We all know we have had a tough year in 2009. We are currently living in extremely challenging times. The developed countries experienced a rapid economic slowdown of epic proportions arising out of the financial crisis that swept the world late 2008. I would like to reflect on this, the resilience of our own financial sector and on what I believe the future holds. Emerging markets, notably India and China, have held up much better and I think we can all see that we are over the worst and that things are going to get better from now on.
Paul Volcker, the former chairman of the US Federal Reserve, said last year that “there had been leveraging in the US economy beyond imagination” and that it was too late to avoid a severe downturn even if the credit markets stabilized as they have done over the past year. He was referring, of course, to the credit excess that in the US pushed private sector debt to well over 300 percent of gross domestic product (GDP). It was thus inevitable that the asset and borrowing bubble would burst. The only question was when.
Financial crises are not new, although some would have us believe that this current one is certainly unprecedented. It is said that history repeats itself first as comedy and then as tragedy. If that is true, then it is certainly a tragedy that we are yet again going through a financial crisis that to a seasoned observer could have been to a large extent avoided.
The human side of economic recession with lost output, postponed investment and rising unemployment is testimony enough to the human aspect. In my career I have lived through certainly four economic recessions, and this one now makes five – all in the space of thirty years – that makes on average one recession every 5 to 6 years. No wonder economics is called the dismal science.
This one has been a bit different for a number of reasons that conspired to bite more or less at the same time: The American Dream: Borrowing was extended down the income scale in a coercive way in the United States with devastating effects as over extended sub-prime borrowers defaulted in huge numbers on their mortgage payments. The dream is not only American though: Britain, Spain, Scandinavia also had the same dream and over borrowed. Property prices escalated wildly in many countries feeding an excessive borrowing habit.
Securitization: This technique of selling mortgages as securities was developed in ways that regulators did not imagine and had no control over. Originating banks relinquished all responsibility for lending standards and simply went for volume throughput. Shadow banking (outside regulatory and capital requirements) became the new nirvana.
Interbank lending: This, as is well known, virtually dried up as banks lost confidence in the quality of each others’ balance sheets, and many banks were also forced to de-gear due to already low capital levels diminished further by huge write offs resulting in the need to lower total asset levels sharply. A very vicious circle, therefore. Excessive wholesale funding is, as one commentator described, akin to playing “Russian Roulette with 5 out of the 6 chambers of the pistol loaded with bullets”. If a bank cannot repay any borrowing on maturity, it is by definition insolvent. As I said, perhaps presciently two years ago, banks are inherently fragile creatures.
Leverage and Wholesale Funding: There is a world of difference between sensible leverage or gearing and being over-geared, and it applies to individual companies and governments. Gearing can be expressed as debt to equity or in terms of debt service capability. Either way it is a deliberate decision and it involves adopting more risk.
If asset values decrease (as they do) or interest rates rise (as they do) and cash flow declines (as it does), then gearing levels rise. What possessed investment banks to adopt gearing levels of 30 x capital, European commercial banks to be geared at 15 x capital with 140% wholesale funding, or individuals to take on 100% mortgages (or banks to grant them), we shall perhaps never know. The consequences have certainly been profound in terms of failures and government rescue packages.
Central Banks: In general they have responded well to the threat of economic recession with swift reductions in interest rates albeit in a few cases somewhat later than was needed – simply because of well founded fears about inflation. What is astonishing is how the asset and borrowing bubbles were allowed to build up without corrective action at an earlier stage. Alan Greenspan still does not acknowledge any responsibility for running too loose a monetary policy that accommodated the build-up to 300% private sector borrowing as a percentage of US GDP.
Economics is known as the dismal science mainly because of the difficulty in getting the timing of monetary and fiscal policy adjustments right so as to sustain rising living standards. In most countries economic policy changes are like steering an oil tanker – adjusting the tiller does not change the direction of the ship for quite some time.
The recent and continuing large reductions in interest rates and quantitative easing will certainly help cushion the effects of recession as will the fiscal rescue packages – but central banks will have to be prepared to move interest rates promptly back up to head off incipient inflation, albeit this is not on the agenda of most central banks currently.
The rating agencies are somewhat discredited
Ratings Agencies and Regulators: The roles and functions of these bodies will need careful examination in a number of countries. The rating agencies are somewhat discredited as a result of the huge losses being sustained by the financial system which thought it was investing in AA or AAA rated securities which have turned out to be anything but safe.
Following on from the WorldCom and Enron and then the Northern Rock, RBS, HBOS, Bear Stearns and Lehman’s failures – all of which were investment grade until the day they were rescued or went insolvent –, the rating agencies have a significant amount of repair work to engage in to restore their credibility.
To be continued
By Antony Withers
Chief Executive Officer, Mauritius Commercial Bank and President of the Mauritius Bankers Association.