Manuel Romera. Professor. IE Business School
9 December 2008
The subprime mortgages unexpectedly sparked the financial crisis, but the resulting raging fire took hold because there was so much more fuel lying around to add to it. How can we rise from the ashes?
The first thing to be considered is the background to the crisis and the essential causes of it. Perhaps the best example has been the strong sensation of liquidity experienced by all the players on the market, which has led to excessive leverage and a significant undervaluation of the risk associated with excess debt and a significant overvaluation of assets that has given rise to clear consequences that include a lack of coherence and macroeconomic consequences such as negative saving rates in the USA and investment records in China in excess of the GDP. All the market analysts expected the system to break down as a result of macrospeculators such as the hedge funds and the CDS (Credit Default Swaps), but neither of the two originated the crisis.
The origin of the crisis actually came from an unexpected trigger, more specifically, the heavy default produced by ´sub-prime´ mortgages, which were none other than loans awarded to the so-called ´NINJAs´, i.e. people in the USA with no income, no job, and no assets, that had been securitised, which means that those who awarded the loans just sold them on the market, in many cases leaving nothing showing in their balances. One of the surprising aspects is that a market as small as the sub-prime mortgage market was the detonator of this entire situation.
What we should also consider is that we have gone from zero liquidity, with AAA-rating assets with real guarantees valued at 50% of the original value instead of a logical loss of around 25% or 30%, to an over-reaction of the market and liquidity levels now flowing into the system from the public sector.
There are several reasons the crisis has taken hold: on the one hand, a highly expansive monetary policy for too long a period, as suggested by Greenspan, the ex-president of the Federal reserve. He knew how to do away with inflation, but not the recession, which is why he was very reticent to lower interest rates to revive the economy; however, that has generated large bubbles that are now bursting. In addition, supervision and regulation have been somewhat weak in certain countries as far as the financial system and the real economy are concerned and, finally, the lack of trust due to a lack of balance of what the banks were lending, with the so-called ´securitisations´, has led to the crisis situation that has made banks very reluctant to lend each other money.
At present, we have a situation of risk aversion beyond any concept of normality and at the highest ever rates. Indeed, one of the indicators most commonly used on the markets to measure risk aversion, the ´VIX´, is at the highest point of its 28-year history.
As far as the real estate crisis is concerned, we can see how the increase in housing has been spectacular in developed countries and, consequently, the fall in housing prices in the USA is also spectacular at the present time.
In the USA, the price of housing has fallen more than 20% in the country´s main cities.
The consequences of the crisis in the USA can be summarised as follows:
1. Fannie Mae and Freddie Mac have been nationalised.
2. Lehman has gone bankrupt.
3. Merrill Lynch has been bought by Bank of America.
4. AIG has been rescued by the government: they will guarantee 80% of its shares.
5. The investment banks created by the legislation that followed on from the Great Depression have disappeared. Morgan Stanley and Goldman Sachs have asked the Fed for a change of status to become commercial banks, receive deposits from the public and submit to the capitalisation and leverage rules of Basel.
6. In order to remain independent, there has been an increase in capital in Goldman Sachs.
7. The government has closed Washington Mutual and sold its assets to JPMorgan Chase.
8. Wells Fargo has bought Wachovia in a transaction in which it withdrew from the government-subsidised sale of the said institution to Citigroup. Citi has turned around and is in negotiations led by the NY Fed.
9. The Congress has approved the rescue of the financial system. It is to cost $700 thousand million and will create an institution for buying the financial institutions´ toxic assets and cleaning up their balance sheets.
In my opinion, cleaning up the disaster is a very complex process and will take years. The scale and complexity will affect all four corners of the world. As an example, the liquidation of Enron took 6 years; that of Lehman could take more than a decade.
If we examine the consequences of the crisis in Europe, we could also list the following:
1. The Belgian, Dutch and Luxembourg governments have supported FORTIS with €11,200 million. BNP has purchased DEXIA in a transaction valued at €14,500 million.
2. The Belgian and French governments have capitalised DEXIA with €6400 million.
3. The Icelandic government has intervened in the country´s third-largest bank and provided €600 million. The state then went bankrupt.
4. Germany has rescued the mortgage bank HypoReal Estate and capitalised it with €35,000 million.
5. England has partially nationalised (the ´bad bank´) one of its leading commercial banks (Bradford & Bingley) owing to the dismal state of its mortgage portfolio and the ´good bank´ has been sold to Santander. With this purchase, the Spanish bank has become the third-largest bank in Great Britain.
6. Ireland has injected €400,000 million into its financial system to guarantee all the corresponding deposits.
7. Switzerland has injected €10,000 million to provide its financial system with liquidity.
8. The finance ministers of the EU have decided to proceed in conjunction with each other and have agreed that each one can proceed in accordance with the means at its disposal.
9. ING has been intervened with a capital injection of €10,000 million in subordinate shares.
In view of this situation, almost every government in the world has implemented rescue plans that focus on three cornerstones: first of all, the liquidity of assets, i.e. allocating liquidity funds to purchase bad or good assets in order to provide the system with liquidity; secondly, the allocation of capitalisation funds to enter into the capital of banks that are in difficulty; and thirdly, consideration has been given to issuing guarantees for the interbank loans and the issue of short-term and mid-term debt, as well as an increase in the amount used to guarantee the deposit guarantee funds held by savers in banks.
As for the future of the financial system, the hole is huge and there is a lack of liquidity that has not been caused only by a lack of trust, but also by the need for conserving liquidity in case of what might happen with banks, and the most surprising thing is that it is the first time this has happened in modern history.
The most complicated part of the assessment is that in view of this alleged need for public cash to enter the capital of the world´s leading financial institutions, the market has been placed under a cloud of doubt and several analysts consider that it would be better to let the bad banks disappear and the good ones continue to re-establish the market balance and reward good management instead of that which has generated disasters. However, those who uphold this idea overlook the fact that if one of the commercial or retail banks crashes, it could take the financial system with it as a result of the panic it would cause.
I would summarise the future after the crisis as follows:
• Lower economic growth during what is left of 2008 and 2009. World growth at 3% and developed countries at 0.5%, according to the IMF. Getting used to it will be complicated, since we have been growing on a world scale at rates of 5%-6%.
• The central banks will be concerned with liquidity. This problem surprised everyone and, by everyone, I include all the supranational institutions. I think we need to accept that the ECB is there for more than just controlling inflation, since it is the ultimate lender. Financial problems cannot be treated like the Common Agricultural Policy, but rather they need to be solved more quickly and with more coordination between the various central banks.
• Credit restrictions. The use and responsibility of rating agencies must be reconsidered.
• We must understand that the cost of loans will be higher in general in the future, since the cost of finance has also been increased.
• We must have better, not more, regulation: we need to reconsider the pro-cyclical nature of international accounting regulations, the so-called IAS (mark to market), and the Basel II agreement on capital.
• Strict controls must be applied to every kind of deficit of developed economies in general.
• It will be necessary to encourage family saving and control the salaries of senior executives with mid-term, not short-term, measures.