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News : International Last Updated: Apr 24, 2009 - 5:31:05 PM


Global Financial Crisis: Warnings of danger from 2001 and a Fed all bark but no bite - with monumental consequences
By Michael Hennigan, Founder and Editor of Finfacts
Nov 25, 2008 - 7:40:36 AM

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Federal Hall, 26 Wall Street, New York: It was on this site that the US Congress first met and where George Washington took the oath of office as the first president. Today, the "free enterprise" business titans of the Street are dependent on the US government and the once cowed staff of regulators, earning crumbs by comparison with the Masters of the Universe, have to pick up the pieces.

Global Financial Crisis: Two newspaper stories from London and Washington on Dec 13, 2001, raised warnings about the risk of US predatory lending and the selling  of credit risk through instruments such as credit derivatives and collateralised debt obligations.  One was a report that the Fed had "approved the strongest federal response ever to predatory lending," but alas, it was all bark and no bite, with monumental consequences.

Earlier this month, Queen Elizabeth was given an academic briefing on the origins of the credit crunch and wound up the "lesson" by asking why nobody had seen the crisis coming.

The 82-year-old monarch had the main aspects of the current global financial crisis explained to her during the inauguration of a new building at the London School of Economics (LSE).

The origins and effects of the crisis were explained to her by Professor Luis Garicano, director of research at the LSE's management department, the Press Association reported.

Prof Garicano said afterwards: "The Queen asked me: 'If these things were so large, how come everyone missed them? Why did nobody notice it'?"

When Garicano explained that at "every stage, someone was relying on somebody else and everyone thought they were doing the right thing", she commented: "Awful."

As with the victims of war, most of those suffering the collateral damage of the current crisis, are unseen and unheard, while the culpable remain in clover.

On Dec 13, 2001, the Lex column in the Financial Times,commented on Risk Transfer: Argentina is tottering. Enron has filed for Chapter 11 bankruptcy protection, one of a record $107bn of corporate debt defaults logged by Standard & Poor’s so far this year. US mortgage delinquencies have risen to 4.87 per cent, close to the levels recorded during the savings and loan crisis of the early 1990s. As recession bites, credit quality in Europe and North America can only get worse next year. Yet it is a remarkable features of this recession that the stability and resilience of the financial system is prompting relatively little anxiety.

One explanation is that banks are better this time at assessing and managing risks in their lending portfolios. But if banks are shedding risk, where does it end up? A commentary in the Bank of England’s Financial Stability Review hints at an answer: in the hands of the insurance industry, notably with life assurers in some continental European countries and perhaps Japan.

Banks have been systematically selling credit risk through instruments such as credit derivatives and collateralised debt obligations. Some categories of insurer have been steady buyers. This may be fine, if risk is being spread to those parties best placed to hold it. And, to be fair, the door swings both ways: insurers have transferred some market and insurance risks to the banks and capital markets, for example through catastrophe bonds.But the suspicion remains that the risk will simply have ended up in the hands of those least able to analyse it, and least constrained by their regulators to price it correctly.

On the same day as the FT report, the Washington Post reported under the headline - -Fed Acts to Curb Predatory Lending Practices; Stricter Rules on Subprime Loans Enacted to Protect Unwary Borrowers - -Prodded by consumer complaints about rip-offs in home-equity loans and refinancings, the Federal Reserve Board yesterday approved the strongest federal response ever to predatory lending.

New rules, debated for more than a year, will increase the number of loans that are subject to scrutiny.

Consumer groups and congressional allies said that they welcomed the changes but that the Fed should have acted years ago and could have done more to protect borrowers.

Banking and financial industry groups generally accepted the Fed's changes as inevitable in light of the widespread consumer complaints.

The Fed had noted in a press statement on Dec 12, 2001 that: Oftentimes homeowners in certain communities-particularly, the elderly and minorities-are targeted with offers of high-cost, home-secured credit. The loans carry high up-front fees and may be based on the homeowners' equity in their homes, not their ability to make the scheduled payments. When homeowners have problems repaying the debt, they are often encouraged to refinance the loan. Frequently this leads to another high-fee loan that provides little or no economic benefit to the borrower.

The Fed Chairman Alan Greenspan, was lukewarm at best towards any regulation and the impact of the 2001 rules on predatory lending was effectively zero.

So when a powerful institution or government issues rules, it's a wasted exercise if there is a perception of indifference from the top.

Alan Greenspan at least has admitted that his outlook was flawed.

Finfacts Reports:

Greenspan “shocked” to learn of the breakdown in lending standards and risk management; Says “found a flaw” in his ideology in testimony on the "once-in-a century credit tsunami"

Greatest Bubble in History: Warnings ignored in US and Ireland; Vacant Irish housing units rise 150% to 350,000 in period 2002/08

In a July 2008 article on Finfacts, we wrote that Wall Street contrarian James Grant had said that Wall Street is usually described as an industry, but it shares precious few characteristics with the metal-fasteners business or the auto-parts trade. The big brokerage firms are not in business so much to make a product or even to earn a competitive return for their stockholders. Rather, they open their doors to pay their employees -- specifically, to maximize employee compensation in the short run. How best to do that? Why, to bear more risk by taking on more leverage.

Grant cited Morgan Stanley, which had a ratio of assets to equity of 33 times at year-end 2007 from 26.5 times at the close of 2004. In 2007, Morgan Stanley paid out 59% of its revenues in employee compensation, up from 46% in 2004.

They borrow to the eyes and pay themselves lordly bonuses. Naturally -- eventually -- they drive themselves, and the economy, into a crisis. And to the scene of this inevitable accident rush the government's first responders -- the Fed, the Treasury or the government-sponsored enterprises -- bearing the people's money.

In Monday's FT, in a review of James Grant's Mr Market Miscalculates, a collection of speeches and articles from his newsletter, John Authers, Investment Editor says what is most impressive is that almost all of it was written years before the crisis finally struck in July last year.

Authers says: In August 2001, when many were preoccupied by the fall-out from the tech boom and the risk of deflation, he devoted a column warning that US house prices were up 8.8 per cent from a year earlier. "What could explain a bull market in a non-earning asset in a non-inflationary era?" he asked. "Ample credit is the first answer, low interest rates the second. An overly narrow definition of 'inflation' is the third."

He also warned that Fannie Mae and Freddie Mac had extended their lending by more than 12 per cent over the preceding year and that Americans owed 45 per cent of the value of their homes, up from 14 per cent after the war. To end the column, he disparaged comments by Alan Greenspan, then the chairman of the Fed, that rising house prices were "a very important contributor to the American economy", warned against the "day trading of houses" and said that "the American house market can be described as speculative". This is exactly what we should have been worrying about in the summer of 2001.

John Authers concludes: Mr Market really is a manic-depressive and it is often easy to see where he is going wrong. That means that he gives others the opportunity to profit. Grant spotted those opportunities when it was still possible to make a lot of money from them. If Grant could see what was happening this clearly, and warn of it in a well-circulated publication, how did the world's financial regulators fail to avert the crisis before it became deadly, and how did the rest of us continue to make the irrational investing decisions that make Mr Market behave the way he does?

The explanation given to the Queen of England certainly is a start and a psychologist may add some wisdom on greed and going with the flow as more often than not, sailing against convention in the money economy, usually comes at a cost.

"The Cassandra industry is not so remunerative as the hedge fund business, so the professional investors and bankers stay in the race, taking the kind of risks that their better judgment tells them to avoid," James Grant says in his book.

As for prescience, it is well to remember, that it is not just the preserve of people with media profiles or degrees in economics. For example in Ireland, all the public didn't buy into the notion that the free lunch had been invented, even though the Government became an adjunct of the property industry.  Tax incentives weren't good enough and in addition to marketing support from ministers, like Alan Greenspan's Fed taking its cue from the hands-off Bush administration, Irish central bankers slept safely at the switch.

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