The Hindu Business Line : When banks believed their lies

It seems to be occurring with monotonous regularity – crises and bailouts. It is high time Governments and central banks ask themselves how much longer and often they want economies and financial markets to be periodically held hostage by failing financial institutions, investment banks and hedge funds. Self-regulation, as suggested by Nouriel Roubini, the first economist to foresee the current crash, has turned out to be no regulation.

It is well known that greed and fear cause excesses in markets. But the current crisis is much more than speculation beyond means to make quick money.

The distinctive characteristic of the crisis is that it is not because of trading bets in stocks, currencies, bonds or commodities gone hugely wrong. The fact is that it was just traditional banking, supported by fancy financial engineering, which backfired.

In an environment of ultra-low interest rates and booming house prices, it seemed safe to waive upfront equity requirements from borrowers or their financials, especially when mortgages could be quickly shed in the secondary market through securitization, immediately removing credit risk. Profits of the mortgage-originating institutions became a function of how soon and how many times they could turnover their balance sheets.

Securitised mortgages became part of portfolios of Collateralised Debt Obligations (CDOs) in which a bad debt loss coverage of a few percent by the CDO issuer was enough to earn a prime investment grade rating for the CDOs from your friendly credit agency.

A good time was had by everyone in the loop — the mortgage originator who got his assets off the balance sheet apart from the securitisation profits, the CDO issuers who earned a spread between the mortgage and CDO yields, in addition to fees for the CDO structuring and the rating agencies who earned more for ‘advisory services’ than as rating fees.

For investors it was a good deal. They got a better return on a ‘AAA’ CDO than a conventional ‘AAA’. What is more they could fund the investment with cheap money from the money market. Leverage enhances returns like nothing else.

It was all so nice and easy that the architects – big banks and financial institutions – got carried away. Expectedly, they became the biggest investors - with borrowed money - in the paper they created.

Once house prices turned, there was no hope. The interbank money market seized up as lenders became wary of the quality of the CDO assets. The world’s central banks – the US Fed, ECB and Bank of England – have had to fill the financing void with the substandard collateral held by banks.

It is difficult to see how the money wheels will start revolving normally till a final resolution of the ‘bad’ assets in banks’ balance sheets is reached. And how there could be any alternative to a government or government-sponsored bailout.

The problem started when banks started believing their own lies.

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