As we approach the ten-year anniversary of the Global Financial Crisis (GFC), I thought I’d get in early with a few ruminations, before the experts who didn’t predict the crash write their moot editorials.
I keep reading about the GFC and the predictable question: will it happen again? Well, history has the answers. It was only 20 years prior to the GFC that the US faced the ‘Savings and Loans Crisis’ where the failure of bureaucratic ‘regulatory and enforcement agencies’ ended up costing $160 billion, predominantly funded by taxpayers. Even the learnings from the 2001 Enron scandal were quickly forgotten; where corporate fraud contributed to the company filing for an approx. $63 billion bankruptcy.
When you look back at our historical track record, you realise how heedless we hominids are, as we continue to allow the same fraudulent behaviour to reoccur. Perhaps the answer or reason WHY can best be explained with a closer examination of the judicial system and incarceration rates. There is no doubt that white-collar crime pays. The financial sector’s punishment for transgressions seems to be highly remunerated senior executive positions in government, where they get to set the future policy agenda and protect their ill-gotten wealth by recommending taxpayer-funded bailouts.
So, let’s look at what happened ten years ago and compare it to where we are at now, ask if anything has materially changed and wonder who will pay for the next round of bailouts.
The catalyst for the GFC started with the misguided concept that pretty much everyone should be able to afford a home, much like the present ‘Housing Affordability’ debate in Australia, about how to interfere in free markets to artificially influence affordability. The consequences were higher prices, with exuberant growth generated in the housing sector creating a false and inefficient market which inevitably collapsed with a subsequent correction (as free markets do).
The so-called crisis in the subprime mortgage market in the US was fuelled by readily available and cheap credit, honeymoon deals and high-risk loans where financiers massively misrepresented applicants’ capacity to repay loans. Again, a regime existed where there was a complete lack of regulatory compliance and enforcement, allowing Financial Institutions and Banks to lend unabated, fuelled by commissioned staff who were immorally motivated by their employers; employers who set the wrong Key Performance Indicators (KPIs), the wrong remuneration models and therefore unsurprisingly, we saw the wrong behaviour.
Meanwhile, the Financial Institutions and Banks were generating obscene profits as they actively promoted high-risk lending, but without having to carry the associated risk. They simply shifted the risk to the mortgage insurance companies, who covered the banks against loss in the event of default. The rot set in when the insurers collapsed, with a central insurance player in the US eventually requiring a taxpayer-funded bailout, reportedly around $180 billion.
Financial Institutions and Banks had to find creative ways to get these junk loans off their books before they defaulted. Their solution was to bundle and package up these rubbish mortgages and sell them off as defensive or low-risk income investments i.e. monthly income mortgage funds (backed by property, what could go wrong?)! The target market was conservative investors and retirement/pension funds, looking for a regular monthly income stream.
The question is: how do you convince conservative investors to buy junk mortgages i.e. how do you ‘window dress’ high-risk mortgages as low-risk income investments? This deception could only be perpetrated with the assistance of a complicit rating agencies industry, who sell the desired credit ratings for the right price and that’s exactly what the rating agencies did. They rated ‘junk’ as ‘investment grade’ effectively giving licenses to Financial Institutions and Banks to credibly disguise and sell rubbish investments in the open market.
They knowingly ripped off consumers, because they knew these instruments would fail when the underlying loans inevitably defaulted. This was an orchestrated fraud and collusion on a scale never seen before! If the rating agencies’ actions were not fraudulent, then they were certainly complicit, yet somehow they managed to deflect responsibility and have never been held to account. Keep in mind that these agencies are responsible for rating the sovereign risk of our country! Why has their behaviour gone unchecked and how do they get away with it? Why is there still no meaningful regulation around rating agencies?
These rating agencies continue to control and influence the investment and advisory industries and, as a direct consequence, investor behaviour. How can they possibly be trusted when investment fund managers are still buying favourable ratings for a negotiated price? As a consequence, investors are still losing money on underperforming investments, while the money managers and credit rating agencies never lose. The credit rating system is corrupt and totally ineffective as a management or due diligence tool for consumers to gauge the worthiness or suitability of any given investment.
The next level of greed and deception perpetrated by the Financial Institutions and Banks was to orchestrate additional profits from the junk mortgages they sold to retail & wholesale investors. How? Manufactured products! A number of these Financial Institutions and Banks were so confident that the bundled junk investments they sold would be worthless, that they took out insurance on them failing (derivative positions) and then collected when they imploded.
So when the loans defaulted, they collected twofold, once when they sold the junk product and later when it failed (by trading their derivative position). Talk about benefiting from the misery of others when you can make twice the money from ‘engineering failure’ than you can from honest trading and all at the expense of the consumers who believe that their governments have the right governance, compliance and enforcement controls in place to protect them. We poor misguided citizens!
This is what happens when our trusted Financial Institutions and Banks are left unchecked as government regulators fail to enforce the law. What is the value of paying thousands of ineffective bureaucrats for not holding the Financial Institutions and Banks executives to account, perhaps because most of these executives are now bureaucrats themselves? What a great system: governments act as enablers for institutional theft and then use our taxes to fund the corporate bailouts. How do we keep losing the same dollar twice? We need to improve regulation but more importantly, we need government to start enforcing the current laws. (See Why Are Government Regulators Not Working?)
How is it that a corporation can go bust after losing our money and then expect taxpayers to bail them out because they were ‘too big to fail’? If a corporation is ‘too big to fail’ then governments should legislate to unwind conglomerates and reverse the ‘bigger is better’ trend, because it is not!
I believe change is urgently needed if we are to minimise the risk of future financial losses at the hands of institutions. Start, as I have emphasised above, by dealing with credit rating agencies. It’s a flawed model and there needs to be a mechanism in place to hold them accountable for their performance i.e. some transparency around the accuracy and value of research, rather than just being allowed to sell a rating without recourse.
Favourable credit ratings give Financial Institutions and Banks, fund managers and stockbrokers a licence to print money, even when the underlying investment fund, equity or product, fails to meet the performance expectations as set out in the rating agencies initial report. All these ill-gotten profits are funded from money lost by investors who were given misleading or inaccurate information right from the start.
Secondly, there needs to be a closer look at how Financial Institutions and Banks use mortgage insurance companies. Basically every loan approved conditional to mortgage insurance means that the Financial Institutions and Banks recognise that the risk is too high to carry on their balance sheet. So the Financial Institutions and Banks subrogate control and responsibility of the ‘loan default’ process to the insurance company. That leaves the borrower without any capacity to negotiate with their financiers, who are now beholden to the insurance companies.
Unlike banks, insurance companies do not have the same legislated capital reserves, so what are the potential risks in the event of rising defaults? What is the cost of making housing more affordable in the short-term when there is no long-term contingency plan when interest rates and unemployment rise? History tells us that if the housing sector is artificially stimulated, then you can expect with a high-degree of certainty that a correction is a foregone conclusion. It’s just a question of whether you’ll be one of the many little people who end up bailing out the big end of town so they can maintain their hedonistic and privileged lifestyles.
I keep hearing that banks are bastards; well wait until you have to deal with insurance companies if your loan defaults! What is the point of taxpayers funding government bureaucrats for governance, compliance and enforcement controls, when they are plainly not doing their job to prosecute the laws that were meant to protect consumers, not Bankers? Finally, if a corporation is ‘too big to fail’, then start legislating to enforce demergers.
23 April 2017
“I sincerely believe… that banking establishments are more dangerous than standing armies”. Thomas Jefferson