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How did the banks mess it up?

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.

23 thoughts on “How did the banks mess it up?”

  1. It is really sad to see how the banks were allowed to get so out of hand in the US. I find it appalling how much they took advantage of people. To me that is just wrong. I wouldn’t be able to sleep at night. I am lucky living in Canada because we do have regulated banks here and we are protected from scams like this. Thank goodness,.

  2. Hmm @Miss T. I am sure Canadian regulation will be better than the relative free-for-all allowed in some more unmentionable markets but I guess Canadian banks will still use fractional reserve banking and may have bought some toxic loans.

    It may just be that the capitalisation in Canada is more conservative and/or they didn’t buy that much so can cover their losses. So it is a matter of degree really but the banks that have been ‘supported’ by the taxpayer or central bank have been rather more careless with their privileged position. And I remember talking to someone from the NatWest Bank in about 2007 who was quite sure that there were no problems. NatWest is of course owned by the Royal Bank of Scotland. 😛

    • Welcome @DrS – yes they are notorious as well for being incredibly inefficient, hiding behind their vast earnings. See my recent posts (click on the Tax tag in the cloud)….

  3. S&P, Moody’s & Fitches all knew that the CDMs they were packaging were a few good mortgages packaged with a lot of junk mortgages but looked the other way because they relied on fees from the very investment banks that were asking for favorable ratings!

    • I’ve heard this before and clearly the system is prone to such corruption.

      S&P, Moody’s and Fitches should be prosecuted and called to account and a better model should be found to fund the ratings agencies.

      Ultimately the regulation of the financial system needs funding by the financial system itself. Perhaps some of the tax moneys I have suggested could go this way.

      Whatever, the idea that the investment banks pay the agencies to rate their own ‘products’ is corrupt.

    • @Marissa – I think it will take at least 10 years to recover although I hope I am being pessimistic. Meanwhile the economic centre will move east (well I guess west from a US perspective) to China, India and the like.

      While you are understandably concerned for the future generations, the present generation has had other problems to deal with. As survivors, we forget those who have already fallen through the net left by the previous generation – fallen in total war which hasn’t occurred since ’45, the serious poverty of the ’20s and ’30s, diseases now largely solved. This may be ancient history to some but it is real all the same.

      Things are a lot better now at least in some parts of the world so we need to celebrate it. This banking problem is a large issue that has to be dealt with. It was predictable at some point but no-one wanted to look at the consequences because all the ‘leaders’ hoped it wouldn’t happen on their watch.

  4. The marketing of loans that had no income verification started this mess! Selling these loans as AAA just made it worse. I would like the originator of the bad loans to get the worst of it, but that won’t happen.

  5. The rating agencies are a bologna. They need to unbiased and truly independent. They are rating the people who pay them. Of course they would provide the person paying them a favorable rating. An effective bank regulations is no more bailouts. Speculation should never be rewarded with assistance.

    • It’s the first rule of any science, logic or whatever isn’t it?

      But I haven’t heard so much as a whisper about this. Why not, I wonder?

      Mind you it is not an easy thing to do – the evaluation of risk I mean.

      Firstly to do it properly is technically very complex requiring essentially a world economic and political model. Gulp – that assumes the model is right so you need a population of models all driven by people who genuinely don’t know what the other folk are doing.

      Secondly it needs full and frank disclosure and confidentiality.

      All this smacks rather too much of big brother. So we are left with guess work and judgement but again many of the people guessing and judging have been to the same schools, read the same textbooks so will likely come to a similar conclusion however the funding is found….

  6. I think that banks have too much freedom really. They set the rates without regulation, sign people up for loans they can’t service and pay off their debt with other peoples money. I doubt it will ever really get better, we as consumers just have to get smarter.

  7. Thanks @Shaun. We can of course move to more ‘obedient’ banks if such can be found, but also we (ie the legislators whom we elect) can impose taxes on them if they step out of line – hence the Three Taxes proposals. If they misbehave that can have an immediate effect whereas most customers (and we are just the small guys of course) stay put so competition doesn’t really work.

  8. There are a lot of good points here and I think the banks, mortgage brokers, rating agencies, etc… own a fair share of the blame. But, to play devil’s advocate for a moment, there are certainly plenty of individuals out there that damn well knew they could not afford the house and the mortgage they signed on to with no-money-down. I mean, if you are making $30k/year and have no down-payment or a really small (<5% of purchase price) down-payment, then what makes you think you can really afford a $750,000 house? It defies all common logic. And of course the banks and mortgage companies are to blame as well for underwriting that loan.

    • Welcome Neo – all devil’s advocates gratefully accepted! The example you gave of a mortgage of 25 times income I hope is an extreme. I had heard of 12:1. Of course if that $750,000 house increased in value along (then) historical lines, the owners would be laughing and able to downsize to a mortgage-free property. But that’s not what happened.

      I read recently that 16% of Americans still suffer from negative equity. Now I am sure many of these can meet their mortgage payments at least semi-comfortably and while they had an expectation that prices would increase which would give them security, at the moment they just can’t move. I know there are schemes available to enable you to re-mortgage at a lower interest rate but I don’t think such schemes are portable to a new house. This means that people are stuck where they are.

      Property prices particularly in the US, Spain, Ireland have taken a real tumble and it will take 10 years for this to be recovered. The situation in that respect is a little better in the UK because there is a continued shortage of housing and quite strong regulation of where building is carried out – we are nostalgically attached to our green and pleasant land! So while there has been some easing of house prices – perhaps on average 20% – and not a lot of sales going on right now, that aspect is not uppermost in peoples’ minds.

      Our issue is that unemployment to a large extent initiated by cuts in public sector funding of 25% over 4 years. It is a big worry not only for the public sectore but also because many private sector jobs depend ultimately on the public sector. And then of course there is the continued recession – or near recession – in our Eurozone customers. 🙁

  9. Unfortunately, in the US we saw plenty of cases of 200x leverage, mainly because people were doing back-to-back mortgages. Taking a small mortgage for the downpayment and then another mortgage for the other 80% of the house… A real mess.

  10. Ouch! Is there no legal charge placed on properties?

    I think this is impossible in the UK. When you take a mortgage out a charge is placed on the property with the Land Registry. Any second loan has to be agreed by the first mortgagee and the seniority of claim has to be established. It is possible to have two loans to start with but again both mortgagees have to know about it and agree.

    While people were clearly stupid and/or greedy to do this in the first place, the mortgage broker or agent must have known about it and I would have thought there was a clear case for a class action and for them being disbarred from practising as a financial advisor in any form.

    You can leverage 200x on FX and stuff – that’s pretty risky IMHO – but to do it on your property is mad. If you can do this in the US no wonder it fell apart!

  11. Ah – I see. Thanks for this @Neo

    Some googling shows that they do (or have) existed in the UK but before the crash some lenders were willing to go towards the 100% anyway (at an elevated interest rate or people had to take insurance policies out) so they were not so necessary. Northern Rock which had to be nationalised was well known for this habit. I gather in the US mortgages generally max out at 80% LTV.

    Although this can be effectively infinite leverage at 100%, and self-certified mortgages were available here for a few years, I’ve still never heard of anyone at least blatantly getting a mortgage 25 times their income. Apart from anything else, big houses have big costs and I doubt they could afford even to heat the house, let alone maintaine it. I guess they were just gambling on flipping it. Maybe there were some who were unscrupulous or had crooked accountants… 😛

    Interesting stuff!

  12. At least in the US, rating agencies were calculating risk based on a flawed formula. There was certainly preditory lending, but there was also a lot of consumer over-reach. Most people defaulting on their mortgage when the bubble broke were young, educated adults with good future income prospects.

    • Hi @Shaun – great to see you!

      I suspect the formula was over-simple. As I said somewhere before, in the UK, if you have a mortgage and haven’t slipped a payment you pretty well have a gold-plated credit rating and get inundated with offers for credit cards, financial ‘products’ and so on. Which begs the question of how you get to have a mortgage in the first place.

      The modelling of credit scores is the subject of much academic research but very little implementation by the banks because the models are generally extremely complex.

      One of the more interesting credit cards is actually Capital One who use their card limits. interest rates and other parameters to carry out loads of experiments – some 6000 a year I think – so they can optimise the return on their business. An unusually sophisticated approach I think but I know the guy who does a lot of consultancy for them so I am pretty sure it will be a properly conducted experiment and analysis.

      Direct Line Insurance have their own scales for motor vehicles derived from their own observations and do not depend on the industry ones. Some companies are better than others in these respects.

      It may well be that a healthier attitude to failure and bankruptcy in the US helps in the default scenario. Young and educated people may have taken a risk and accepted their mistakes. They may also get back on their bikes and start again. I suspect that over here the people who defaulted will be older, possibly with kids (which gives some ‘protection’) and more likely to give up. I may be wrong but whereas the attitude towards business in the US is much like walking, which is a process of not-falling-over but accepting that to learn to walk you have to learn to fall over, over here there is much more stigma attached to failure so people don’t take so much risk. That means they don’t know how to handle failure so well either.

      ‘Nuff said!


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