Financial deregulation and the sub-prime crisis

One of the central tenets of the Washington consensus - pursued remorselessly by the International Monetary Fund (IMF) - has been the neoliberal view of the ostensible benefits that financial deregulation would bestow. Throughout the 1980s and 1990s, most countries reduced or abolished restrictions on capital movements and enacted policies of domestic financial deregulation.

These policies inevitably led to the rise of highly liquid, speculative short-term flows of capital, mostly emanating from offshore financial centres, which began to have a destabilising impact on international financial markets and hastened a whole series of financial-economic crises in Latin America, East Asia and Russia.

In the US itself, regulations that had limited domestic banks to the role of financial intermediaries were relaxed to allow commercial banks to engage in more speculative activities through the creation of banking affiliates. These transactions could be made outside the balance sheets of the banking system and allowed commercial banks to engage in the trading of securities, and in the underwriting of debt.

Financial deregulation witnessed a decoupling of the functions performed by financial intermediation, as commercial banks were no longer obliged to evaluate risk and the creditworthiness of borrowers since the loans which were originated could be sold to the secondary bond markets in the form of collateralised assets. This implied that the traditional role of banks in the evaluation of risk was transferred to the powerful credit agencies.

The primary concern of banks was the ability to sell these collateralised assets in order to earn a fee or a commission. These assets, in turn, were selected on the basis of their investment yield rather than by the past credit profile of the borrower. In other words, financial deregulation allowed banks to issue loans and sell these assets into secondary markets, which were then re-packaged and blended into other classes of yield bearing financial assets.

The whole logic of "securitisation" was aimed at overcoming financial regulations, which had prevented formerly illiquid assets held in banks' own portfolios from being transferred into banking affiliates and sold into secondary bond markets.

Consequently, the secondary bond markets assimilated these collateralised assets into mortgage-backed securities (MBSs) - which were issued on the basis of their yield - calculated in terms of the expected streams of income in the form of interest and principal payments from the underlying pool of mortgage debt. As banks moved their securitised loans off their books, there was a proliferation of mortgage companies and real estate developers entering the market, which had the effect of accentuating the gulf between the ownership of assets and the risks incurred.

The whole process led to the downgrading of credit risk, outright fraudulent practices and the alarming growth of Ponzi schemes. Indeed, in the aftermath of financial deregulation, MBSs emerged as one of the largest pools of financial assets traded in the US capital markets. It was the rapid growth of these new classes of engineered financial assets, known as collateralised debt obligations (CDOs), which acted as the trigger for the sub-prime crisis as defaults began to escalate.

The value of CDOs issued had tripled between 2004 and 2006, from US$125 billion to US$350 billion per year. As defaults mounted, the entire structure of debt began to collapse and the contagion effect soon spread to safer assets as investors lost confidence. Widespread panic led to a stampede out of these markets, which hastened a crash and the ultimate termination of funding for CDOs.

In the decade 1997-2007, real estate values more than doubled - from about US$10 trillion to over US$20 trillion. Home mortgage liabilities rose even faster during this period - from US$2 trillion to over US$10 trillion. The ratio of the median house price to median household income increased from about three to one in 2000, which reflected a relatively stable ratio over the previous three decades, to a historically unprecedented ratio of five to one in 2006. Indeed, between 1995 and 2007, house prices rose by more than 70 per cent in real terms (adjusting for the general rate of inflation). This represented an additional US$8 trillion generated by the housing wealth effect.

 The housing boom was doubtless fuelled by the easing of monetary policy as the interest rate on mortgages fell to a 30-year low - from 8.29 per cent in June 2000 to 5.23 per cent in June 2003. In this speculative frenzy, the proportion of Ponzi financial units was on the ascendant. Sub-prime mortgages accounted for 20 per cent of total mortgages issued in 2006. These loans grew by almost five-fold between 2001 and 2005, estimated at an average of US$625 billion annually.

Household debt in the US rose from around 93 per cent of disposable income in 2000 to exceed 130 per cent by the end of 2006. This dramatic upsurge in household indebtedness appeared to coincide with the end of the "new economy" bubble and was instrumental in providing a major catalyst for the recovery from the mild recession of 2001-02. By mid-2006, household debt service payments reached a record high of 14.5 per cent of disposable income.