Unregulated "financial engineering"
and the "shadow banking system"
By Jon Fernquest |
An instructive mini-lecture on how changes in banking and finance over the last decade have led to the current US financial mess, was featured in a Forbes column by noted finance professor Burton Malkiel this week.
Burton G. Malkiel is professor of economics at Princeton University and author of the bestselling A Random Walk Down Wall Street.
Depersonalisation of banking relationships
Banks used to have a much closer relationship with individual borrowers throughout the life of home loans.
If households or businesses had trouble paying back a loan, the bank was there to listen and work out a plan to help them pay back their loan.
This sort of borrower-lender relationship has largely disappeared.
Contact between lender and borrower is often limited to a short mortgage origination period before the loan is bundled into securities sold to several anonymous investors. As professor Malkiel describes it:
Decades ago, banks made mortgage loans to home buyers and kept them on their balance sheets. This was the "originate and hold" model of credit creation. More recently, mortgage credit was offered under an "originate and distribute" model. Mortgage originators (including non-bank institutions) would hold loans only until they could be packaged into a set of complex mortgage-backed securities, broken up into different segments or tranches having different priorities in the right to receive payments from the underlying mortgages.
Over the past decade large amounts of foreign money, especially Chinese foreign exchange reserves, have flowed into the US which fueled an expansion in credit. As US President Bush explained in his speech last night:
"For more than a decade, a massive amount of money flowed into the United States from investors abroad because our country is an attractive and secure place to do business. This large influx of money to U.S. banks and financial institutions, along with low interest rates, made it easier for Americans to get credit. These developments allowed more families to borrow money for cars, and homes, and college tuition, some for the first time. They allowed more entrepreneurs to get loans to start new businesses and create jobs" (Source: New York Times).
An excess supply of loanable funds eventually led to lax lending standards.
Since banks no longer had a long-term relationship with the borrower over the whole length of the loan, they no longer had to worry what happened to the loan many years in the future:
Mortgages were offered to borrowers with no income, no job and no assets (so called NINJA loans) and often with no documentation and with little or no down payment. And easy consumer credit was also offered by credit card companies, auto finance companies, student loan organizations and many more.
Most of this excess supply of credit entered the housing market. Home prices increased quickly creating a housing bubble:
According to S&P Case-Shiller estimates, the inflation-adjusted price of housing ended the 20th century at about the same level it had been 100 years earlier. But from 2000 to 2006, the real price of a single family house almost doubled. Since then, house prices have declined sharply--at rates we have not experienced since the Great Depression.
Risk estimates for mortgage-backed securities were not accurate because they were based on periods when lending standards had been stricter and housing prices were rising. Rating agencies also failed to provide to measure risk accurately (Read article today).
The Shadow banking system
A shadow banking system of unregulated financial institutions arose with this excess credit. These financial institutions created and held what were believed to be innovative new creations of "financial engineering" that "spread risk." As economist Nouriel Roubini prophetically defined this system in February of this year:
The "shadow banking system" (as defined by Pimco), or more precisely the "shadow financial system" (as it is composed by non-bank financial institutions), will soon get into serious trouble. This shadow financial system is composed of financial institutions that — like banks — borrow short and in liquid forms and lend or invest long in more illiquid assets. This system includes: SIVs, conduits, money-market funds, monolines, investment banks, hedge funds and other non-bank financial institutions. All these institutions are subject to market risk, credit risk (given their risky investments) and especially liquidity/rollover risk as their short-term liabilities can be rolled off easily while their assets are more long term and illiquid. Unlike banks, these entities don't have direct or indirect access to the central bank's lender of last resort support as they are not depositary institutions. Thus, in the case of financial distress and/or illiquidity, they may go bankrupt because of the inability to roll over or refinance their short-term liabilities. Deepening problems in the economy and in the financial markets and poor risk management will lead some of these institutions to go belly-up: a few large hedge funds, a few money-market funds, the entire SIV system and, possibly, one or two large and systemically important broker-dealers" (Source: Nouriel Roubini in Financial Week (02-28-08))
These new financial institutions borrowed larges amount of money short-term and were highly leveraged which made them vulnerable to small losses. For example, with a 30-to-1 debt-to-equity ratio, a 4% loss would reduce the equity and capital of the financial institution to zero, an accident waiting to happen:
Market forces demonstrated how fragile the system had become. Short-term lenders became reluctant to finance the highly leveraged institutions, forcing asset sales at increasingly distressed prices and leading in many cases to a death spiral. Lehman declared bankruptcy; Bear, AIG, Fannie and Freddie were "rescued," although it could be hard to convince stockholders that they were saved.
Building a new financial architecture?
A "massive deleveraging" of the US banking and shadow banking system is in the making. This will take place by "shedding assets and "building up capital."
An asset management company similar to the Resolution Trust Corporation (RTC) of the 1980s Savings & Loan Crisis will buy up illiquid assets.
Since asset prices are unlikely to return high prices of the housing bubble painful losses are likely in the near future.
The "complexity and incomprehensibility" of derivative instruments such as credit default swaps has to be replaced with simplicity.
Standardised plain vanilla derivatives that are exchange-traded, fully collateralized and guaranteed by a central clearing corporation have to replace the "innovations" of financial engineering and the shadow banking system.
(Source: Forbes, Commentary, Too Clever By Half, Burton G. Malkiel, 09-22-08, link)
Vocabulary:
shadow banking system - unregulated non-bank financial institutions that have played an important role in the credit expansion in the US and Europe over the last decade, these institutions include hedge funds, special investment vehicles, and until last week investment banks, they employ money investment vehicles such as structured investment vehicles (SIVs) and collateralised debt obligations (CDOs) and credit derivative instruments that allow them to evade banking regulations, they are blamed for contributing to the 2007 subprime mortgage crisis and helping to transform it into a global credit crunch (See Wikipedia)
financial engineering - using higher math and computer calculations in investment strategy
anonymous - no name given, do not know name
originate and hold model (old) - banks make home mortgage loans and then keep them on their balance sheets
originate and distribute model (new) - banks make home mortgages which are then bundled into securities and traded on secondary markets
secondary markets - markets where securities can be sold for a second, thrid, etc...time
an originator, a mortgage orginator - a bank or mortgage broker that makes a mortgage home loan and then sells it to a bank rather than holding it
mortgage-backed securities (MBS) - an asset-backed security whose cash flows are backed by the principal and interest payments of a set of mortgage loans (See Wikipedia)
tranches - a slice, "certain securities, such as collateralized mortgage obligations (CMOs), are made up of a number of classes, called tranches, that differ from each other because they pay different interest rates, mature on different dates, carry different levels of risk, or differ in some other way" (See Wikipedia)
lax lending standards - easy requirements for getting a loan
NINJA loans - loans offered to borrowers with No Income, No Job and No Assets
a down payment - the amount of money paid at the beginning of a loan, before smaller monthly payments are made
Case-Shiller, Case Shiller Index - measures measure the value of the residential real estate market in the United State (See Wikipedia)
rating agencies - companies that give companies and their debt a rating that measures how likely it is that they don't pay the money back
prophetically - mentioned something that could happen in the future (and did)
Resolution Trust Corporation (RTC) -an asset management company owned by the US government that sold off real estate loans of banks (actually "Savings & Loan Associations) that failed during the US Savings and Loan Crisis of the 1980s (See Wikipedia)
Savings & Loan Crisis - a very large financial crisis in the US during the 1980s (See Wikipedia)
illiquid assets - assets that are difficult to sell
incomprehensibility - difficult or impossible to understand
