Passing the Parcel: An Analysis of the Credit Crunch
Interviewer: Steve Macaulay
Interviewee: Professor Sunil Poshakwale
September, 2008
SM:
It is no exaggeration to say that the credit crunch has rocked the world.
To discuss the implications of this I am interviewing Professor Sunil
Poshakwale. Now, Sunil, how on earth did we get ourselves into this
mess?
SP
Good morning, Steve. It is well known now that this credit crunch started
with what we know about the subprime mortgage problem that occurred in
the US. Essentially, loans were granted to people who did not have
income to support the repayment of those mortgages and the result was
that the credit agencies found out about the quality of some of those
subprime mortgages which were being traded by banks and investment
banks in the form of credit default swaps etc. And until the credit agencies
decided to downgrade some of these mortgages, there was panic in the
investment banking industry because those who had bought those debts
suddenly realised that the value of those debts was not as high as they
thought it would be.
I call it typically a passing the parcel game which children play at birthday
parties, where children pass around the parcel and when the music has
stopped a child gets a parcel and usually he finds a birthday gift – some
sort of gift in the parcel. In this case the parcel that the banks were
passing from one to another were basically in the form of what we know as
credit default swaps, the only difference was that these parcels contain a
ticking time bomb instead of a gift.
SM
One of the things that puzzles me is how something in America can have
such a profound effect throughout the world.
SP
That is very relevant; people are asking that question all over the world.
One of the primary reasons why this crisis, which primarily occurred in
the US, has become global is because markets are interlinked – markets
are globalised. A lot of foreign banks – not only from the developed part
of the world, but also from the developing part of the world have invested
in buying US government bonds, buying bonds which were issued by
some of the banks and underlying security under those bonds where the
mortgages were basically toxic, to some extent. Therefore, what we are
witnessing at the moment is a panic all around the world, where the
banks have now started to revalue some of the assets that they thought
would give them good value, and therefore they are in trouble.
SM
Some people have said that the whole system is broke – is that
something that you would agree with?
SP
Well the system hasn’t really broken down, what has happened is that
the wheels have grounded. Typically it’s a situation where the investing
community have lost confidence in the markets. In the capitalist system
that the Anglo Saxon model follows, we always believe that the market
gets it right and that people who are trading in the market make rational
decisions, that they are able to accurately and correctly price assets
based on the risks.
In this case, it has been proved that most banks that were trading in
these credit default swaps or the collaterised debt obligations – CDOs as
they are called – were really careless, to some extent. They did not look
deeply into the quality of assets that were underlying and they were
passing on these bonds from one to another and earning their profits and
everybody seems to be happy in that case, but the problem was once it
was discovered the line value of those swaps, or CDOs, were not what
the market thought they were. People started to stop lending to each
other, and that is why we are in the situation which we call a credit
crunch, where no bank is now willing to lend to one another because no
one trusts each other’s books.
SM
So what are the implications, then? We are where we are, but what is
going to happen next? What ramifications are there?
SP
The ramifications are huge. We have witnessed in the last few weeks,
few months, what has happened starting with Bear Stearns to the
takeover of Freddie Mac and Fannie Mae, the big central mortgage
financing agency in the US. The government had to infuse $200bn, then
there was the rescue of AIG (American Insurance Group), which was
basically the agency which bore most of the risks that were underlying
these credit default swaps, because every time a bank would lend money
the investment banks would take that mortgage off the books of the
banks and then they would package these into deals and they were then
insuring with AIG. So the ultimate risk was lying with AIG and therefore
one of the reasons why AIG had to be rescued was because if the US
government had allowed it to fail, it would have been catastrophic for the
market. So therefore, again, $85bn of infusion in the rescue of AIG.
We have cases, not only in the US but also in the UK where HBoS was
allowed to be taken over by Lloyds TSB recently and now very recent
news is that Bradford and Bingley is being nationalised by the
government in the UK.
So the ramifications, the implications, are there for us to see. The very
existence of investment banking is at risk and some people now calling
this entire episode the end of Wall Street because there are only two
remaining purely independent investment banks – Goldman Sachs and
Morgan Stanley – and they have also now turned commercial banks. As
you will know from a recent announcement, the day before yesterday,
that they will now be allowed to take deposits and the US government
will now be able to regulate those banks. So the independent
investment bank has gone, it’s almost an end of an era for Wall Street.
So the implications are huge not only for the US and other developed
countries, such as the UK and Europe, but also for the other developing
countries around the world.
SM
Have you any views on who is the blame for all of this? Almost
everybody seems to be getting some blame – regulators, investment
banks, central banks, consumers, governments, even greed and the
nature of human beings.
SP
Well, it is a very controversial topic in itself because whenever we start to
point fingers at banks, institutions or anyone for that matter, people don’t
like it – there is a lot of controversy about it. I think, in my view, primarily
the banks are responsible for what has happened. Banks have been
taking excessive levels of risk, they have been careless in lending money
to people who couldn’t afford those mortgages and the internal risk
management system has once again shown to have failed in banks.
This is not the first instance that we are witnessing. We have had
instances in the past, if you remember famously the Barings Bank case
in 1994, and then there was a big hedge fund called Long Term Capital
Management in 1998, which had to be rescued by the Federal Reserve
because they had high exposure in Russian government bonds. And the
rouble fell and therefore because of their very high leverage ratios, once
again if they had been allowed to fail that would have been catastrophic
for the financial markets in the US and for other markets around the
world. And therefore this is not the first instance when people have
found out that internal risk management and governance systems within
banks is not as good as it ought to be.
Secondly, I also put blame on investment banks – partly it has to do with
the kind of bonus culture which exists in some of those banks. The kind
of compensation packages that these banks are able to offer to their
executives and traders, which in a sense motivates them to take higher
levels of risks and therefore as long as you are making money, it doesn’t
matter how you are making money.
Thirdly, I also put some blame on credit rating agencies because it has
been proven once again that the standards imposed and the Moody’s of
this world, haven’t really done their jobs as well as people expected them
to. For example, why did it take them so long to start to examine the
quality of the assets that they were rating, why did it take so long to
downgrade some of those assets? Why couldn’t it have been done
earlier when the mortgages were being taken on the banks’ books?
And finally, it’s the regulatory authorities – I think it has been shown
through this episode that the regulation board in the US, as well as in the
UK to some extent, has failed to regulate banks. Of course, one of the
reasons why investment banks were investment banks is because they
were independent, they were not regulated. But now we all know that
that model is unsustainable because that has much wider repercussions
and it can hurt the average man on the street and therefore these banks
also need to be regulated. So it’s a combination of all these where I
squarely feel the blame should lie.
SM
Yes – so you can actually point your finger at quite a few people that
must shoulder some blame for this?
SP
I think so. One thing that has happened in this process is that when
credit is easily available it encourages people to borrow money. To
some extent, you can say that the governments were very relaxed about
it. Some people are also talking about the US Federal Reserve Bank’s
policy about five, six or seven years ago, when Alan Greenspan used to
head the Fed Reserve – at that time the interest rates were kept low,
despite the reservations by some of the economists and commentators
that this would lead to a property bubble and to some extent they have
been proven right. So easy availability of credit encourages spending
habits, discourages savings – low interest rates doesn’t help the average
man on the street to put his money in the bank.
SM
Could I ask you a personal question – did you see any of this coming?
SP
Well hindsight is wonderful isn’t it? With hindsight you can always say
oh, yes, I knew it was going to happen, but honestly in my own view and
in my own research and study that I have been conducting, I could see it
coming to some extent. I could see that something was going to give
way. As I said, excessive levels of debts, excessive valuations of
properties, low interest rates, debt levels were mounting – both at
individual levels as well as institutional levels in banks. So something
had to give.
The period of wonderful economic growth that we have witnessed for the
last ten years or so was not likely to last – there had to be a correction in
the market. So in a sense, I had an inkling that the market was due for
correction. However, I must admit that I did not envisage the extent to
which this would damage the confidence of the financial community
around the world.
SM
I guess you and a lot of other people would be in that boat. I would like
to move on to look at some of the remedies that have been proposed. I
have been quite shocked by the extent of government intervention, even
from the land of the free market in America. Do you think these are
going to be enough, these bail outs and challenges?
SP
Well, that’s the million dollar question – rather we should say billion dollar
question, given the billions that the US government and also the UK
government and now, in fact, Belgian and Dutch governments are trying
to save Fortis – are trying to pump in, in the banking system and the
financial system.
The issue is that someone has to intervene. The regulatory system that
exists in the US and in Western Europe generally is not capable of acting
as lenders of the last resort. Government had to come as lenders of the
last resort in this case. Now, whether the action that the governments
are taking will be enough or not, as I have said, is a billion dollar
question. There are several things that I would like to share with you
here.
First of all, it is not certain that the $700bn package that Congress is in
the process of approving which the Treasury Secretary in the US
believes will help stop this panic which is spreading across the financial
markets. Will that be enough? What if the $700bn worth of bonds – the
toxic assets that the US government is going to buy by exchanging these
assets with their treasury bonds – are not enough to clean up the
system? It may in fact undermine the financial market’s confidence
even more than the government thinks.
To give you some examples, Merrill Lynch when they were trying to sell
some of their mortgage book assets, they realised only 22 per cent of the
book value of the assets that they tried to sell in the market. The assets
of many regional banks in the US are being valued at about 50 or 75 per
cent of their book value. If these assets which are bought by the
government, if their true value is much lower than $700bn, who is going
to pay? Who is going to suffer those losses? Are we then looking to a
scenario where the average man on the street will be paying higher taxes
in the future? Another question.
The third is that the US government will have to borrow this money –
they can’t just print money, because if they print money it will lead to
inflationary pressures which again can be catastrophic for the financial
system. Therefore they have to borrow money, which would mean that
their dependence on the foreign banks would be even greater.
What will happen with the issuance of $700bn worth of treasury bills and
bonds? What will it do to the bond prices in the market? What will it do
to the returns available on those bonds? These are some of the really
unknown issues that we face as we speak and it’s going to be quite an
interesting development for us to witness in the next few months –
indeed, few years.
SM
Thank you – I think what you have done is give some useful insights.
Lots of questions still unanswered, so I guess the best thing we can do
now is to look how things develop and come back here and have another
interview in a few months time to see where things are.