Credit Cringe

In mid-2006 the global financial crisis (GFC) began in inauspicious circumstances when a US shadow bank called Merit Financial went bankrupt. A subsequent investigation revealed the unorthodox lending practices that would come to characterise the crash.

Merit was founded in 2001 by former Washington Huskies’ football star Scott Greenlaw, then aged twenty-nine. It specialised in lending to clients with a bad credit history (subprime borrowers). Within five years it had written more than $2 billion of mortgages and employed 400 people.

According to the Seattle Times, Greenlaw employed loan officers in his own image. Many were ex-footballers, one an ex-Hooters girl. The loan officers went through a 19-step training program lasting one hour. After the bankruptcy, one employee confessed that many officers ‘didn’t even know how to read a credit report’. Many former employees described Merit’s working environment as a raucous, sometimes lewd ‘frat party’. Merit provided kegs of beer for staff meetings, and employees were free to bring in six-packs on Fridays. Several loan officers boasted online that doing drugs was a favourite pastime. ‘Let’s get hopped up and make some bad decisions’ wrote one, beside a photo of himself grinning broadly.

How did the nation which spawned conservative banking legends like J.P. Morgan stoop to this? As the new US financial regulation bill sweeps across the landscape of American political economy, Australia should pause for a moment to consider this question, as well as whether or not the new bill addresses the real causes of the crisis. We have a keen vested interest in US regulators bringing stability to its debt markets because our banks are utterly reliant on their smooth functioning. Second, the process by which the Obama Administration has succeeded and failed can tell us a great deal about our own efforts to regulate against another round of bank bailouts here.

At the passing of the bill, one of its co-authors, Senator Christopher J. Dodd of Connecticut, said: “We can’t legislate wisdom or passion. We can’t legislate competency. All we can do is create the structures and hope that good people will be appointed who will attract other good people.” But as the story of Merit Financial shows, relying on prompts to good behaviour is perilous, especially if the structural changes that caused the crisis remain intact.

The primary cause of the 2008 freeze in US, and subsequently global, credit markets was a collapse of confidence in the ‘shadow banking system’. Traditional banking is the process through which those with savings are connected with those who wish to borrow. The connection is made by a bank, who takes the savings as deposits (liabilities) and lends that money on. (assets) Importantly, both assets and liabilities are held on the bank balance sheet, and regulators determine how much capital the bank must hold in reserve to cover loans that go bad. Also supporting the system is a central bank, which lends money to the bank in the event that too many deposits are taken out at any given time. Thus, any risk arising from the mismatch between the duration and the quality of the assets and liabilities at the bank is managed.

Through the deregulation of the eighties and nineties, however, the mechanism that connected savers and borrowers shifted away from banks and toward credit markets. That is, investors and businesses put their savings directly into floating securities made up of bundled loans. Banks, especially investment banks, became the middlemen who did the packaging of the security, often with mortgages bought from new retail players like Merit Financial. Neither kept an interest in the security once it was in the hands of investors, nor was the asset and liability recorded on any balance sheet. Instead, risk was managed through derivative contracts which effectively insured the security and rating agencies who approved the individual risk profile of each investment. Banks had shifted much of their business to the shadows where no capital was required to backstop transactions, nor was there any central bank support in the event that risks became reality.

Sadly, in 2007 and 2008, when US housing values collapsed, the entire system was exposed as a fraud. The assets (loans) that made up the securities were replete with the kind of rosy assumptions one might expect from a Friday afternoon loan at Merit Financial. The derivatives that managed the risk had no capital backing them up, and when called upon destroyed such behemoth firms as American Insurance Group (AIG). Rating agency approvals were of the rubber-stamp variety. And as it all unravelled, investors ran for the hills. The entire system dodged annihilation only by the sudden and near-complete sponsorship of the US Treasury and Federal Reserve to the tune of over $2 trillion.

So, does the new financial regulation bill address the causes? According to specialist US financial sources, the short answer is no. A new Consumer Protection Agency will have the scope to diagnose abusive lending practices and dodgy shops like Merit, and offers hope that any future consumer-based bubble will not go undetected. However, as the history of US finance shows, the next bubble is almost certain to be elsewhere.

The bill also moves some of the derivatives that were designed to insure market-based credit products onto exchanges where they can be monitored, and capital reserves enforced. However, according to Yves Smith, editor of the expert finance blog, Naked Capitalism, estimates of the percentage of derivatives that will shift to exchanges are as low as 20 per cent.

The bill also contains a new resolution authority to cover banks or shadow banks that threaten “grave risk” to the financial system. Known as the Kanjorski Amendment, it is an attempt to neutralise the power of too-big-to-fail institutions that require bailout. Former IMF chief economist and consistent critic of the power of large Wall Street banks, Simon Johnson, has celebrated this dimension of the bill because “for the first time someone at the federal level must make a determination regarding whether an individual firm poses system risk.”

However, the new power is governed by a council of 10 senior US regulators, who, as the GFC showed, are unlikely to move on any institution until a crisis is so advanced that bailing out is still the most likely outcome. Another lesson of the GFC was that regulators themselves are often “captured” by the interests they seek to constrain. According to Mike Konczal of another specialist US finance blog, Rortybomb, this was obvious even in the passage of the bill as the US Treasury fought against many of its proposed rules.

The most significant of these is the watering down of the Volcker Rule that sought to limit too-big-to-fail by prohibiting deposit-taking banks from engaging in shadow banking activity at all. In the final days of the bill, Wall Street lobbying opened a loophole that allows 3 per cent of commercial bank capital to be deployed in various forms of proprietary trading.

If history is any guide, that hole will expand to a gaping pipe through which the next crisis will flow. Above all other failures in the bill, it is this that has many US commentators observing that the final form of financial regulation offers no structural reform to separate banks from the risky shadow-bank behaviour that caused the crisis. Rather, it is seen as reform of the regulators.

In Australia, since the crisis of 2008, banks have enjoyed a reputation for exceptionalism. Though it is true that they did not, for the most part, engage in the same credit-market chicanery as US banks, it is not true that Australia’s big banks avoided all shadow banking-like activities. If we broaden the definition of shadow banking to parameters like ‘the mediation of short-term investor capital using derivatives to manage risk’, then Australian banks’ addiction to international wholesale funds fits perfectly.

It seems more than fair to do so given that, despite Australian bank liabilities and assets being recorded on balance sheet, the GFC’s shadow-banking freeze triggered a collapse in Australian bank liquidity that meant the big lenders suddenly faced the prospect of being unable to roll over their wholesale debts. This transpired despite the Reserve Bank tearing up its rule book on acceptable collateral for loans to the banks. Fiscal intervention, in the form of the wholesale guarantee, prevented a disastrous credit crunch in Australia and likely insolvency for some, if not all, of the major banks. As much was stated to the government at the time.

Needless to say, if efforts at US re-regulation have failed, then Australian banks continue to be exposed to the liquidity risk in their wholesale liabilities, which have grown 9 per cent since the crisis to above $385 billion - still some 15 per cent of their total liabilities. Yet in large measure, Australia has either deluded itself or denied this weakness. There has been no enquiry, no explicit policy shifts and conflicting responses by regulators with different mandates.

It’s no wonder that when the Federal government removed the wholesale guarantee earlier this year it said nothing about whether it would return in the event of another crisis. Of course it will. It is our own version of too-big-to-fail and, ironically, the moral hazard embedded in its idled status guarantees its return.

The US may have failed to address the causes of the crisis but it has at least had the courage to try, and by doing so set in place stronger foundations of public awareness for the next battle to re-regulate banks after the crisis to come.

This feature was published in The Age and SMH on July 20th.