By Terry Smith
Appeared in the Daily Telegraph 20 September 2008
Given the events of the past week in financial markets there are a few questions I imagine you might want to know the answers to like: What is happening and why? Who is to blame? What can and should be done about it?
Strong medicine is needed to cure society of the ills of cheap money.
What is happening is a painful adjustment to reflect the fact that collectively we have all been living beyond our means. The period since the recession of 1990-92 was the longest run of uninterrupted economic growth since reliable records have been kept. Whilst this was very pleasant, it ignores the fact that recessions and bear markets are necessary evils. They sweep away excess and punish profligate individuals and companies. During this period, the financial markets and economy were saved from a downturn by the US Federal Reserve’s knee jerk reaction to any problem which was to cut interest rates and flood the market with liquidity. It did do so when the hedge fund Long Term Capital Management went bust, following the Asian and Russian collapses in 1997-98, after 9/11 and after the bursting of the dotcom bubble.
This willingness to bail out the market at the first sign of trouble even had a name: “the Greenspan put”. Those who borrowed too much, leveraged their banks too highly, or bought weird and wonderful derivative instruments such as CDOs (collateralized debt obligations) and SIVs (structured investment vehicles) based on sub-prime mortgages could always rely on the former Chairman of the Federal Reserve, Alan Greenspan, to bail them out. Bond traders used to chant “Alan Greenspan, he’s our hero because he sends our rates to zero.”
The limitless supply of cheap money convinced us collectively to live beyond our means. People borrowed more than 100 per cent of the cost of buying a house. They borrowed against their houses to fund purchases of cars, holidays and other consumables. The borrowings were frequently interest only mortgages which were not being repaid and/or at low “teaser” interest rates which have started to go up. Money was lent to those who simply should never have been allowed to borrow, hence the sub-prime crisis.
Once borrowers’ inability to repay their sub-prime loans became apparent, the entire edifice started to crumble. Knowing who is to blame is important not just because it makes us feel better, but because it often gives some clue as the action needed to prevent a recurrence.
It’s easy and to some extent correct to blame greedy and stupid bankers and dealers in the City and Wall Street. I also lay a lot of blame at the door of Alan Greenspan, who seemed to forget that the role of a central banker is to ensure the integrity of the financial system, not to bail out investment bankers and speculators from the consequences of their greed. To say that he ignored the warning signs about the risks of excessive leverage would be a gross understatement. But above all we should blame ourselves. Our “I want it now” culture is at the root of the problem; Greenspan just gave us what we wanted when his job was to give us what we needed.
What to do about it all?
Oddly enough, the response is one which I have so criticised because the authorities used it too readily in the past – in more minor crises – is what governments now need to do. They have to make funds available to prevent institutions failing since the systemic risk of a failure of a major counterparty such as AIG (American International Group), the insurance conglomerate, or a retail bank like HBOS does not bear thinking about.
With a lot of luck these measures may overcome the panic. But never mind the symptoms, what about addressing the causes?
What is needed is more and better regulation. Deregulation isn’t always a good thing. If you look for proof of this, the Fed had to lend $85bn (£46.4bn) to AIG. The Fed doesn’t regulate insurance companies, but AIG had written some $440 billion of credit default swaps in which it underwrote defaults on loans made by banks. You might well ask what an insurance company was doing underwriting bank loans.
In future, we may want regulators to make insurance companies stick to insuring things like buildings, cars, boats and planes, not loans.
I also think US regulators should re-impose the Glass-Steagall Act which was passed in 1933 in the wake of the Wall Street Crash and the ensuing Great Depression where so much damage was done by banks originating weird and wonderful loans, and selling them onto unsuspecting investors who lost their shirts. Sounds familiar?
Glass-Steagall kept commercial banking (the taking of deposits and making loans) separate from investment banking (issuing and underwriting securities, trading and M&A advice). Re-imposing Glass-Steagall would force investment banks to go back to their roots and accept that their main functions should be advising clients and dealing for them as agents that requires little if any capital, and commercial banks would go back to making loans and holding them until they are repaid.
As soon as you separate loan origination from the repayment risk you have a problem. When I was growing up, the bank manager lent you money and then he and you sweated during the period it took you to repay it. He didn’t package it up in a structured vehicle and sell it to someone in an insurance company.
Given that the abolition of Glass-Steagall is behind some of the conflicts which have caused this crisis, the Democrats in the US election, who are lambasting the Republicans over the credit crunch, would do well to recall that the Act was repealed by one Bill Clinton. When it was repealed it was described as an 'arcane Depression era Act’. Yes, one that had saved us from disaster for 75 years.
© Telegraph Media Group Limited 2009