The Fudge Factor

Over the past couple of years many millions of words have been written by a whole host of different commentators on the whys and wherefores of the global economic crisis. Some of those commentators are highly respected, some are less so, some are old and experienced and some less so. With the benefit of 20-20 hindsight, however, much of this analysis isn’t particularly revelationary – by and large it points to the same basic contributory factors: Global trade imbalances, excessively loose monetary policy, poorly regulated financial institutions, undercapitalised banks, and misaligned incentives for those running our financial institutions. All undoubtedly played their part.

People writing on the economic crisis (or any topic for that matter) do so for different reasons. Forming a practical response to the factors that caused the crisis would tend to fall well down the list of reasons for journalists putting pen to paper, or hand to keyboard. To deal in practical realities is akin to hard work. Where journalists and commentators have an advantage over policy makers is that they can live in an idealistic world, separated from the practicalities of implementing any of the ‘fixes’ that ailed the economic system in the past.

It’s easy to say that the trade imbalances between China and the US that developed over the past 15 years were a key cause of the financial crisis, without ever having to really discuss how things could have or should have been different in practical terms. Similarly, analysts can point to the situation, for example, that banks like Lehman Brothers being close to 50 times leveraged against their capital was a blatant failure on the part of regulators, shareholders and the bank’s misaligned management team. Likewise, the securitisation market, which allowed banks and other financial institutions to shift mortgages, credit card debts and the like off balance sheet was a key tool in the armoury of banks as they looked to window dress their regulatory capital position. It was also the key tool in allowing the huge expansion of credit between 2000 and 2007.

All of the above has been written about in countless articles, so in a sense it is the ‘accepted wisdom’. Yet, when it comes to mapping political responses to this analysis it’s clear that the practical issues of reforming the structure of financial markets are sufficiently difficult that much of the accepted wisdom is being by-passed in favour of pragmatic deferral – what I’m choosing to call ‘the fudge factor’.

As a case in point – it is broadly recognised that serious structural changes are required to the rules for bank capital. Journalists suggest that banks clearly need more of the stuff, as did many policymakers at the recent G20 meeting in Toronto; politicians on the other hand want them to lend more – and central banks, whose liquidity lifelines have kept the sector ticking over, now want to withdraw that support. It’s not easy to manage each of those concerns simultaneously – forcing banks to raise more capital and getting them to lend more don’t necessarily go hand-in-hand.

With the pressure on to raise cash and free up balance sheets, banks are now looking to revisit an old favourite of the pre-crisis era. Securitised products, which many commentators point to as being central to the financial crisis, are seemingly back on the agenda. Many central banks and governments are hoping that a ‘new form’ of more transparent securitised products can help address the issue of undercapitalised banks and lack of credit simultaneously, even though we all accept that such a thought process allowed us to get into a mess in the first place. The ‘accepted wisdom’ goes out of the window when short-term practicality is at stake.

In the first seven years of the past decade the securitisation sector expanded at an amazing pace, providing an ever increasing proportion of the credit which fuelled western growth. By mid-2007, for example, upwards of $8,000bn worth of assets were securitised – ie funded in these markets – which represented more than half of all credit creation in some sectors.

But since the onset of the financial crisis, these markets have collapsed. Last year, for example, just $4bn worth of collateralised debt obligations were sold, compared with $520bn in 2006. In Europe, about €30bn of securitised bonds have been sold this year, compared with more than €500bn before the crisis.

So far, few non-bankers have really noticed this collapse, largely because governments have stepped into the breach, papering over the massive funding hole. In the US, for example, the Federal Reserve has bought $1,250bn of mortgage-backed securities. In Europe, the Bank of England and ECB have gobbled up mortgage-backed bonds, and other securitised assets, via repo deals. Before 2007, eurozone banks sold more than 95 per cent of their securitised products to private sector investors; now it is under 5 per cent – with the rest going mostly to the ECB.

The crucial question is: how long will this pattern continue? Unsurprisingly, all western central banks are deeply uncomfortable about the fact that they have replaced, or become, the securitisation buyer. They are understandably looking for exit strategies and urging the banking industry to restart the securitisation machine. Against that backdrop governments are demanding that banks they own or part-own should lend more. Furthermore, financial journalists continue to point out the role that securitisation played in the financial crisis developing in the first place. Everybody can’t be right at the same time.

In 2007, when securitisation bankers were tucking in to the champagne, a large source of the demand for securitised bonds came from quasi “invented” buyers – that is, banks and bank-funded vehicles that were developing investment strategies to take advantage of regulatory and rating agency loopholes, fuelled by artificially cheap loans.

Cheap funding has since vanished and governments are determined to close all those loopholes. As a result, those invented buyers have disappeared. So how can we have a situation where we find a new funder (other than government) for the $8 trillion worth of funding that has disappeared and where banks are better capitalised leading to a safer financial system?

The fundamental answer is that pursuing these tasks simultaneously isn’t possible. Nor is it possible for journalists to blindly utter the mantra that securitisation is bad, bank capital is insufficient and that we need more credit available to our businesses, and think that if we follow each of those paths that things will work out economically.

That leaves G20 leaders with an unpalatable choice: either the government continues to replace the securitisation market indefinitely, to maintain credit growth, or it must adjust to a world where credit is far more rationed and costly. That first option is hated by most central bankers. However, the second is disliked by most politicians.

If you want to understand what could happen to global growth, then understanding what is happening in securitisation now – or more specifically what is not – is hugely important. Who is going to fill that funding gap for the long term, and what will the economic ramifications be? Without that financing where will global demand come from? We are fudging our way through at the moment, pretending that things will work out for the best.

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