Home / Regulation / Causes of the Credit Crash, Part Three: the Governors

Causes of the Credit Crash, Part Three: the Governors

Having had a nice Easter break, this was going to be a short entry about the regulators role in the credit crash … but
it’s really, really long.  Sorry.  But it does start to get to the
heart of the matter.

So, what’s the real problem here?

Is it the machines, the humans?  The banks,
the citizens?  Or the regulators?

Well, the regulators do have a lot to answer for,
as they create the conditions in which the market operates. 

As Jeff Jacoby points out in the Boston Globe, the Community
Reinvestment Act (CRA) of 1977 created the credit focus amongst the US banks,
as it prohibited banks from only targeting wealthier areas.  This
targeting was a practice known as ‘redlining’ and, under the CRA, banks were
graded on their attentiveness to the ‘credit needs’ of poorer areas.  As a
result, banks were viewed as being more community oriented, and graded higher
accordingly, if they focused upon offering riskier loans to poorer folks.

This maybe one reason for the time bomb of mortgage debt, as Jeff concludes with the line: "And all of it thanks to the government, which was sure it understood
the credit industry better than the free market did, and confidently
created the conditions that made disaster unavoidable."

Equally, we could say the same in the UK, as the
situation that created today’s issues could be viewed as being sown through the
seeds of deregulation back in the 1980’s.

In 1986, the UK government deregulated the
Building Societies.  In 2007, the firms being viewed as most at risk –
Northern Rock, HBOS (Halifax), Alliance & Leicester and Bradford &
Bingley – are all converted building societies.  These firms also all have
leveraged mortgage books.  For example, when Northern Rock hit rock bottom
last September, here were the loans to deposits ratios of each bank:

    Loans         Deposit to Loan
        (£ bns)      
(£bns)              Ratio
Northern Rock          
£1 – £3.25
211.9          376.8         
£1 – £1.78
Bradford & Bingley    
    £1 – £1.63
Alliance & Leicester      
46.4          £1 – £1.57
Lloyds TSB            
  £1 – £1.35
446.9          £1 – £1.16
282.3          £1 – £1.10
442.4           428.2
         £1 – £0.97

As can be seen, the banks with the greatest
exposure were the ones that were originally buildings societies who

Before the Building Societies Act (BSA) of 1986,
these societies focused upon mortgages based upon coverage by deposits.
Now, as proprietary banks, they were seeking to increase returns to
shareholders and lower cost-income ratio by doing the opposite: as in promoting
mortgages based upon a leveraged loan book.  The fact they could leverage
that loan book using cheap access to credit in the interbank markets was also part of the
bubble that burst in 2007, some might say. 

Both Acts – the CRA and the BSA – could account
for some of the seeds of this crisis therefore and, whatever your view, the
fact is that we sit here today with market conditions that allowed banks to
create a loans crisis of over $1.5 trillion and that is now being bailed out by
the Central Banks and taxpayers.

The governors must take some blame here therefore,
as they are meant to govern the markets.

The Governors
are all those in power who are meant to manage the markets: the politicians,
the lawmakers, the law enforcers, the regulators, the policymakers and so
on.  A disparate bunch with little consistency.  And yet, critically,
this disparate bunch of governors are meant to protect the hard-earned savings,
pensions and investments of Mr. Jack and Mrs. Jill, the citizens.  And
they do not seem to be doing very well at it.

After all, you would think that where you see an
economy ‘fuelled by consumer demand’ based upon ‘rapidly rising debt’
and supported by ‘house price inflation’ that someone would say,
hold on a minute.  It’s the emperor’s new clothes.

For example, the Economist’s main story this week is about the
Wall Street crisis, and quotes research from Canadian firm BCA Research.
This research identified that America’s financial services industry grew from
10% of all of America’s corporate profits in 1980 to 40% last year.  Its
stock market value grew from 6% of all American equity to 19% during the same
period.  Yet, financial services only accounted for 5% of jobs in the
private sector, and only 15% of corporate gross value-added.

What should have stopped such growth was the
dotcom bubble bursting, which meant that consequent American corporate growth
slowed.  Instead, financial markets carried on careering over the hill,
happily making billions whilst everything else stagnated.

This was because the continued, unabated profiteering
in the financial markets was being secured by debt, with financial sector debt
rising from a tenth of the size of non-financial debt in 1980 to half of all
debt today.  In other words, financial markets were bubbling over with
wealth fuelled by debt.  Goldman Sachs’ $40 billion of equity allowed them
to leverage $1.1 trillion of assets, whilst Merrill Lynch’s $30 billion of
equity pumped $1 trillion of assets around the markets.  This leveraged
gearing is like a magic carpet during good times but, someone pulls the rug
away, then the drop is sudden. 

The emperor’s new clothes: look we’re all making
money!  But look, it’s all based upon borrowing, so there’s no real money

Suddenly, the tide turns, the borrowing isn’t
there and everything drops faster than Colin Farrell’s underwear.  And the
fact that no-one kept this in check means that the governors must take some, or
even most, of the blame.

Part of this is because of the fragmentation and
lack of coordination of the governors; and part of this is that regulators no
longer understand what they are regulating.  This was admitted by the Bank
of England in light of the Northern Rock collapse, and appears to be admitted
by the Federal Reserve in light of the Bear Stearns debacle. 

First, the UK demonstrated a critical regulatory faux
with Northern Rock. 

This was a situation created by a triumvirate of
buck passing between the Bank of England, the Treasury and Financial Services
Authority (FSA), where each could hand-off and blame the other for missing
things between the cracks of their authority. 

The Northern Rock example is an interesting one
because they lent on the basis of the risk model being one where the UK housing
market might collapse.  As a result of looking at this risk, they estimated
they had to cover only 40% of their total borrowings: the amount of a
correction in the UK housing market in worst case scenario, forecasted by their
risk analytic models.  The fact that they never took into account the
tightening of the lending markets, particularly short-term lending, was their
fundamental flaw.  This is why, when they went belly-up, Northern Rock had
lent £3.25 for every £1 on deposit whilst only having £1.5 billion of
‘liquidity insurance’ against their £90 billion mortgage portfolio. 
A recipe for disaster as it turned out.

Yet Northern Rock was applauded as a great UK bank with the best
cost-income ratio for years.  How come no-one spotted this risk?
Because no-one thought credit would dry up? 

Well, the FSA and Bank of England showed some concern in early
2007, but the fact that no-one foresaw a squeeze on interbank lending
just shows a basically mistaken hypothesis.   

The fact that the
FSA, Bank of England and Treasury all acted independently meant that,
when Northern Rock entered into crisis mode, no-one acted in a
coordinated manner.  The FSA tried to broker a deal for the bank to be
acquired with Lloyds TSB, but the Bank of England felt they could not
allow this.  They then went public with their need to be lender of last
resort for Northern Rock which meant the bank’s security became
questionable.  The Bank of England blamed this on EU disclosure rules,
which was incorrect, and the Treasury were made to look like idiots as
it resulted in the first UK bank run for decades.

The Bank of England blamed this on EU disclosure
rules, which was incorrect, and the Treasury were made to look like idiots.

The real issue, as disclosed later by the Bank of
England, is that they didn’t understand the markets.  CDOs, SIVs, Credit
Default Swaps, Hedge Funds and all this leveraged, global debt and risk was
beyond the ability of their little grey cells to understand.  Equally, the
FSA seems culpable of the same basic views of the markets, with little real
knowledge of the depths underneath, as demonstrated by their reaction to the
most recent rogue trader scandal.

So this is the crux of the regulator’s issue: how
to keep up with markets that are changing rapidly, are linked globally, and
have products that are so complex only rocket scientists can understand them?

Which brings us to the governors of Bear Stearns.

For a long time, everyone thought the SEC had
cleaned up Wall Street, thanks to their lightning rod leader: the New York
State Attorney, Eliot Spitzer.  Rod being the operative word as it turns
out.  Nevertheless, under Spitzer, everyone thought Wall Street had been
cleaned up. Not really.

Now, in a post-Bear Stearns market, you have
people like Barney Frank, who chairs the Senate’s financial services committee,
saying: “To the extent that anybody is creating credit,
they ought to be subject to the same type of prudential supervision that now
applies only to banks”, with the Federal Reserve empowered to act as the regulator.

Some might wonder why
credit firms aren’t subject to the same prudential supervision as the
banks, which brings us to the same point as the Northern Rock issue.
The USA has a regulatory market
between the Treasury, the Federal Reserve and the SEC, just like the UK was
split between the Treasury, the Bank of England and the FSA.  Again, many are now saying that this is a recipe for regulatory disaster.

This is why the U.S. Treasury is saying that there
will be broad changes to the regulatory structure in the near and short term,
in light of the subprime credit crisis and, particularly, in light of Bear

What happened to Bear Stearns is a similar case in
point to Northern Rock.  Again, Bear Stearns were exposed because of their
huge exposure to the Structured Investment Vehicles (SIVs) and mortgage books
of the subprime American markets, and now Merrill Lynch and others have also been

Investors lost confidence, removed funds in droves
and started another bank meltdown that was averted from total explosion by the
bailout by JP Morgan at the last minute … thanks to the Fed’s $30 billion
line of credit providing a step in to support JPM’s bid.  It was this last
piece that changed things fundamentally in the US, as governments do not prop
up the banks and have not done so since the Great Depression of 1929 which
resulted in the Glass-Steagall Act … funnily enough, an Act that was meant to
separate brokers, dealers and investment houses from insurance and general

Now, it appears that the Federal Reserve have determined that the
SEC cannot manage the investment markets, as investment markets are so intertwined with retail and insurance.  After all:

Your mortgage bones are connected to your derivatives bones,
Your derivatives bones are connected to your investment bank bones,
Your investment bank bones are connected to your monoline insurer bones,
Oh, hear the word of the Fed.

The bottom-line is that regulators are too fragmented, uncoordinated,
with little or no real knowledge of the markets they are meant to be
regulating.  This is why they have made a strong contribution to the
issues arising in the markets today, especially as many think they can
control the markets … often only in hindsight however.   

The overall view therefore, is that regulators are
fragmented, uncoordinated and have no knowledge of the markets they are meant
to be regulating.  This is a recipe for disaster, and a strong
contribution to why we have seen the issues arising in the markets.

The result is that we shall see a swathe of new
regulations coming downstream in light of the market crisis of 2007-08 (note:
good news for all tech firms – new regs always means new systems sales!)

Already, the Federal Reserve and Treasury are
working closely with Wall Street, around the SEC.  This new regime will
probably not come in until the current administration moves out, but when
George W hands over to whoever then there will be change in 2009.

The UK has also proposed major structural changes to the banking regulatory environment in January, with the British Banker’s Association responding in March, and draft legislation likely to be released during the next Quarter.

Equally, Europe has agreed to improve the regulatory structures beyond today’s multitude of Directives through four principles which will:

  • improve transparency with respect to banks’ exposures relating to securitisation and off-balance sheet items;
  • upgrade valuation standards to respond to any problems arising from the valuation of illiquid assets;
  • strengthen the prudential framework
    for the banking sector, including the treatment of large exposures,
    banks’ capital requirements for securitisation, and liquidity risk
    management; and
  • investigate structural market issues, such as the role played by credit rating agencies and the ‘originate and distribute’ model.

Therefore, the regulators will change regulatory
regimes as a result of the credit crisis, but will never solve the
issues.  Why?  Because:

(a) they will create risks in the market that will
only come to light much later on in hindsight, such as the issues of today that
date back to the 1970’s and 1980’s regulatory structures;

(b) there are too many gaps between regulatory
offices and not enough integration or ‘joined up’ thinking;

(c) regulators do not understand what they are
regulating anymore anyway, as CDOs, SIVs and Credit Default Swaps were way
beyond them … who knows what they would make of algorithmic quant analytics;

(d) the most fundamental issue: they are domestic.

Domestic regulators cannot regulate global
markets.  Global markets need global regulation and, today, there is no
ability to globally regulate.  In fact, we cannot even regulate
effectively across Europe.

When we live in global markets, with risks being
moved between firms, across geographies, instantaneously and in real-time, to
have regulators who cannot even regulate effectively domestically means that we
have to rely on market self-regulation.  And the issue with
self-regulation is that, when times are good and markets are running away with
profiteering, who the hell cares about giving up their millions just to keep
the governors happy? 


About Chris M Skinner

Chris M Skinner
Chris Skinner is best known as an independent commentator on the financial markets through his blog, the Finanser.com, as author of the bestselling book Digital Bank, and Chair of the European networking forum the Financial Services Club. He has been voted one of the most influential people in banking by The Financial Brand (as well as one of the best blogs), a FinTech Titan (Next Bank), one of the Fintech Leaders you need to follow (City AM, Deluxe and Jax Finance), as well as one of the Top 40 most influential people in financial technology by the Wall Street Journal’s Financial News. To learn more click here...

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