At least we can now identify the next scam

BY JOHN MCCRONE

OPINION: What just happened? At the time, all we knew was the world economy was about to disappear down the toilet. Now, in books and movies, people are beginning to make sense of the credit crunch, the past few years of financial turmoil. And as the fog of confusion clears, here comes the anger. Because what happened seems pretty outrageous.

An unregulated shadow banking system that grew explosively over seven years, placed a quadrillion dollars in bets then palmed off the trillions of dollars in losses back on to the public while keeping its liberty and bonuses – is plotting to do it all again.

As they say, some of it you could not make up. The richest investment bank, Goldman Sachs was selling billion-dollar packages loaded with subprime mortgage liabilities, while at the same time quietly betting further money on their very failure. A way to win and win again.

Of course – as noted by Reserve Bank Governor Alan Bollard, whose own insider account, Crisis: One Central Bank Governor and the Global Financial Collapse, will be launched on Thursday – New Zealand got off relatively lightly.

As a small country on the sidelines, barely involved in the derivatives game, we have only suffered from the recession that followed the credit crunch. But it could have been much worse. There was almost a run on the banks here, Mr Bollard reveals.

In mid-September 2008, the Reserve Bank had to check its emergency stock of $100 notes as worried Kiwis withdrew savings, "stuffing bundles of cash up the chimney or burying them in the garden".

And Dr Bollard says even those at the top, like himself, had the feeling it could all be slithering out of control.

"It started getting an inexorable feel about it. Initially we saw a subprime problem, which then became a credit problem, and then a liquidity problem, and then a funding problem. And then we said `heck, what happens next?' as it became an economic problem with trade falling off a cliff."

Dr Bollard says his own response to the credit crunch is now a mixture of horror and awe – horror at the destruction of wealth on a scale never seen before, yet also awe at the sheer elemental power of a system created by humans.

Some are now arguing the credit crunch is evidence that naked capitalism, unbridled consumerism, is broke as a model of economics. It creates destructive forces we cannot control. Even now, predatory finance is getting set to go with the next big thing – carbon credit trading.

Dr Bollard disagrees. Things are broke, he says, but we can fix them. Gradually the sensible ones – the grey-suited banking regulators like himself – will spend the next few years drafting the necessary regulatory controls.

But first, an anatomy of the crisis. What did just happen, now that we can look back on it and more clearly tell the tale? It began in 1999 with the deregulation of the US banking industry.

Ever since the Great Depression of the 1930s, some basic rules had been in place to separate ordinary banks from speculative banks. The proper social function of finance, after all, is to channel money into economic growth. Businesses need cash to start up and expand. And financial institutions like banks and stockmarkets exist to make smart choices about where to direct the available capital.

In turn, there has always been a natural division between the types of investment. Some, like shares, are riskier, but offer the chance of a higher payback. You buy an actual slice of a business and ride its fortunes. Others, like bonds, are safer. A bond is simply a loan with a promised interest rate – an investment designed to be dully predictable.

Likewise, the banking industry itself had been clearly divided by a maze of regulations into its staid high street banks, taking deposits and making loans with the sedateness of national utilities, and, at the other end of the scale, the merchant or investment banks like Goldman Sachs, JP Morgan, Lehman and Merrill Lynch.

These were the wheeler-dealers. But because they were mostly risking the money of their partner-owners, or their super-rich clients, and because they were only a small part of the banking industry, they were granted a freer hand to chase opportunities.

Then in 1999, the US's Glass-Steagall Act, which divided the banking world, was repealed. The way to an era of super-growth, it was said, was to grant the finance markets full creative freedom.

In 2000, this was followed by the Commodity Futures Modernisation Act, which removed all controls on futures and other financial derivatives – exactly the kind of creative deal-making to generate the new prosperity.

Derivatives are simply various kinds of bets on events. A future, for example, is a bet that the price you pay for, say, a barrel of oil today will be cheaper than what you might have to pay tomorrow. An option is similar, except it is the right to buy at a set price at some future date. A swap is the other side of the deal where you contract to deliver something for a price, on a date.

It quickly gets fantastically more complex. But the key to a derivative is that it is a mechanism for amplifying the effects of financial behaviour. Because only a little money actually has to be staked upfront at the time of the deal, small wagers can be multiplied, or "leveraged", into gambles, which are extremely large.

Derivatives can be structured both ways. They can be used aggressively to magnify the risks being taken, but also defensively to minimise them, which is hedging. So you can insure against the risk of an action, such as issuing a loan, by simultaneously taking out a derivative-based deal, like a credit default swap, which will pay out if something happens to your loan. For a small down-payment, you can set up a counter-bet on your other bet.

It was this kind of financial flexibility that made tearing up the rules seem such a good idea. Deregulation would allow the natural risk-takers, like the investment banks, to make even bigger plays in the market. Yet equally, it would let those who valued safe and steady returns to do the opposite and hedge away their risks.

Or if you were really clever, you might manage to do both – lessen risks while increasing earnings. And this is what the industry ended up claiming it was doing.

Well, so much for the theory. What actually happened with deregulation was the wolves were allowed into the pen with the sheep. Many of the sheep, far from being alarmed, even fancied themselves as wolves for a while. And it all came to a sticky end.

Again, the point of finance is to be the economy's plumbing, the system that puts the dollars where they make the most sense. But something changed around about the 1980s when the Wall Street Gordon Gekkos first started proclaiming that "greed is good".

Finance became predatory. The investment banks, and the private hedge funds that followed, had grown large enough to manipulate markets, creating speculative games that had little to do with the real economy.

During the 1980s the rage was for junk-bond fuelled mergers and acquisitions. Armed only with the power of leverage, raiders would take down old established firms – slow moving targets – and pick them apart. The excuse was this would make for a leaner corporate world, but mostly it seemed a way to shake-down the easy marks.

Then from 1995 to 2000, there was the Nasdaq dotcom sharemarket boom when the stocks of hi-tech start-ups were talked sky high. This became a way to suck up the savings of dentists and doctors. Ordinary investors, as well as gullible pension funds, were drawn into the speculative bubble. After that market crashed, investigations revealed how the investment banks had manipulated share prices through practices such as laddering and spinning – colluding with favoured customers to inflate the stock of newly launched start-ups.

Fines were handed out to firms like Goldman Sachs, but were trivial in amount compared with the profits that were pocketed.

Yet apart from currency speculation, the action remained largely confined to the stock markets. This changed after the 1999 decision to knock down the walls between the different parts of the finance industry. Suddenly the world of credit – of bonds, mortgages, loans and other kinds of simple interest-paying debt – was opened up to the investment banks and their leverage tricks.

That mortgages then became the central play of the resulting speculative bubble was no accident. People who won't invest in much else still need to borrow to buy a house, so there was a huge pool of mortgage loans. This pool had also been cautiously managed, making it ripe for exploitation by those with a more turbo-charged approach. Predatory finance likes nothing more than a fat, slumbering victim.

The weapon of choice was the now infamous collateralised debt obligation (CDO). A CDO takes a bundle of individually created debts – they could be mortgages, but also corporate bonds, car loans, credit card accounts – and sticks them in a single pot. The CDO is then sliced into tranches – artificially divided up into grades of risk.

There is a top risk slice, effectively a junk bond, which pays the highest interest because investors are contracting to take the first wave of any loan defaults. With rating agencies like Moody's signing off the risk models, and people simply believing in the creative magic of derivatives, the AAA bonds were lapped up by pension funds and other investors, without anyone asking too many questions about how these new structured investments covered their costly middleman fees and traders' bonuses, yet still managed to pay a per cent or two more than traditional bonds.

With CDOs, mortgage loans could be turned into a freely traded commodity, packaged in a way that appeared to divorce them from their real-world risks. And for the high street banks, this was great. Instead of having to own their customers' debts, they could move into the business of generating and selling AAA bonds. Sliced and diced this way, US mortgages could end up in the investment portfolio of a Korean superannuation fund or British town council.

In itself, the behaviour was not toxic. As Dr Bollard remarks, in Australia and New Zealand the banks relaxed their lending rules, however it never got out of hand.

But in the US in particular, the banks moved into subprime – mortgages for those with uncertain income or a bad credit history. Or as it turned out, often no job and no security at all.

Subprime sounds a bad deal. Yet higher risk allows a mortgage-writer to charge higher interest (though this was usually disguised for the first three years by a special teaser rate). With CDOs then apparently managing away the risk while keeping much of the higher interest rate, subprime became the more desirable business to do. Between 2004 and 2007, the number of subprime loans grew exponentially. It became a self-fuelling bubble.

As creators of this new alternative banking system based on derivatives, the investment banks were ballooning too. By mid-2007, the five biggest US investment banks were worth US$4 trillion, almost matching the US$6t of the five biggest regular banks.

And the money being extracted from the flows of loans into AAA CDO bonds was legendary. At Goldman Sachs, now clear top dog, the average bonus across the company in 2007 was US$675,250. The chief executive took home performance pay of nearly US$70m.

With such a big gap opening between the actual wealth being created in the real economy and the notional wealth tied up in rising house prices and the trillions in derivatives now backing them, clearly it was a system set to blow. In fact, this was not so clear at all for those meant to be in charge of the banking world, like Dr Bollard. Being unregulated meant the shadow banking system, as it came to be called, was quite opaque in its workings.

Dr Bollard says traditional securities, like shares, bonds and even futures, are traded on public exchanges. The movement of money can be seen. But CDOs and the other new structured investment vehicles (SIVs) were sold mostly over-the-counter. They were privately run deals taking place among a network of traders.

By 2007, central bankers certainly knew something was up, but not what, he says. "A lot of us were really nervous."

Dr Bollard describes being at a regulators' annual meeting in Switzerland where a young business school professor was describing the complexities of a CDO deal. The professor asked the room who had understood the investment, its risks and how it might unravel? No hands went up.

Dr Bollard admits that even "subprime" was a term he had to Google after news of the first US mortgage broker failures.

The economic establishment had not realised private trading had built up an interlocking web of bets that has since proved to have totalled a quadrillion – that is, a thousand trillion – dollars.

Dr Bollard says while much of this quadrillion was self-cancelling bets against bets, it still formed a maze of uncertainty where no-one could be sure who would be left with the short straws as the whole system unwound.

August 2007 saw the first wave of market panic when the French bank BNP Paribas froze three subprime funds, valued at US$2b, because it said it no longer really knew what they were worth. The world banking system seized up in fright, refusing to lend. Governments had to pump in their own cash to keep the whole show going. Failures and bailouts began.

Another crisis moment was September 2008 when three of the biggest US subprime players needed rescuing in just a few days. That was when Dr Bollard feared the collapse of a speculative finance bubble was going to take the real economy with it, triggering a depression on a scale never experienced before.

Then 2009 ended with entire nations like Dubai and Greece needing rescuing from bankruptcy. The bailout bill for financial institutions is reckoned to have topped US$8.5t (NZ$12t) for the US alone, and US$12-US$15t for the world. While most of this is in the form of credit guarantees to restore confidence, some US$2t has still been just written off – dumped in the lap of taxpayers.

We are now into the "soggy recovery phase," says Dr Bollard. "There are many people feeling very stressed and weary."

The regulators are trying to learn the macro-economic lessons so it won't be allowed to happen again. One of the debates is whether the problem was one of scale or interconnectedness, says Dr Bollard. Were some of the individual players, like the investment banks, just too big to be shifting such sums of money around the table? Or was the issue the tangled maze and complexity?

Others are pointing out that perhaps it is too simple to blame solely the financial institutions. The housing bubble can also be blamed on the US Government for keeping its official interest rates so low from 2001 on.

Yet others are feeling the disbelief and anger – those who believe the finance industry has mutated into something it shouldn't be.

"Do we admit that control over the economy in the past decade was ceded to a small group of rapacious criminals who to this day are engaged in a mind-numbing campaign of theft on a global scale?" writes Matt Taibbi in Rolling Stone magazine.

The critics note how even right in the midst of the crisis in 2008, the investment banks and hedge funds had turned their attention to the new speculative bubble of commodities.

The price of everything from wheat to coffee beans, and especially oil, began to soar as traders attacked the futures market. Goldman Sachs enjoyed another stellar year in 2009, recording its biggest profit ever of US$16.2b. And watch out, critics are warning. Another game is coming along which could even dwarf mortgages – cap-and-trade, or trading in carbon credits.

There are fears many of the offset schemes – like Brazilian villagers being paid not to not cut trees – will be as realistic as subprime mortgages.

Friends of the Earth expert Michelle Chan, herself a former trader, warned a congressional hearing: "Wall Street won't just be brokering in plain carbon derivatives – they'll get creative."

So, as fast as one game gets closed down, another starts up. In another 10 years, will we be here once more? Looking back, wondering how the heck all that was allowed to happen?

- © Fairfax NZ News