Who will Rescue Finance?: The Role of the Academics, Bankers, Politicians, Regulators
216
Who will Rescue Finance?: The Role of the Academics, Bankers, Politicians, Regulators
216eBook
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Product Details
| ISBN-13: | 9788885486829 |
|---|---|
| Publisher: | EGEA Spa - Bocconi University Press |
| Publication date: | 01/10/2019 |
| Sold by: | Barnes & Noble |
| Format: | eBook |
| Pages: | 216 |
| File size: | 1 MB |
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CHAPTER 1
The Origin of the Crisis in the U.S.
Let's start with an episode already discussed beyond measure. While visiting the prestigious London School of Economics, in November 2008 the Queen of England posed a direct question to the English academic world: "Why did nobody notice it?" The sentence appears innocent for its candour and leniency, almost harmless. Yet it is not innocent at all; the Queen was not referring to a pickpocket on the street, but to the deepest financial crisis since that of 1929, which we can now say, will definitely mark the history of this young century.
Orthodox economists replied with a piqued defence claiming that one of the implications of Financial Market Theory is precisely the unpredictability of markets, and thus the impossibility of predicting the outbreak of a crisis. Markets are "efficient" because they are unpredictable.
The argument goes more or less as follows: the market is populated by rational people who are interested in taking advantage of every investment opportunity that allows them to make money. If there were a way to predict the trend of financial markets (with good reliability), and the outbreak of a crisis, a person could make money by exploiting this possibility. His trades in the market on the basis of the information would change the price of the securities, thus cancelling this potential advantage, at least in part. As a matter of fact, if a person were convinced a stock is overvalued, then he would sell it in a massive way (even short if he is allowed to) contributing to reducing its price and thus dampening a possible bubble.
Markets are said to be characterized by internal rebalancing forces, a feature that has led many observers to attribute them an anthropomorphic nature, claiming that they are "rational". Since any piece of information about the future value of a security will be used by rational people to get rich, prices will tend to move as a result of market trades in the direction indicated by the information, dampening a possible (upward or downward) trend. Market prices incorporate the information available in the market, and this makes future prices unpredictable, or "efficient" according to the theory of finance. It is not a coincidence that in finance one refers to a "random walk" in order to describe the dynamics of the price of a security. This theory is confirmed by the empirical evidence showing that it is very difficult to build a profitable investment strategy based on information available on the market. It is said that it is very difficult to "beat" the market.
In assuming this position, economists have shown that they have not grasped the Queen's challenge, and the risk is that with this approach, they certify their own irrelevance. Faced with an unprecedented crisis, it cannot be said that the failure to predict the crisis confirms a theory whose main message is the unpredictability of markets and crises. If this were the case, then the question would become: what is the relevance of financial theory? As a matter of fact, the relevance of a theory is assessed by its ability to predict and govern phenomena. A defensive position like the one described above induces people to laugh in front of the innocence of the Queen's question.
Claiming that the failure to foresee the financial crisis confirms a theory according to which it is impossible to predict the future is fully legitimate, but it could also be the case that a crisis represents a considerable breakdown of the pillars on which the theory itself is based. Even the magnitude makes a difference: daily market movements are mostly smooth, while a financial crisis implies a larger movement. While the failure to predict a small, day-by-day variation can be consistent with the efficient markets theory, it is more difficult to agree with this position in the case of a significant and repeated downward market movement.
Some economists have counterattacked by arguing that financial bubbles cannot be identified, that crises cannot be predicted, and that ultimately a crisis is a rare event which entails positive implications, fuelling the Schumpeterian process of creative destruction. According to this interpretation, all in all, crises involve a very limited cost compared to the advantages that the development of the market economy brings with it, and therefore the approach was that it was better to deal with the aftermath of bubbles in stock markets and housing markets than to try to prevent them. It is very difficult to fully assess this claim. A welfare-based analysis of financial crises for the economy as a whole is far from being feasible. The risk is that this thesis can be encapsulated in the tautological consideration that the market economy (as well as democracy) is the best of all possible worlds. This position may contain some elements of truth, but that does not help us prevent and manage financial crises.
Economists (and regulators) have had much to say on the origin and management of the crisis; I will return to them at the end of the book. To understand the financial crisis, I want to start from its origin: subprime mortgages and the famous toxic securities, securitization of subprime mortgages and asset-backed securities. For the time being, I will limit myself as much as possible to presenting some facts, leaving the interpretations to the following chapters.
1. The origin of the crisis: subprime mortgages
The origin of the financial crisis does not lie in complicated derivative contracts, but rather the simplest and most common of financial contracts: mortgages allowing American families to purchase homes.
By now the story has been widely investigated, so I can concentrate on the salient features. This event gives us a good starting point for our analysis, because it reminds us of something we should never forget: when a transaction takes place in a market, there are always those who buy and those who sell. It is therefore necessary to understand the reasons that led people to conduct a transaction. Identifying the reason for a market transaction as the irrationality of traders, disinformation they had, or bad faith seems to be a hasty answer, which risks not recognizing the truth, and above all, does not help us adequately prepare a response for the future.
In this case we have banks, brokers, and intermediaries who originated mortgages for the purchase of houses by people whose characteristics did not bode well for their ability to repay the loans. Why did these financial operators offer mortgages to these people, and why did the people accept them?
The answer has at least three ingredients: income distribution in U.S. society, low interest rates, and mortgage securitization.
Understanding the phenomenon requires us to broaden the horizon of our analysis, by looking at the U.S. society. In the background, we have the growth of inequality in developed economies. One figure makes the phenomenon very clear: take the 10% of the U.S. population with higher income and the 10% with lower income. In 1975, the first group had an income equal to three times that of the latter, while in 2005 the ratio had risen to five times as much.
Faced with the growth of inequality, the recourse to debt provided an "easy" way out for American families. They borrowed to buy their homes and to sustain a level of consumption that was no longer guaranteed by their income. The phenomenon is common to all developed countries, but it is particularly significant in the United States: from 2002 to 2007, the level of debt of U.S. households doubled, and the ratio of debt to income grew by 50%. The connection with the growth of inequality in U.S. society is shown by the fact that less reliable people, those with a low level of creditworthiness (low FICO credit scoring), were the main protagonists of the phenomenon: the debt-to-income ratio doubled among the 20% of population with the lowest credit scores. The less reliable people in terms of credit quality were also the protagonists during the financial crisis: those who belonged to the 40% of the population with the lowest level of creditworthiness were responsible for 70% of the mortgages that were not honoured after 2007.
In-depth studies on the U.S. economy have confirmed this interpretation: the areas of the United States characterized by high growth of mortgages in the 2000s were also characterized by a relative (and in some cases even absolute) decrease in the income of the population. This negative relationship is an absolutely new phenomenon; indeed, in the 90s the relationship was positive.
This interpretation, which links inequality and the growth of debt in the U.S. population, has for a long time not been accepted by policymakers and academics, who have considered the growth of debt to be quite natural, even at the level of the economy as a whole (a current account imbalance with foreign countries) as a response to the growth of productivity connected to new technologies.
Monetary policy accompanied the growth of debt in the U.S. by guaranteeing a very long period of low interest rates. Short-term interest rates in the money market were significantly lower than the rates that would have been derived from the application of the Taylor rule, which was the reference point for monetary policy at the turn of the new millennium. In particular, monetary tightening should have taken place at the end of 2001, but instead came only in 2004. The reason for the Fed's loose monetary policy is to be found in the fact that despite the growth of the economy, inflation did not rear its head and unemployment did not decrease. The loose monetary policy also influenced long-term bonds (between 2000 and 2005, the rate of ten-year U.S. government bonds fell by almost 2%) and the average rate of a fixed-rate standard mortgage contract (which fell from 8.2 to 6.1%). In the same period, property prices doubled. According to some estimates, the prolonged season of low interest rates may have accounted for about 30% of the rise in property prices in the new millennium by fuelling the demand for mortgages. According to critics, the Fed abandoned the rules of strict monetary policy
it had up to that point, to take a discretionary approach that had serious consequences (the real estate bubble and then the financial crisis). Opinions about the relevance of an accommodative monetary policy in creating the conditions for the financial crisis are discordant. For example, the chairman of the Fed at the time, Alan Greenspan, argued that it was not short-term interest rates (controlled by the Fed) that "caused" the crisis, since long-term interest rates (not controlled by the Fed) had been excessively low because of excess global savings (global saving glut). Ben Bernanke, who succeeded Greenspan as chairman of the Fed, argued that the period of low interest rates at the beginning of the new millennium did not actually deviate significantly from Taylor's rule. For sure, the monetary tightening in 2004 was the trigger of the crisis: from June 2004 to June 2006, the LIBOR rate (the interest rate at which banks exchange liquidity among themselves) increased by 3.5% and the rate of a standard subprime mortgage rose from 8% to 11.5%. The increase in mortgage rates led to an increase in delinquency of borrowers who held adjustable rate mortgages (ARM).
The securitization of mortgages, to which I will return in the next section, contributed significantly to the boom in the real estate market (with a 60% increase in the decade before the crisis) and thus to fuelling the bubble and creating the conditions for the crisis. A study that distinguishes among different regions in the United States highlighted a coincidence that is not so strange: regions characterized by a strong increase of subprime mortgages, i.e. to people who did not have a high credit rating, also experienced a high rate of securitized mortgages and a sharp rise in property prices in the early 2000s; after 2007, those same regions were characterized by a significant increase in mortgage defaults and a marked decline in property prices.
It seems that in the 2000s, the value of the properties negatively correlated with the income of the population - while in the previous century the correlation was positive - and positively correlated with the share of securitized mortgages. Moreover, in the regions of the U.S. with a low increase in income and a high share of securitized mortgages, we observed other phenomena: a significant decrease in the rate of rejection by banks in granting mortgages, an increase of the borrower's debt-to-income ratio, and a reduction in the spread between the rate for subprime mortgages and that for prime mortgages. These phenomena suggest that the conditions for originating mortgages were "softened" to favour families contracting a mortgage. This was facilitated by the securitization of mortgages. The bill for this "drugged" market arrived all at once in 2007, with a very high proportion of mortgage defaults.
This picture shows us how the boom in the real estate market and the subsequent crisis are closely linked to two phenomena: the increase in subprime mortgages, and their securitization. The phenomena were mutually reinforcing: thanks to securitization, an increase in mortgages (in particular subprime mortgages) led to an increase in the demand for houses, which translated into an increase in their value. Such a price increase in turn led people to refinance the mortgage and/or to borrow even more as the property provided as collateral had a higher value.
In order to better understand the phenomenon, I start by tracing an outline of the "subprime mortgages phenomenon".
Subprime mortgages (and Alt-A mortgages that have less extreme characteristics) were mortgages granted to people that did not meet the credit standards usually adopted by banks (prime or jumbo mortgages): low credit rating, and therefore high probability of default (the median FICO credit scoring indicator was less than 620), late payments in the last two years, bankruptcy in the last five years, mortgage/earnings ratio above 50%, and high loan to value of the property, that could even exceed 90%. There are many anecdotes about the fact that the banks pushed to provide credit to so-called NINJA (no income, no job and no assets), or to people who were not able to provide material evidence of their income: about 1/3 of subprime mortgages, and an even higher percentage in the case of Alt-A loans, were missing part of the proper documentation.
The subprime and Alt-A mortgage segment became significant in the 2000s: subprime and Alt-A mortgages granted in 2000 accounted for only 12% of the total ($125 bn, 6% subprime), by 2006 the share had risen to 34% ($1,000 bn, 20% subprime). The growth was impressive: in the 2000s (before the crisis), as the total amount of good quality mortgages (prime and jumbo) doubled, subprime mortgages rose by 800%. In terms of stock, subprime mortgages in 2006 represented 15% of total mortgages (28% including Alt-A) which amounted to $10 trillion (70% of U.S. GDP). Note that the debt market in the U.S. as a whole amounted to $18 trillion.
The subprime and Alt-A mortgages were obviously riskier than the prime and jumbo mortgages. One figure represents the point well: the delinquency rate on subprime mortgages (a delay of more than ninety days in payments or foreclosure) was above 10% for all of the 2000s, and in 2007, it reached the level of 17%. The same figure for prime mortgages has never moved from 3%. Similar differences can be seen for foreclosures. 50% of the subprime mortgages originated in 2007 went into default within five years. The delinquency rate was high in the case of mortgages with a high loan to value, mortgages with incomplete documentation, and those with low credit quality.
The subprime mortgage contracts were different from prime mortgages that were offered to households whose characteristics were more reassuring. Considering a thirty-year contract, 2/28 subprime mortgages (a contract quite common for subprime mortgages) typically had these features.
• Unlike prime contracts, which were mostly fixed rate (FRM), the 2/28 subprime mortgages were hybrid with a relatively low fixed rate (teaser rate) for the first two years and a variable rate (ARM) over the next twenty-eight years with a very high rate spread over the benchmark rate (e.g. the LIBOR rate). The rate of a mortgage taken out in 2006 could go from 8% to 11% after two years.
• The fees to repay the mortgage before its natural maturity (prepayment) were very high, and were present in about 75% of the subprime mortgages, while prime mortgages typically did not foresee any fees of this type. The penalty lasted at least until the date on which the mortgage shifted to a variable rate.
Contracts of this type (fixed rate for the first years and then a variable rate in the following years) represented 70% of the subprime mortgages issued between 2000 and 2007. For example, in 2006, 53% of subprime mortgages were designed as indicated above, while the share of prime mortgages was 14%.
(Continues…)
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Table of Contents
Introduction,
List of Acronyms,
1 The Origin of the Crisis in the U.S.,
1. The origin of the crisis: subprime mortgages,
2. And securitizations ...,
3. Contagion: liquidity evaporates overnight,
4. Summing up,
2 Crossing the Atlantic,
1. The Euro crisis,
2. The wonder couple: capital ratio and stress tests,
3. Banking crises and rescue in Europe,
4. Summing up,
3 The Commoditization of Risk,
1. What is risk?,
2. How to measure risk?,
3. Unimaginable risks materialize,
4. Financial education and risk culture,
5. Summing up,
4 Intermediaries Struggling for Life,
1. Volume, risk, and profits,
2. Shadow banking I: the "originate to distribute" model,
3. Shadow banking II: the dealer bank model,
4. Corporate governance and remuneration,
5. Summing up,
5 The Invisible Hand did not Show up,
1. The Invisible Hand entered no man's land,
2. The Invisible Hand lost the street,
3. The Invisible Hand disappeared,
4. Summing up,
6 Institutions in Trouble,
1. The unconventional weapons of monetary policy,
2. The catch-up of regulation and supervision,
3. Do we need states?,
4. Summing up,
7 The Legacy,
1. Those who speak but do not know how to act,
2. Those who act assuming they know what to do,
3. Is Fintech the solution?,
Epilogue: the Lessons to be Learned,