America, Australia and the GFC

As its name suggests, terrestrial breadth has helped distinguish the global financial crisis from past economic downturns. Like the modern family who finds its members scattered across the globe, what started as a dalliance between aspiring American homeowners, loose lending and exotic derivatives has since spread itself far and wide. But while the GFC epithet has conditioned us to think of the crisis as universal, as the dust starts to settle we see economies in assorted states of disrepair. Among Western nations it can be said that (touchwood) Australia is faring relatively well. We are yet to officially enter recession and the latest figures indicate that housing finance is strong and consumer sentiment is rising.

Predictably, debate continues to wage both at home and abroad regarding the case for and against regulation of financial markets. Unfortunately much of the discussion is mired in generalities which overlook the fact that regulation is not a broad brush proposition; not simply a case of more or less. While Kevin Rudd’s invective in The Monthly nailed his ideological colours to the mast, proclaiming the “death of neo-liberalism” offers little by way of solution. As author Charles Morris wrote in the same magazine, “large scale interventions are the bluntest of tools”. The key to effective regulatory reform will lie in its calibration to a nation’s particular problems and existing structures.

It is also important that the debate in Australia does not lose track of the significant differences between our and America’s financial systems. The IMF estimates losses for US banks alone will total US$1.6 trillion. The wreckage this figure represents is thrown into sharp relief when put next to another figure, US$1.3 trillion: the total equity capital of the American banking system. By comparison Australia’s banks have performed remarkably well; our big four comprise a third of the world’s strongest. This owes much to the fact that unlike their counterparts abroad, Australia’s banks had minimal direct exposure to the securities spun from dicey American mortgages. Where foreign banks have buckled under the weight of limp toxic assets, Australian banks have only really been hit by the (lesser) problem of illiquid money markets.

In a regulatory context much has been written of US Congress’ decision in the late 1990s to repeal the prohibition against marriages of Wall and Main Street banks. While it’s impossible to quantify its direct impact, the legislation no doubt had a hand in the rise of the financial super-institution. Citigroup, UBS and Deutsche Bank are all notable residents of the house the Gramm-Leach-Billey Act built: enabling retail banks to play with opaque financial products and services. While the US Fed continued to regulate the “asset to capital” ratio of commercial banks, these banks began holding riskier assets and hedge funds started acting like banks (or, in AIG’s case, an insurance company became a hedge fund). Further, lending practices within these institutions became less about the underpinning revenue generation and capital of the debtor company and more about ensuring the financial growth of the institution itself.

In this environment of easy money a largely unregulated shadow financial system flourished. While derivatives and mortgage-backed securities had existed for years, the products were becoming increasingly sophisticated and opaque. The securitisation process meant banks could act with a sense of impunity in making high-risk loans because they were able to sell them to investment banks for conversion into a structured debt product (or, in some cases, convert them in-house in the brave new Gramm-Leach-Billey world). Derivatives such as collateralised debt obligations (CDOs) and credit default swaps became the darlings of the financial markets, with everyone wanting a piece of the high-margin pie. These products, along with over-the-counter derivatives and structured investment vehicles existed in a virtually unregulated universe, a universe which by 2008 had bubbled to an estimated market capitalisation of $55 trillion.

A breathtaking figure, but what was underpinning it? Not real capital, unfortunately. In capital’s place were computer pricing models programmed at predicting risk: models which, as we have now spectacularly seen, were overly optimistic. As Alan Greenspan conceded, “the whole intellectual edifice (pricing model) collapsed last year because the data inputted into the risk-management models generally covered only the past two decades, a period of euphoria”.

Greenspan had long been a champion of derivatives as “efficient allocators of risk”, which wouldn’t have been such a problem had he not been at the wheel while the market spiralled out of control. Indeed, he’d declared his affection for them early in his tenure as Fed chairman stating in 1988 that "what many critics of equity derivatives fail to realise is that the markets for these instruments have become so large not because of slick sales campaigns, but because they are providing economic value to their users”. It appears this was the logic informing his blind faith in a largely unfettered shadow financial system, a system that played a leading role in turning a boom in American property into a global financial crisis.

Which brings us to one of the great policy challenges of our time: how to fetter these financial markets?

Demanding greater transparency and disclosure in the securitisation process is essential to effective reform. The complexity of the instruments involved makes this a perilous undertaking but one which governments must strive to get right. Decreasing the scope for companies to creatively account for derivatives on their balance sheets will also assist.

Regulation of credit rating agencies must also be reassessed. At the boom’s peak, rating agencies such as Moody’s and S&P had applied AAA credit ratings to some 64,000 securities, while a mere 12 companies were ascribed this top rating. Why? The answer resides in Adam Smith’s invisible hand: self interest. The fees on products like CDOs were three times as high as conventional bond ratings. Regulation of the ratings industry is already afoot and will have a large bearing on achieving an effective long-term response to the crisis.

So what does this mean for Australia? Just as we depend upon the policy response of larger emitting countries to remedy climate change, protecting Australia from another financial crisis depends on larger governments, particularly the Obama administration, leading the charge. Crucial to Australia’s relative health is that we didn’t have a property bubble built on sub-prime loans. Regulation and prudent lending practices of Australian banks (including the requirement of mortgage insurance on high-leverage loans) helped confine the Australian sub-prime market to less than 1 per cent of all mortgages (compared with over 15 per cent in the United States). Further, we didn’t have government intermediaries like Fannie Mae and Freddie Mac promoting low-document, low-income lending. The role of these institutions in the American sub-prime implosion - making a profit while promoting homeownership - was pivotal. Without having to redress such systemic defects, Australia’s response needs to be tailored, measured and incremental.

Fortunately, despite some ideological posturing, the initial signs are that the Rudd Government appreciates this. Until now the focus has rightly been about targeting the hole in aggregate demand and softening the crisis’ impact on the real economy. When the time comes to consider measures to reform Australia’s banking and financial system, let’s hope that front of the government’s mind is that old adage: if it ain’t (really) broke …