BANKS: THE PILLARS OF SOCIETAL FINANCIAL SECURITY
July 12 - 18, 2010
Sub-prime mortgage is the key word in all discussions on the 2008 spectacular fall of the economic and financial systems based on the free market concept. The root cause of the financial collapse, sub-prime mortgage, seems to have labeled mortgage business with an indelible stigma. The late 80s' failure of S&L (Savings and Loans) business-that was run successfully for a number of years-reinforces the view that there is something basically wrong with the housing business. This, of course, is not a pragmatic view as no genuine business per se can be held responsible for the failures of those who run it and the system under which that business operates.
The idea of owning a house (by each and every family of a country) is certainly not wrong. It is the structure and implementation of the scheme and the role of the parties involved that comes under the scanner when things go seriously wrong. The basic parties to the scheme were US citizens, house builders, mortgage originators, and banks. The builders overacted by producing excessively high number of homes for which there was no matching number of genuine buyers. The act of builders was guided by the profit maximisation motive as well as the absence of proper regulatory mechanism - the two basic ingredients of free market economy.
The citizen-mortgagors overacted by blindly signing the mortgage agreements they were not financially capable of honoring. Not that all of them did not qualify for such deals; a good number of them were genuine mortgagors with adequate flow of income to satisfy the mortgage. The prospective defaulters were knowingly drawn into the deals as the loop holes in the regulatory framework encouraged the unscrupulous set of mortgage originators. A horde of spurious mortgage originators was allowed to operate with minimum restrictions and literally no initial investment. They would simply occupy a rented office, arrange a deal between the home-desirers and the home builders and then pass on the deal to the banks within a week time. The banks would pay the mortgage originators who, after retaining their fee, pass on the payment to the home builders. Now, it is between the banks and the citizen-mortgagors. Home builders and mortgage originators, after receiving their respective shares of the booty are no more in the picture.
The crisis developed when the mortgagee banks, having become conscious of over-exposure, started to look for safe exits. It was at this point when the Wall Street engineers and technicians (so-called financial experts), brokerage houses and law firms saw an opportunity to earn high fees and remunerations.
In collaboration with each other, they designed highly complex and intricate financial documents to cater to the 'securitisation' need of the mortgagee banks.
The rating agencies awarded AAA status to these dubious documents. These documents known as financial derivatives represented debt transfer papers that required a high degree of financial acumen to bring them into the realm of comprehension. Even the financial experts sitting in the state-of-the-art offices of insurance companies, brokerage firms, hedge funds, pension funds fell for the attractive covenants and bought into the sinister scheme by investing huge public money in the hope of earning attractive returns. The intermediation fees, commissions, and charges added to the original cost of mortgages making the payback difficult for the mortgagors. The regulators failed to timely check the explosive development as they were trained for decades under the free market regime to offer as little a regulatory resistance as possible. The auditors seemed dazzled by the new dynamics of the financial world and chose to remain unobtrusive.
The Fed had seen at its helm a real protagonist of free market economy-Alan Greenspan-for almost two decades. His successor Ben Bernanke perhaps caught between the conflicting ideologies of two frontline economists: Lord Keynes and Milton Friedman who had a deep influence on the US economy also failed to erect a mechanism to stop the imminent freefall.
After going through the entire episode, it is not difficult to single out banks as the main culprits. If the mortgage rules were honestly followed, a great number of substandard borrowers could have been easily denied access to the unmanageable mortgage deals. This measure would have discouraged the builders to go for excessive production of houses. In the face of genuine mortgages, there was no need for the banks to go for securitisation for risk dispersion purposes. Fixing the blame on banks does not necessarily absolve others, particularly the US central bank which was responsible to oversee the banking sector operations.
There are many who believe that the global financial crisis could not have taken place had Paul Volcker been in the place of Alan Greenspan as Fed chairperson. The latter being a great proponent of market capitalism deliberately created excessive liquidity in the market by cutting on interest rates. The low interest rates offer little maneuvering space to the banks, which helplessly see their margins shrink. The free market economy has created a new breed of CEOs who most of the times are found busy in devising ways and means to maximise corporate profits to be eligible for hefty bonuses. The gap between the earnings of corporate CEOs and common corporate employees has hugely widened during the market capitalism era; in some cases this gap has been as wide as 1 to 534. The bank CEOs' endeavor to maximise bank profits in low-interest-rate regime prompted them to chart some new territories, irrespective of the risks to the bank and to the economy. The investors, for their part, also failed to judge the market and consequently indulged in wrong risk pricing that is more risks were taken for a fractionally higher return. In a post analysis, Alan Greenspan admitted this, but failed to take corrective measures when he was still in the Fed hot seat, and the economic bubble had all the signs of an imminent burst.
It was the perceived strength of US banking system and faith in the mighty dollar that attracted global economies with mountains of reserve dollars to the spurious market of US financial derivatives. The only satisfying aspect of this business for these economies was the dollar-denomination. They hardly tried to test these securities, real or synthetic, n the internationally accepted standards of financial soundness. When these economies lost hundreds of billions of dollars, they in fact lost confidence in the decades-old strong banking system of the United States.
The Nobel Prize winner for Economics, Joseph Stiglitz summarizes in his book Freefall the role of banks in generating the global financial crisis in the following words:
"It was this involvement in mortgage securitisation that proved lethal. In the Middle Ages, alchemists attempted to transform base metals into gold. Modern alchemy entailed the transformation of risky sub-prime mortgages into AAA-rated products safe enough to be held by pension funds. And, the rating agencies blessed what the banks had done. Finally, the banks got directly involved in gambling-including not just acting for intermediaries for the risky assets that they were creating but also actually holding the assets. They, and their regulators, might have thought that they had passed the unsavory risks they had created on to others, but when the day of reckoning came-when the markets collapsed-it turned out that they too were caught off guard."
Banks are supposed to be the pillars of societal financial security. They are the custodians of the hard-earned public money. They should not commit this money to the high-risk financial adventures just to achieve personal goals of higher profits for the sake of higher bonuses and lavish perks. Their misadventures have resulted in huge costs to the global society and the world economy.