I had quoted, last week, the Bank of England’s estimate of the aggregate central bank and government support to banks in US and Europe at £5 trillion. It is already looking a gross under-estimate: Bloomberg has estimated the figure for the US alone at $7.4 trillion! And, this still does not include the 171 banks the Federal Deposit Insurance Corporation considers vulnerable, nor the $800 billion support to government-sponsored housing finance entities (Fannie Mae and Freddie Mac) announced on November 25th. One wonders whether, even now, the authorities have a reasonable estimate of the support needed to persuade the banks to resume lending.
My suspicion about the authorities’ understanding of the situation is enhanced by the $325 billion bailout of the Citibank; just a couple of months back, the authorities were supporting Citibank’s takeover of weaker entities. Now, Citi itself has had to be rescued after its share price slumped, despite its announcing a staff reduction of around a fifth of its total. For much of the 20th century, Citi has been the symbol of the US’s predominance in the world financial system, with operations in more than a hundred countries. It was known for aggressive pursuit of business objectives, often treading close to, and sometimes crossing, the regulatory boundaries within which it had to operate (one example: it escaped lightly from the 1992 Securities Scam in India compared to Stanchart and other banks). More importantly, are there any more dominoes to fall?
The excesses of the financial economy have increasingly started affecting the real economy. US GDP shrank 0.5 per cent in Q3; Germany and Japan are both in recession. Unemployment is growing in the OECD countries, with a million losing jobs in the current year in the US alone. A couple of million others are being thrown out of their houses after defaulting on their mortgage loans. The origins of the present problem are with the “originate and sell” model of housing finance, and a touching faith in the ever-increasing value of real estate. This tempted brokers and lenders to market to financially weak, sub-prime borrowers.
Complex structured securities like CDOs and their synthetic counterparts, have been blamed for the mark-to-market losses in the trading books of banks. I sometimes wonder whether it is integral to the nature of derivatives that the risk too often gets passed to those least able to appreciate or bear it. (This is also witnessed by the losses in currency derivatives suffered by so many SMEs in India.) Consider the hierarchy of those who have suffered the most:
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I recently re-read an interesting article Sub-prime: Tentacles of a Crisis by Randall Dodd in Finance & Development, Dec 2007. It argues that for long the securitisation of mortgage loans was dominated by Fannie Mae and Freddie Mac. The market was healthy and led to a much wider ownership of houses. After the two firms had to restate their earnings because of accounting problems, Wall Street firms launched an aggressive move into the issuance of mortgage-backed securities. While Fannie/Freddie accounted for three quarters of mortgage-backed securities till 2003, private structurers accounted for 60 per cent by 2006. The proportion of securities backed by sub-prime and the slightly less risky Alt-A loans increased from 48 per cent in 2003 to 74 per cent in H1 2006. They found a ready market in bank-sponsored conduits or special investment vehicles, the banks themselves, and the hedge funds. High gearing made the returns very attractive. The crisis escalated to headline news when the secondary market became illiquid at the very time that house prices started falling, defaults mounted, highly leveraged investors were forced to liquidate their holdings, and secondary market prices of the securities crashed. The rest, as they say, is history.