of default (the norm in the rest of the world).
  • Mortgage Debt wasn't held by banks, but resold to one of two "Government Sponsored Enterprises" (Freddie Mac and Fannie Mae) at a small discount, allowing the banks to relend the same money over-and-over again.
  • The two Federal Mortgage consolidators resold their debt into the larger US and global markets.
There were two inventions that allowed the explosion of this "commercial paper" to be sold by the Investment Banks:
  • CDO's, "Collaterized Debt Obligations". Individual mortgages were bundled together (aggregated) and sold together as a single lot.
  • CDS's, "Credit Default Swaps". These are a form of commercial insurance. They were used to convert the highly risky CDO's into "AAA" (risk-free) debt.
  • Investment Banks are not regulated like normal "Deposit Taking Institutions": Retail Banks.
    They can sell what they like because they deal with "Sophisticated Investors" who fully understand the risks they are taking and the deals they are entering into.
Which brings in another critical player: the Investment (or Credit) Rating Agencies.
Standard and Poor and Moody's are two of the largest global players.

Credit Rating Agencies are thought to be impartial and expert assessors that investors can rely upon.
As events transpired, all those "AAA" rated high-yield bonds were both too good to be true and entirely wrongly assessed.
And that the notional risk implied by the high returns were massively understated.

How could a catastrophic mistake on a massive scale and as-wrong-as-it-gets be made?
This was a systemic fault - it applied everywhere to all the Rating Agencies.

As in Why could that happen at all, and Why did it not get noticed by oversight bodies?

The simple answer is that the Ratings Agencies didn't understand the real risks: they were incompetent in their work (or more politely, unaware of the full implications), were deluded or duped, knew and didn't properly inform investors, or were complicit or negligent.

The central conflict is the Rating Agencies are paid by the Seller, not Buyer. They could only make money by assessing instruments as "very low risk", very wrongly as it turns out, and they did.

One of the contributing factors in all this, globally as well, is that individuals responsible for each part of this process bear no consequences for losses, but do gain from all sales and often share in the profits.

This asymmetry, there is no personal downside for actors in Finance and Investment, is a monumental systemic flaw that will only lead to more problems.

If you think this isn't so or doesn't matter, ask this question:
 Did any of the people who personally benefited from the bubble have to pay back their profits or make any reparations?

In most other areas of Commercial Law, fraudulent or suspect transactions can be "unwound" or reversed. At least for the last 7 years.
  • Would the impact of the GFC have been nearly as bad if 7 years of faulty transactions have been reversed? [No]
  • Could Governments and Financial Regulators around the world have done that? [Yes]
  • Would recovery have been complete? [Not nearly]
  • Would more people have been personally affected? [probably]
  • Would those involved in Finance/Investment now be more cautious? [Yes]
One of the major weapons now against selling drugs is the seizure of assets and "proceeds of crime".
Losing your improperly acquired wealth is a far more potent penalty than even jail-time.

But obviously Governments don't hold this view for "white collar" crime, preferring to spread the pain to the innocent and less wealthy.

So what's my thesis?
  • None of the responsible professions foresaw the 2007 GFC, nor acted to warn Governments, Investors or the Public.
  • Not Accountants, Economists, Auditors, Valuers, Investment Advisors, ....
  • The existing Regulatory Framework was wholly inadequate.
  • The oversight bodies and control mechanisms failed completely - they didn't warn of the building problem and failed to prevent the collapse.
  • The Guilty kept their ill-gotten gains, the rest of us paid through failed banks and Government bailouts - and will pay for decades to come.
  • Those responsible for outright fraud and deception have not been brought to book.
    Those who's inaction, negligence, incompetence or indolence created the economic maelstrom have been allowed to escape unnoticed and without consequence.
  • Systemic problems of inherent conflict of interest and lack of personal consequences remain unchanged.
As a global community,
we don't know precisely what elements, apart from greed, led to the GFC,
nor what changed to trigger it.

Without knowing the causes, we are helpless to prevent more recurrences.
There have to be more financial meltdowns simply because we don't know why the 2007 GFC happened.

In the Military, generals are always fighting the last war.
In Government and Economics, they are always fighting the last crisis.

From the New York Review of Books:
Partly this was because the most serious economic crises are centered in the banking and financial system, the basic source of credit, and none of those that occurred during this period involved the banking system in a major way.
The list of crises that were contained is long and impressive,
including the stock market crash of 1987,
the junk bond collapse of 1989–1990,
the Asian crisis of 1997,
the Russian default in 1998,
the failure of Long Term Capital Management—a large and hugely leveraged hedge fund—later that year, and
the collapse of technology stocks in 2000–2001.
 Quick and effective responses to these and other dangers by Greenspan’s Fed appear to have induced banks and investors to rely unduly on its ability to stave off collapses that threaten the system, and to ignore the serious malfunctioning of the financial markets.
These same successes may have led Greenspan himself to believe that he actually was, in the words of the Financial Times, the “guardian angel of the financial markets.”
The general pattern of those years was similar to earlier extended periods of growth and great optimism.