Launching an investigation into credit rating agencies’ role in fueling the financial crisis, Attorney General Edmund G. Brown Jr. today issued subpoenas to Standard & Poor’s, Moody’s and Fitch to determine whether the firms violated California law when they recklessly gave “stellar ratings to shaky assets.”

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By Simon van Norden

Today, we’re fortunate to have Simon van Norden, Professor of Finance at HEC Montréal (École des Hautes Études Commerciales), as a guest blogger.

“Once you’ve seen one financial market crisis…you’ve seen one financial market crisis.”

— Attributed to Federal Reserve Board Governor Kevin Warsh by former US Treasury Assistant Secretary for Economic Policy Phillip Swagel in The Financial Crisis: an Inside View, March 2009, p. 4.

The financial crisis has set a lot of records so far; it’s certainly the worst US banking crisis of my lifetime. Some, as suggested by the above quote, see such crises as unique events; each one is singular and there’s not much to be learned about how to handle one from looking at past crises. For example, there’s no precedent that I know of for a banking crisis involves the failure of the biggest counterparties for credit default swaps.

I think a much smaller number of people see the crisis differently; they think of it as another potato, a big one. No two potatoes are exactly alike in size and shape, but they all taste pretty much the same and you can use the same recipe for most of them. For that reason, it’s interesting to see to what extent the current crisis behaves like other crises, even if it has some unique features.

I think there’s some interesting parallels between the current crisis, the Savings and Loan (S&L) crisis of the 80s and 90s, and the Long-Term Capital Management (LTCM) Crisis of 1998. But before I talk about that, let me talk about what a “typical” banking crisis looks like.

The Basel View of “Typical” Banking Crises

If we set the way-back machine to 2004, a time long before terms like ARM, CDS, and AIG entered common conversation, we can see what people thought a typical bank crisis looked like. That’s the year the guys in Basel who worry about such things published “Bank Failures in Mature Economies.” They looked at the main banking crises in developed countries from 1980 to 2000 and asked themselves what they saw. To be sure, they saw some differences, but they also saw some patterns. Here’s part of their main conclusions (note that “credit risk” is Banker for “bad loans”).

Most of the widespread [banking] failures required some amount of public support, sometimes in very large amounts. All of the episodes that involved large amounts of public support were caused by credit risk problems. …The widespread banking crises that involved credit risk were remarkably similar. A period of financial deregulation resulted in rapid growth in lending, particularly in real estate related lending. Rapidly rising real estate prices encouraged more lending, abetted by lax regulatory systems in many cases. When economic recessions occurred, inflated real estate prices collapsed, leading directly to the failures. (BIS, 2004, p.66)

That sounds a lot like what the US (and some other countries) experienced immediately afterwards. There had been some financial deregulation, which was followed by a period of very rapid growth in real-estate-related lending. Rapidly rising real estate values encouraged more lending. The biggest difference seems to be the last point; the recession did not cause real estate prices to collapse; they had peaked by 2006 and fell before the recession started. We could probably also argue about whether it was financial deregulation or “financial innovation that avoided regulations” that helped fuel the increase in real-estate lending. However, in this view the boom and bust cycle in real estate, the subsequent fallout for the banking sector, and the need for a major publicly-funded bailout is not remarkable; we’ve seen this kind of story before. In fact, Reinhart and Rogoff have gone so far as to tabulate what happens to government debt in the aftermath of a banking crisis. They find that real government debt increases by an average of 86% in the three years after the start of a crisis. So regardless of how you feel about the US government’s spending during the crisis, it seems less remarkable when compared to what typically happens in a banking crisis.

Figure from Reinhart, Carmen M., and Kenneth S. Rogoff. 2009. “The Aftermath of Financial Crises.” American Economic Review, 99(2): 466-72.

Three American Financial Market Crises

More support for the view that banking crises follow similar patterns can be found by comparing the last three US banking crises; the S&L crisis of the late 80s and early 90s, the collapse of LTCM and the most recent crisis. The S&L crisis closely followed the pattern described by the BIS report quoted above; financial deregulation, followed by a rapid growth in real estate lending, creation of local speculative bubbles in real estate prices, and the failure of institutions as bubbles burst (For descriptions of the S&L crisis, see BIS (2004) or the GAO 1996 report). The General Accounting Office put the cost of the S&L bailout to US taxpayers at $132.1 billion, or a bit under 2% of GDP (United States General Accounting Office (1996) “Financial Audit: Resolution Trust Corporation’s 1994 and 1995 Financial Statements,” Table 3 and author’s calculations). That may seem small compared to the size of TARP or this year’s projected federal deficit, but it was shocking at the time.

At first glance, the LTCM crisis appears quite different; no bank failed (LTCM was a hedge fund), its failure was unrelated to real estate investment or credit risk, and the crisis was resolved at no cost to the taxpayer. However, the LTCM crisis showed that, as a result of deregulation, a systemic crisis could start outside the regulated banking system. Another GAO study noted:

The LTCM case illustrated that market discipline can break down and showed that potential systemic risk can be posed not only by a cascade of major firm failures, but also by leveraged trading positions. LTCM was able to establish leveraged trading positions of a size that posed potential systemic risk primarily because the banks and securities and futures firms that were its creditors and counterparties failed to enforce their own risk management standards. (US GAO (1999) p. 29)

The same report noted:

• Gaps in [US Government agencies'] regulatory authority limits their ability to identify and mitigate systemic risk (US GAO (1999) p. 24)
• Regulators did not identify weaknesses in firms’ risk management practices until after the crisis (US GAO (1999) p. 16)
• Monitoring did not reveal the potential systemic threat posed by LTCM (US GAO (1999) p. 17)

and provided a variety of proposals (some of which are mentioned below) to reform the financial system by reducing systemic risks.

The success of those reforms can be judged by role of similar factors in the most recent US banking crisis. An important factor in the latter has been the role of trading in derivative securities, primarily mortgage-based securities and credit default swaps (CDS). Again, government oversight of this market was limited due to faith in the market’s ability to manage its exposure to risk, and was further weakened by divided responsibilities between multiple agencies. Regulators and private lenders alike were again unaware of major firms’ exposure to losses on derivative securities; this time even the heads of major financial institutions were not aware of the extent of their own exposures. Again, this was in part due to the lack of transparency, lack of clearing and high leverage afforded by trade in Over-the-Counter (OTC) derivatives (particularly those traded at Bear Stearns.) Again, weaknesses in firms’ risk management practices became apparent only in hindsight. Again, major financial firms that were not regulated as traditional deposit-taking banks took on highly-leveraged positions and posed major systemic threats to the banking system. These included several investment banks (such as Bear Stearns, Goldman Sachs, Lehman Brothers, and CitiGroup) and the insurance company AIG.

Conclusion

Looking at recent events from this perspective, I still see the size of the losses as breathtaking, but the causes and dynamics seem much more familiar. What bothers me is that some of the suggested solutions sound pretty familiar too; make derivative trading more transparent, improve coordination among the regulators, give regulators more power to control systemic risk in new places, and so on. Despite that, not only was there another crisis, but it was much larger than the two previous crises combined.

This post written by Simon van Norden.

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When a maverick idea becomes vindicated, there’s a good story to tell. It usually involves a person (or small group of people) who courageously challenge the orthodoxy of the day — and, over time, the unorthodox yet better idea prevails.

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Dear reader,
Our friends over at Elliott Wave International (EWI) are offering Bob Prechter’s recent 10-page market letter, free. It challenges current recovery hype with hard facts, independent analysis, and insightful charts. You’ll find out why the worst is NOT over and what you can do to safeguard your financial future. Learn more.

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We are persuaded that the government is waiting for the next wave of failures, or some exogenous event of catastrophic proportion, to provide their rationale to take new aggressive action.

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Tim Iacono submits:

While searching for a good time line of the financial crisis the other day, this paper(.pdf) was stumbled upon containing a most interesting opening item or two:
The genesis of the ongoing financial crisis seems quite clear to some and, contrary to what you might think from the above, this is not some sort of high-level summary – it goes on for another 63 pages, describing in great detail the events of the last couple years.

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Arianna appeared on “Countdown” tonight, guest-hosted by Howard Dean, to discuss the dysfunctional financial industry, and in particular Congress’s battle to ensure that executive compensation doesn’t stem from CEOs making risky moves that are not in the interest of shareholders and that could threaten the system itself.

WATCH:

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The headline exaggerates, but not by much. Back in April, a Vanity Fair story about Iceland’s remarkable financial blow up was grist for a Vanity Fair story by Michael Lewis, “Wall Street on the Tundra“. The quick version is that Icelandic men were not merely reckless, that is such a common male pathology as to barely warrant mention, but were possessed of a particular fondness for physical aggression and bullheadedness that helped make Iceland ground zero for the most spectacular banking industry boom and bust in the history of man. Iceland managed to go on a debt party that saw its obligations soar to 850% of GDP, leaving America at a mere 350% firmly in the dust.

So how is Iceland faring now? One would assume still broke and chastened. One would be dead wrong.

The krona is down 50% from its peak, and it seems to have sparked a speedy revival. I remarked when Iceland fell apart that someone should swoop in and buy a business that sold strictly in international markets (I had thought fish oil would be a good candidate). But that takes time, legwork, and walking around money.

This is the same remedy that the Nordic countries used in their banking crises, save they nationalized the banks, put in new management, cleaned them up, and reprivatized them, But they also devalued their currencies versus the ECU.

But Iceland and the Nordic countries can make moves like that without precipitating competitive devaluations. What works individually does not work collectively.

The EU bashing is a bit heavy handed, but the general comments are nevertheless useful.

BTW, reader Richard Kiine is in Iceland now, perhaps he can give a report when he returns.

From Ambrose Evans-Pritchard at the Telegraph:

The krona has fallen by half against the euro since the `New Viking’ trio of Landsbanki, Glitnir, and Kaupthing strayed out of their depth and brought down Iceland’s financial system.

Nothing is cheap, but prices have come within reach. Reykjavik’s cafés are packed with euro-youth, at last able to afford a taste of all-night dancing at this Arctic Ibiza…

Out in Iceland’s Eastern fjords, Alcoa has raised aluminium production to record levels – and metal matters as much as fish for exports.

“The smelters are running full speed,” said the new-broom finance minister, Steingrimur Sigfusson. So is Mr Sigfusson himself. Last week he launched three new banks on the ruins of the old. Normality is returning. “We are going to get through this better than feared. We’re feeling real activity in the economy, and much of this comes from a favourable exchange rate,” said Mr Sigfusson.

Iceland’s great lurch towards casino capitalism over the last decade has a cultural logic. “We are a fishing culture: when the herring is there, we take it,” said Andri Snaer Magnason, author of `Dreamland: A Self-Help Manual for a Frightened Nation’.
There was no easier catch on offer than the Greenspan bubble and the global “carry trade”. How could fishermen resist?
In one sense it was a terrifying shock for the 310,000 inhabitants of this Norse-Celtic outpost of lava rock to see their currency, banks, and global image crash in a single week last autumn. Yet nothing has really changed.

“Everything still feels normal. The services of the state are intact. The swimming pool is open. You can still have a decent heart attack in Iceland,” said Mr Magnason.

“Friends who lost jobs in banking have already found new work, and you could say the krona has worked as a buffer for us. We all went down together, and that has led to healthier recession without mass unemployment.”

The jobless rate has risen to 9.1pc. This is below the eurozone average of 9.5pc, and is stabilising much earlier.

Those who point to Iceland as a scarecrow exhibit of what happens to a small country caught in a financial storm without the shield of euro membership have the matter backwards, as will become ever clearer over the next two years.

The OECD expects Iceland’s economy to shrink 7pc this year. This is much better than Ireland at minus 9.8pc, and recovery will come sooner. So next time you hear the Sacra Congregatio of the euro faith incant yet again that EMU saved Ireland from a terrible fate, know that they deceive only themselves.

You take your punishment early with devaluation, as Britain did on leaving Gold in 1931, or ending the D-mark torture in 1992, or now. You look a sorry sight at first, but sweet vindication comes later.

It is those caught in a deflation trap with fixed exchange rates that face slow asphyxiation, and deeper social damage. Youth unemployment is already 34pc in Spain, 28pc in Latvia, 25pc in Italy, 24pc in Greece, and rising.

At Iceland’s central bank – mercifully, no longer listed beside al Qaeda as a terrorist body by UK authorities – Governor Svein Harald Oygard says currency therapy is working as it should. “If you lean back and look you can see that fall of the krona accentuated the shock at first, but it is also now working as a turbocharger for recovery.

“We’ve seen a strong hit on wealth and asset values, but the story for real economy is very different.”

Devaluation is always double-edged. Some 13pc of households in Iceland hold mortgages in euros, Swiss francs, or God forbid, yen. Their debt levels doubled overnight.

Some 70pc of corporate loans are in foreign currencies. Exporters are hedged. Those that earn in krona are not, and a “large number” are now in dire straits.

The Governor is a Norwegian who cut his teeth in the Oslo banking crisis of the early 1990s. He was brought in as a troubleshooter after the last crew was literally banged out of the Sedlabanki by the Saucepan Revolution in February.
With justifiable pride, he showed me the latest trade figures. Iceland has defied the global shipping crash to eke out an 11pc rise in exports over the last year. Even China has seen a fall of 21pc.

Iceland will be back in surplus by next year, from a peak deficit of 25pc of GDP. You could say the same about Latvia, which has stuck to its euro peg under orders from Brussels. But there is a big difference.

Latvia is balancing its books by crushing demand. Exports are down 28pc, but imports are down even more. The result of this Stone Age policy is economic contraction of 18pc this year, and 4pc in 2010 (state data).

Icelanders have taken a hit, of course. Unions have accepted ‘real’ wage cuts of 10pc. Health care and welfare is being cut 5pc, education 7pc, and the rest 10pc. This is comparable to what is happening in Ireland, but again there is a difference. Dublin faces a Sysphean task as collapsing tax revenues force ever deeper austerity: Reykjavik is over the worst.

It baffles me why rating agencies still talk of downgrading Iceland’s debt to junk. The country should emerge with public debt of 80pc to 100pc of GDP – much like Britain. Yet Iceland also has the world’s best-funded pension system at 120pc of GDP. It is the two together that counts.

In their angst, Icelanders look wistfully at the apparent safe port of EU membership. The Althingi has voted to start entry talks. But the storm will have blown over well before an EU referendum is held in two or three years. By then the delayed cluster bomb of Europe’s unemployment will have detonated. Try selling EU protection then.

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Martin Weiss writes: Just as the authorities were touting the “end of the financial crisis,” all heck has broken loose again …
We have a new surge in unemployment, and even without counting those who are excluded from the official numbers, 14.7 million are now jobless, the most since records dating back to 1948. Worse, for the first time since the Great Depression, every single job created after the prior recession has been wiped out.

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