Last week I showed how the apparently benign (or not so benign) interest charged by the banks translates in their perspective into a real bonus.  How they make many hundreds of percent interest per year which means they are multiplying their assets by substantial numbers.  This is of course how some of them have managed to repay their debts so rapidly – which raises the question of how did they end up with such massive debts?

It comes down to three main factors – the inadequate evaluation by ratings agencies, lack of due diligence by the banks themselves and a lax regulatory framework that allowed the banks effectively to police themselves – and the bigger the bank, the more it seemed to get away with.

I leave out the issue of the Eurozone, which I discussed  last Saturday.  I expect to return to that topic later on when the dust has settled a little but the straw that broke the camel’s back was the 2007/8 problem which really dealt with excess lending on so-called securitised real estate products.

I say ‘so-called’ because not only is money not a product but there was no security – it was a total illusion.  The only truth was it was all to do with real estate.

Slick sales people persuaded the innocent to take out large mortgages – which are by their nature large loans repayable over a long period of time.  This occurred under three main conditions – relatively uncontrolled building, excessively low interest rates and/or a large supply of land relative to the population.

Spain ticked the first box in particular and speculative building on the Costa del Plenty ended up not being sold which depressed the market.   Ireland ticked the second and third boxes in particular – they have quite a small population and the Eurozone interest rates were too low for their (then) tiger economy that was attracting many multinationals to its shores.   The US ticked all three as the Fed held rates at a record low, the US is a massive country by any standards and there are not too many controls on what is built and where.

The mortgage companies preyed on people pointing to the past history of continuous price escalation – and cleaned up.  Many of these mortgages were bundled together and sold in slices to unsuspecting but careless buyers who claimed them as assets.   In other cases, the mortgages were retained by the original mortgagees and again claimed as assets on their books.  Another mistake.   In the rush for growth, banks and mortgage companies were overcome with greed and, as I showed last week, were multiplying these assets by many times each year.

But even a small downturn – the local plant closes – or upturn in the economy – interest rates increase – spelt disaster. People couldn’t pay their mortgages and the properties were re-possessed. But they couldn’t be sold either – or not at anything that could cover the mortgage so the property price collapsed and people were left holding negative equity, made bankrupt, families ruined, marriages put on the rocks and suicides occurred. This was not so publicised as the odd trader jumping out of the windows of Wall St in the 1930s but was much worse.

These products were AAA rated. Incredible with hindsight but the three ratings agencies, Moodys, S&P and Fitches, really should have known better.  The evaluation of risk is a complex business. Most of it is by guess work to be honest. And the trouble with guessing is that you are biased by recent events and history. When the environment of instantaneous trading etc has never been around before, it is all bunkum – there is no history.  I guess they just saw the words ‘real estate’.

The banks that bought these ‘securitised products’ should have been able to see (maybe they just didn’t ask) what they were buying.  No-one in their right mind would buy a car that had rust under the carpet and could fall apart over the next big bump. This is what the banks did in the belief that they would become bigger than the next guy on the back of this boom.  In the case of The Royal Bank of Scotland, even bidding ridiculous money clearly without due diligence for ABN Amro, which had been doing much the same thing buying mortgages. They should have known better – transparency is the key word here.  No-one has called in the ratings agencies to explain their part in the global downturm but they are as guilty as the banks.

Caveat emptor, they say.  Well Caveat Taxpayer it turned out as many banks nearly went to the wall or had to be propped up with shedloads of the peoples’ hard-earned all round the world otherwise the ATMs would have dried up.  RBS was, it has been claimed, 15 minutes from that point.

So why were the regulators not more effective?  Here I want to point to the Financial Services Authority report into RBS failure.  At the height, the capitalisation under Basel 3 standards has now been found to be as low as 2% – under the rules prevalent at the time it appeared to be rather higher.  Yet the issue of bank safety was hardly a concern at the FSA, according to a BBC summary of this document.  And I don’t want to beat the UK up too much – I suspect much the same was happening elsewhere in the world.  The consequences of bank failure was so frightening that the people meant (and paid) to consider it thought it so unlikely they ignored it.  Well history is a good teacher.  Now they know.

So we need to

  1. beef up the ratings agencies – probably by having more and independent agencies – improve transparency even at the cost of confidentiality,
  2. improve the governance of banks, which is what we hope Basel 3 will do, and
  3. reformulate the role of the regulator, anathema though that may be to the financial services industry.

When we were on holiday in Greece in 2007, I remember a San Diego-based Greek American telling me that the property price in the US was going to go belly-up due to uncontrolled building. How right he was.