‘a. business % school |ece-1074 CAUSES AND CONSEQUENCES OF THE CREDIT CRUNCH Original wetton by pretessors Barbara Huerta de San mao e Ignacio de la Tore a IE Business School ‘Original version, 29 Maren 2009, Transiated, May 2009. Last revised, 20 July 2008, Published by I Publishing Department. Maria de Molina 19, 28006 ~ Madi, Spain. (©2000 IE. Total or paral pubcaton ofthe document whut the express, writen consent ot Ef prohibted INTRODUCTION Now, my dear, | must say that lately | have been having a great deal of luck in finances. Sir Harry McGowan asked me, before | left, that if the opportunity arose, whether he could buy shares on my behalf without asking me first. | told him that I could always obtain two or three thousand pounds sterling. | mentioned it as a limit on the investment, that is to say, the maximum outright purchase of shares. He clearly understood the figure as the limit I would be willing to go up to in the case of a credit purchase on margin. He therefore multiplied my usual scale tenfold (...] and in just a few weeks we have earned a small fortune’. The letter this quote is taken from was written by Winston Churchill to his wife one month before the 1929 stock-market crash. In it, the British politician was referring to how easy it was to make money on the stock market by means of "leveraged" purchases where the investor (Churchill) put up some money of his own (two or three thousand pounds) and the bank multiplied this bet with a loan. Thus, if the sum invested, say 200,000 or 300,000 pounds, yielded a return of 20% on the stock market, the profits would be between 40,000 and 60,000 pounds. A small share of this would have to be repaid to the bank as interest, but the rest would be profit for the investor: "a small fortune.” Obviously, this kind of leveraged strategy worked well during a period of strong economic growth and rising markets. However, in a downturn, the risk for both the investor and the bank was huge. In the event of a fallin the stock market they would both lose their money, resulting in panic; which is precisely what happened in October 1929. What followed was known as the Great Depression, and the world described here unfortunately sounds very similar to that experienced between 2008 and 2007. In Boston in the nineteen twenties a young Italian immigrant, Carlo Ponzi, managed to convince a ‘number of other Italian-Americans to deposit part of their savings in Spanish stamps. According to Ponzi, these stamps were an asset class that offered a more attractive retum than other types of investment, such as shares or treasury bills, which had already risen sharply, making further returns more difficult. To convince sceptics, Ponzi guaranteed a return on investments in the stamps. As might be imagined, the savings deposited by the most recent investors were used to pay the returns promised to earlier investors in the stamps; the scheme being run was therefore a pyramid scheme. Why is this story from almost eighty years ago so chillingly similar to the more recent cases of Forum and Afinsa'? The answer is simple: human nature is the same, and financial cycles, which * Quoted by P. JOHNSON, Modem Times (Translated back into English from the text quoted from the Spe translation, Tiempos Modemos,p. 286). * Two Ponzi scheme scandals occurred in Spain in the early XX! century, generating more than Eur. 2bn losses for retail investors, shIE Business Schoo! ‘CAUSES AND CONSEGUENGES OF THE CREDIT CRUNCH ] ece-t074 ate very similar to economic cycles, but much less well understood, repeat themselves over the course of history. This book aims to identify the patterns defining these cycles so as to understand the credit crisis the world has been suffering since the summer of 2007. Understanding the causes, effects and consequences of this crisis will be crucial to the world that will emerge. Major financial debacles usually bring bad news with them, mainly in terms of the devastating effect a banking crisis has on the economy. But times of crisis are also times in which new business opportunities can emerge. During the weeks in which the future of banking is being defined, those financial institutions which are able to internalise the implications of the financial crisis for the world economy most effectively will be those which will have a stronger position from which to lead the industry in the 21" century. In the autumn of 2006 money invested in emerging market bonds offered a return just 1.3% above that on money invested in US government bonds. How can we explain how countries where ‘common sense ought to tell us there is a risk of default can obtain finance with such a small increment on that paid by the US government, which has never failed to pay its debt? The answer lies in excess liquidity. When the money supply is normal, assets are assigned prices that are rational, in the sense that there are notable differences between the return on emerging-market debt (where there is a bigger risk of default) and US debt. If the money supply keeps expanding (i.e. money is cheap) once "rational" prices have been reached, this will keep driving the financial market to search for better returns. The problems start when the search is based only on returns and not on a calibration of the risk of the assets, as this is the point at which the seeds of a financial crisis start to be sown. Something similar happened when billions and billions of dollars poured into subprime mortgages in the US. Once the bubble had burst everyone agreed that it made no sense to have put so much money into mortgages which had such a big risk of default, but very few people had been able to predict events before the crisis exploded. CAUSES OF THE CREDIT CRUNCH Rather than trying to formulate complex macro- and micro-economic hypotheses explaining the ‘causes of the credit crisis we intend to examine it here from a much more individual perspective, namely that of the reader. You will put yourself in the shoes of some of the key players in the credit crisis in specific situations, and you will need to respond to the dilemma each individual faces. After these stories and the decisions you have taken we will try to recap to give a uniform explanation that will help give an understanding the main factors leading to the financial crisis. Before we star, it is worth briefly mentioning the ratings agencies Moody's, Standard and Poor's and Fitch IBCA~ which are responsible for analysing debt issues and giving issuers a rating based on their risk profile. This rating ranges from a top rating of "AAA" (which is given to the very lowest risk issuers, such as the US government) to "D" (a company on the verge of bankruptcy). Central banks lend money to commercial banks. However, these need to back these loans with collateral in the form of instruments with a top credit rating from one of the three credit rating agencies (and only these three). In practice this fact results in there being an oligopoly. This explains the errors made by the agencies in the ratings they gave to many bond issues. At the same time, because the issuer pays the agency's fees, there is a powerful conflict of interest as the threat that the issuer may turn to a rival agency may affect the rating given to the issue. We will look at the role of the rating agencies in more detail later. THE BANK MANAGER'S DILEMMA: GRANTING LOANS DURING PERIODS OF CHEAP MONEY Imagine you are the manager of a bank branch. Over the many years you have been working for the bank you have seen periods in which the focus has been on attracting deposits and others where there has been more emphasis on giving loans. You know that interest rates are a crucial factor in deciding whether one goal or another prevails. Since 1995 you have seen how the policy has been focused primarily on expanding the loan portfolio. The year is 2004 and EuropeanIE Business Schoo! ‘CAUSES AND CONSEGUENGES OF THE CREDIT CRUNCH ] ece-t074 interest rates are at all-time lows, encouraging cheap money and successive waves of liquidity Against this backdrop you have already drawn upon the pool of customer deposits to grant very moderate risk mortgages, and have taken the utmost care to ensure that these mortgages were only given to individuals with a steady job and on no account did the value of the mortgage exceed 80% of the value of the property. However, the money supply continues to expand, and you still have access to new funds at very reasonable cost (around 3%) and are not sure how to exploit this opportunity. You have to make a decision on an application for a consumer loan with an interest rate of 6% which the applicant says he wants in order to buy new furniture. The applicant's ‘employment background is not very strong, but you know that it you do not give him the loan another bank will. Moreover, if there is any possible problem of non-payment the excess liquidity will allow the individual concemed to obtain further loans from other institutions, thus almost completely eliminating the risk of default. In this context, the only situation which might cause the individual to default would be if all banks suddenly found it hard to obtain liquidity, as this would make it dificult for him to meet his monthly repayments. However, you know that this scenario is unforeseeable. How could all banks have difficulty obtaining liquidity at the same time? The application is waiting on your desk. Will you agree to the loan? ‘THE CHINESE CENTRAL BANK TREASURER'S DILEMMA: WHAT TO DO WITH CURRENCY RESERVES Imagine you are the treasurer of the Chinese central bank in early 2003. After years of strong export-led economic growth, your country has managed to build up a huge pile of foreign currency reserves. Politicians are comfortable with this, as in theory these reserves give the country the solvency it needs so as not to have to rely on the Intemational Monetary Fund in the event of a crisis, as happened in 1998 in Indonesia or Thailand. However, this monetary bonanza means you are faced with a dilemma: where can you invest all this money, the volume of which continues to {grow at an impressive rate month after month? Signs of inflation have begun to appear in China, Suggesting that it would be wisest to avoid investing in Chinese assets (as putting all this money into circulation in China could cause even more inflation and the risk of surplus investment, as ‘experienced by Thailand in 1998). However, the desire to keep a fixed exchange rate between the Chinese currency (RMB) and the dollar suggests that the logical thing to do would be to invest in ‘American assets, so as to maintain the exchange rate belween the Chinese currency and the dollar (monetary stability is a key policy when it comes to attracting investments and maintaining the rate of exports), Given the strategic nature of a central bank's reserves, risky assets such as shares or venture capital, have to be ruled out. This leaves the bank with few options other than buying US treasury bills. However, something is bothering you. if you use all the available liquidity to buy US bonds, this will drive up their price, as the cash injection will raise bond prices, from which it can be deduced that the interest on them will drop. As the central bank has other goals and does not aim to maximise its returns this is not an unassailable obstacle, but if US interest rates fall too far there is a risk that US citizens will take advantage of these low interest rates to take on huge amounts of debt to buy cars, houses, holidays, etc. The US government could even finance a possible invasion of Iraq more economically if the confrontation with Saddam Hussein turns into war. If people buy these ‘goods with what they produce, that would be a good thing, but if they buy them using debt, it is a cause for concern, as it could lead to bubbles in the medium term which might be very dangerous for the US economy (which is the main importer of Chinese goods) and for the bonds themselves. When you put these concerns to the Economy Minister, the minister replied as follows: If the best investment option is in US bonds, and the fact that the Central Bank of China is buying them results in lower interest rates, and these interest rates allow ‘Americans to buy more, whose products will they buy? China's of course. This scenario is the best one for us, as deploying our reserves to buy US assets will allow Us to increase our exports, encouraging Chinese economic growth.IE Business Schoo! ‘CAUSES AND CONSEGUENGES OF THE CREDIT CRUNCH ] ece-t074 Alter listening carefully to the minister, you put think about these arguments. A decision needs to be made, will you invest China's currency reserves in US bonds? ‘THE FEDERAL RESERVE'S DILEMMA: AN EXCESS OF MONEY Since the demise of the gold standard, the price of money has been determined by central banks. When setting interest rates, central banks have taken two factors into account -offically or semi- officially: consumer price inflation and economic growth (as an indicator of the level of job creation). It a period of strong economic growth (such as that which began in the second half of 2003) is not accompanied by an increase in inflation, the central bank can afford to keep interest rates low. This will make liquidity abundant in the system, accelerating growth and thus contributing to reducing the level of unemployment. In theory, periods of strong economic growth tend to lead to a shortage of factors of production (capital and labour), which in tum drives up inflation. However, in the period with which we are concemed (2003-2006), the effective integration in the world economy of countries such as China, India, and former Soviet satellite states, was enabling access to products manufactured by individuals with salary costs well below those paid in western countries. These days a graduate in computing from the University of Madrid does not have to compete with another ‘graduate from the University of Bareona, but with a graduate from Buenos Aires who is able to do the same job for seven dollars an hour, compared with the twenty dollars the graduate from Madrid expects to be paid. A company wanting to redesign its website will need to consider both offers, and the only way in which the Madrid graduate can win the business is to be able to demonstrate that his productivity per hour is at least three times that of the Buenos Aires graduate. Western consumers have benefited from this process as they have paid highly affordable prices for items such as toys or textiles, without the extra demand pushing up prices. And emerging countries, have also benefited, as they have been able to build a model of economic growth based on ‘exports. As a result of this process, during the period 2003-2006 the world underwent strong ‘economic growth while inflation remained under control. In this context, imagine you belong to the board of governors of the US Federal Reserve, the country's central bank, and that the Federal Reserve has to decide whether or not to raise interest rates. You know that consumer price inflation is not a problem for now, but are worried because you have seen how excess money has caused a strong rise in the value of shares, bonds, promissory notes, gold, commodities, and most dangerous of all: house prices. In theory you should only be worried about the consumer price index (CPI), i.e. factors such as bread, petrol, electricity. But you are aware that successive asset bubbles can be lethal, as you saw after the bursting of the technology bubble in 2000 and the devastating effect it had on stock markets, causing an economic recession and a large-scale banking crisis. When you put these objections to the board of governors, arguing for an increase in interest rates s0 as to limit the money supply, this is the chairman of the Federal Reserve's reply: ‘The Federal Reserve's mandate is to maintain consumer prices and promote economic growth. It is not the central bank's place to decide whether or not a bubble is forming; that is for the market to decide. If the crisis you foresee occurs, the Fed will respond by slashing interest rates, as we did in 2001. This will calm the markets and allow us to get back on the path of economic growth. You have just heard these declarations and have to cast your vote: do you prefer to keep interest rates on hold (as there is as yet no risk of inflation) or will you vote to raise rates despite the chairman's arguments? ‘THE MORTGAGE AGENT'S DILEMMA: THE ORIGINATE AND DISTRIBUTE MODEL, Let's imagine you are a mortgage agent at a mortgage lending firm in San Diego, California. It is your job to spot opportunities to provide mortgages to individuals from all walks of life. The characteristic feature of a mortgage agency is that it has hardly any capital ofits own and it has no deposits at all. It obtains the cash with which to offer mortgages from the capital market. TheIE Business Schoo! ‘CAUSES AND CONSEGUENGES OF THE CREDIT CRUNCH ] ece-t074 agency receives bridging loans from large investment banks, which it uses to grant mortgages. ‘These are then given to the investment banks to repay the bridging loans. The investment banks then package these mortgages, distributing the right to collect the monthly payments on them to a. range of investors (many of whom are international) In theory the model is attractive. The risk of non-payment of the mortgage is not concentrated at a local bank in San Diego, thus, any potential property crisis in the city would not cause local banks to collapse. Diversifying the risk around the world makes it possible to access capital more efficiently, and so enables individuals to buy a home. So far, so good. However, a customer has just walked into your office asking for 250,000 dollars to buy a house. When you look at the individual's record you see that he has never really held down a steady job, and has spent long periods on the dole. Your potential customer is currently working as a bricklayer, and you know that the construction industry in California is constantly having its ups and downs, meaning there is a very real risk he will lose his job again. However, when deciding whether or not to give him a mortgage, you have to take another factor into account: your firm sells the mortgage to an investment bank, which in turn packages it and sells it along with a lot of other mortgages. Thus, your firm will not suffer any repercussions if the mortgage is not repaid as this will affect the final investor buying the collection rights from the investment bank. Therefore, the instructions from your superiors are clear: your mission is to increase the volume of mortgages granted in 2006 by '50% compared with 2005. You will not be responsible for whether these mortgages turn into bad loans or not, you are merely responsible for increasing the volume of mortgages granted. The {question you have to ask yourself is whether or not you would give the bricklayer from San Diego a mortgage in these circumstances. ‘THE WALL STREET "PACKAGER'S" DILEMMA. SECURITISED LOANS. Imagine you are an employee in the fixed-income division of Lehman Brothers in New York. Your job is to grant bridging loans to US mortgage agencies specialising in subprime lending. These agencies repay their bridging loans by selling your bank the mortgages they have granted. You package all these mortgages into a bond issue specially created for this purpose. As the mortgages are drawn from right across the United States, geographical risk is minimised. Thus, there might be a drop in the property market in Los Angeles, but this would be offset by a boom in Atlanta, for instance. After all itis inconceivable that the value of homes could fall all over the US fall at the same time. The company with which the mortgages have been deposited issues bonds whose payment is backed up by these same mortgages, and institutional investors in the EU and worldwide buy the bonds on account of the guarantees they offer (the mortgages are backed up by property) and their high returns. In the process of granting bridging loans, buying subprime mortgages, packaging and reselling them to institutional investors (a process known as securitisation), your bank obtains a good return (they have been given an AAA rating, the highest possible, by the rating agencies, and despite their very low risk, offer returns 1% above those of US treasury bills) You are paid a fixed salary of 125,000 dollars, plus a bonus that depends on the amount of business you help to generate for your bank. Last year (2005) your bank rewarded you with a bonus four times your salary (500,000 dollars) to ensure your loyalty to the firm and avoid your working for a rival bank in such a profitable business line. You are currently (second half of 2006) preparing the purchase and securitisation of a billion dollars’ worth of subprime mortgages granted during the first half of the year. You are aware that there is a lot of abuse taking place in the way these mortgages are being allocated, as when they are sold to third-party investors (many of whom are intemational), mortgage agencies do not worry about only giving mortgages to good risks, but are granting mortgages on a massive scale without concerning themselves about borrowers’ credit quality. However, your job consists of buying these mortgages and reselling them (a process which takes around three months). This would only be a problem if this risk you know exists were detected during the three months the billion dollars is on Lehman Brothers’ balance sheet. If you warn of the risk and cancel the transaction the most likely outcome is that you will not get a bonus, a all your business this year is concentrated in this transaction. If it goes ahead, the size of theIE Business Schoo! ‘CAUSES AND CONSEGUENGES OF THE CREDIT CRUNCH ] ece-t074 deal is such that you estimate your bonus could be as much as 800,000 dollars, payable at the end of December. What will you decide to do? ‘THE CEO OF CITIGROUP'S DILEMMA ~ EXPANDING THE BALANCE SHEET Imagine you are Chuck Prince, the CEO of Citigroup in late 2006. Your organisation has been enjoying unprecedented profit growth. Part of this growth has been due to the expansion of their assets. Thus, mortgage opportunities have allowed Merrill Lynch to accumulate subprime bond securitisations with the highest (AAA) credit ratings, offering very attractive returns. Being AAA products your bank can take on these assets with barely any need to inorease its equity. Thus, with equity of 60 billion dollars, total assets have now reached a trilion dollars. By concentrating returns on such a small volume of equity, the return on equity (ROE), the ratio most closely followed by analysts, has risen sharply since 2002. At this point, you have to decide whether to expand the balance sheet further to take on a five billion dollar share of a fifteen billion dollar securitised issue. The assets are bonds backed by subprime mortgages with a maximum credit rating (AAA). You know that this uncontrolled rush of liquidity cannot end well, as just as soon as the ease of obtaining loans changes, many of these mortgages may turn sour, which could be a deadly blow to the banking system and the economy as a whole. However, analysts are watching Citigroup's earnings under your management on a daily basis. If you decide not to add these products to your balance sheet the likely outcome is that profits will stop rising in line with analysts’ and investors’ expectations, and the market may call for your resignation. If 2006 ends the same way as 2005 (without problems) you can expect to obtain a total income of forty million dollars. If you are sacked, your severance package guarantees you at least 125 million dollars. Bearing this in mind, will you decide to include these mortgages on your balance sheet despite the fact that you ate aware of the risk? ‘THE TREASURER OF NORTHERN ROCK'S DILEMMA. ASSET-LIABILITY MANAGEMENT You are the treasurer of the British bank Northern Rock. Excess liquidity and the economic boom have made home buying very popular among the British. This phenomenon has led to a sharp rise in house prices, which in tum has led to an increase in consumer confidence. Seeing the value of their assets rise, many Britons stepped up their consumer spending, which led to faster economic growth and a bigger drop in unemployment. Your bank has benefited from this environment, as its main business is to provide mortgages. However, the bank's deposit base is small, so it has to draw upon inter-bank markets to fund all the mortgages it offers. As the credit expansion continues you have to make a decision. The bank's average mortgage has a lifetime of twenty years, and Produces a return of close to 5.5%. To fund new financial needs, you could issue bonds with a similar maturity (twenty years), back these bonds with mortgages, and thus obtain the money you need by paying an interest rate of close to 5.2% (leaving you with a profit of 0.3%). Alternatively, you could raise finance on the short-term money market (with average maturities of a month), taking advantage of interest rates of close to 4%, thus leaving a profit of 1.5%. Although the profits are greater, the problem this second option raises is that the loans need to be refinanced monthly. It, for whatever reason, this market, which is highly liquid at the moment, were to close due to a lack of liquidity, your bank could go bankrupt, not because its mortgages are bad quality (the bank has been very careful with the type of risks it takes on), but because of a simple lack of liquidity (inability to renew monthly loans). The decision to tum to the one-month money market brings short-term profits, but entails a risk of bankruptcy over twenty years. However, the goal set by the bank's board of directors is to maximise profits in the current financial year, and this has been set as an objective for the bank's executives, yourself included. What decision will you make? We have set out several framework decisions which many participants in the genesis of the financial crisis had to take. Considered in isolation they may seem crazy decisions. When they are juxtaposed and placed in context, it becomes clear how excess liquidity could lead to decisions which are wrong in the long term but understandable in the short term. Let's now look at some of the other key causes of the crisis.IE Business Schoo! ‘CAUSES AND CONSEGUENGES OF THE CREDIT CRUNCH ] ece-t074 WHY DID THE RATING AGENCIES CLASS ISSUES AS AAA WHEN THEY WERE IN FACT CONSIDERABLY RISKIER? Many readers have probably been wondering how it is possible that prestigious agencies such as Moody's, Standard and Poor's or FITCH IBCA, were offering top credit ratings (AAA, which is similar in quality to Germany's or the US's national debt) to packages of high risk mortgages. Before explaining how this was possible itis worth pointing out that credit rating agencies operate in near-monopoly situation, as central banks, when they lend money to commercial banks, demand assets with the highest rating from the three rating agencies as collateral. This means the market is virtually closed to new competitors. This lack of competition explains in part how the agencies have made such high profile mistakes on occasions, such as when rating Enron's or Parmalat's bonds (which they judged to be investment grade until the day the bankruptcy was announced), The agencies have always appealed to freedom of expression (as if they were newspapers) to defend themselves against the collateral damage their mistakes have caused in the financial system or the economy. At the same time, it is worth highlighting that the rating agencies are paid by the issuer. Thus, if France Telecom wants Moody's to issue a rating of its bonds, it would be RENFE that pays Moody's, leading to a clear conflict of interest. France Telecom, {As the investment banks were packaging more and more subprime mortgages into bond issues (collateralised debt obligations, CDOs), it was necessaty to have a “suitable* rating in order to be able to sell these bonds to institutional investors. The banks were oblaining juicy commissions on this business and were using a share of these fees to pay the rating agencies for the ratings they gave. And this is the interesting bit: how can financial engineering manage to turn a subprime risk into a triple A rated bond? The secret lies in slicing the bond issue up into various tranches so that the riskier bonds pay more interest in exchange for the increased risk of default on mortgage repayments. The first losses would therefore be met by the holders of these bonds, whose high risk earns them a “junk" rating. These bonds are usually bought by specialist hedge funds. Immediately above these bonds are other bonds with somewhat lower returns, but whose capital is protected by the losses that the buyers of the junk bonds have to face first in the event of default on the mortgage. Lastly, there is a broad tranche of bonds with returns that are somewhat lower, but always above the rate paid on triple-A treasury bills. The intention was to demonstrate that the risk on these bonds was very low, as a lot of the mortgages would need to be in default before they were affected. Powerful quantitative models (some of which would later be shown to be incorrect) showed how illusory it was for this default risk to affect the safest tranche of the bond issue. Moreover, in the context of rising house prices, widespread liquidity and diversification of ‘geographical risk (mortgages from all over the United States being in the same package, although there might be a property crisis in California, the crisis would need to be nationwide to affect the risk on the asset class as a whole, and a fall in house prices across the country as a whole had not happened since the second world war), the rating agencies’ analysts were persuaded to issue triple-A ratings (in addition to the fat commissions they would obtain for them). WHY DID A CRISIS THAT SO CLEARLY BEGAN IN THE USA END UP HITTING EUROPE SO HARD? Paradoxically the first victim of the subprime crisis was a German bank, IKB, in late July 2007. Germany is a country of savers, with no property bubble, and yet it took a direct hit from the crisis. The contagion mechanisms made it vulnerable. However, the effect of contagion is relatively simple. At the start of the decade the use of credit default swaps (CDSs), a type of credit derivative, became popular. By 2007 it had grown into a market worth over 50 trillion dollars; more than the total value of the global economy. A CDS is a type of insurance against a counterparty’s going bankrupt. Thus, if you hold bonds issued by Telefénica and you want to protect yourself against the possible risk of its bankruptcy, you could buy a CDS. This would mean that if Telefénica were to go into liquidation, although you would lose the value of your bond you would recoup your money through the CDS you have taken out. A CDS can also be used as a bet on a company’s bankruptcy or survival. So, if in early 2008 you thought that Lehman Brothers could go bankrupt,IE Business Schoo! ‘CAUSES AND CONSEGUENGES OF THE CREDIT CRUNCH ] ece-t074 you would just need to buy a CDS. The price of the insurance would rise as the likelihood of Lehman's bankruptey increased, and vice versa. These instruments were praised by Alan Greenspan, the former chaitman of the Federal Reserve, as they allowed risk to be diversified across the globe. However, the legendary investor Warren Buffet defined them as "weapons of mass destruction’ as an isolated crisis would cause losses worldwide, and, given the scale of this market, the sudden shift in confidence such a crisis could represent might jeopardise the stability of the whole financial system. In the light of subsequent events, Warren Buffet was right. Through these instruments, packaged into collateralised debt obligations, numerous European institutions bought exposure to US subprime risks. The reason was simple: an AAA grade investment in a German bond paid considerably less than an investment in a AAA subprime mortgage security. For the treasurer of a bank like IKB whose goal it was to maximise the profitability of the bank's portfolio, and whose bonus probably depended on it, when choosing between two AAA investments he would tend to choose the one offering the highest return, even though in the back of his mind he might be aware that the real risk was greater than that suggested by the AAA rating, The consequences were terrible, RECAP. WHAT WERE THE CIRCUMSTANCES THAT LED TO THE CREDIT CRISIS? By presenting and analysing these short examples we have tried to give tangible shape to the conflicts of interest which led to the current situation. Considering each in isolation they should not have caused a storm such as that currently being experienced. However, each decision taken in isolation was precisely the most dangerous: the treasurer of the central bank of China invested most of the bank's reserves in dollars by buying US bonds (in order to prop up the exchange rate); the US Federal Reserve held interest rates low despite the dangerous rise in property prices; the bank manager gave consumer credit as a result of the instructions he was given to increase the volume of lending and the context of low defaults deriving from the excess of liquidity; the mortgage agent will not hesitate to grant a subprime mortgage as he knows it will be sold on to international investors, eliminating the risk faced by his agency; the Wall Street packager will buy the portfolio of subprime mortgages expecting the environment to remain the same and thus allowing him to earn another multimillion dollar bonus; Citigroup's CEO will accept an increase in the size of the bank's balance sheet with AAA assets as almost all its competitors are doing the same, and if the bank does not follow suit, the loss of market share will threaten its position; the treasurer of Northern Rock will prefer to take on short-term debt to raise the cash needed to grant long-term mortgages 50 as to increase the financial year’s profits, which is what determines his objectives; and finally, the rating agencies will easily let themselves be convinced that the complex structured products have a tiny risk, giving them the maximum AAA rating as “what likelihood is there that all property values fall at the same time, that liquidity dries up from the financial system, banks go bust and unemployment rockets?" Readers will be able to guess for themselves what the common nexus linking all these factors is. This nexus, namely liquidity and the lack of it, is what explains how all these decisions came together in a dangerous alignment of the stars. Market confidence plays a crucial role in the transition from an excess of liquidity to a shortage of it. A minor event, such as the default on a series of subprime mortgages in February 2007, was enough to cause this change in confidence, which then brought down the whole house of cards built on excess liquidity. These ideas are not new. Indeed, they were formulated in the US in the nineteen seventies by @ neo-Keynesian economist called Hyman Minsky. Minsky put forward the “financial instability hypothesis’, which states that in a world in which there is confidence in the effectiveness of the central bank and its ability to control inflation, banks will react to this confidence by expanding their credit portfolios. This expansion leads to an increase in the price of real assets in which the money provided by the bank ends up being invested (mainly property). The increasing price of these assets, together with the money supply, will lead to a reduction in defaults, which will create moreIE Business Schoo! ‘CAUSES AND CONSEQUENCES OF THE CREDIT CRUNCH ec2074 incentives for banks to expand the volume of loans, again leading to greater increases in asset prices, increased liquidity and lower default rates. This leads to a vicious circle in which loans are given without distinguishing the risk, such that it only comes to light when an event such as a default on series of mortgages causes market panic, and this in turn causes the opposite phenomenon to that just described: there is an almost complete freeze on new loans, which in turn leads to an economic crisis, a drop in asset prices, increased default and tighter restrictions on bank lending. In other words, commercial banks do not smooth out economic cycles but aggravate them. According to Minsky, from this fact it can be inferred that when conducting economic policy it is necessary to study how to avoid this threat. Minsky’s arguments did not meet with widespread acceptance. However, the extraordinary liquidity situation between 2004 and 2006 led certain leading economists (including Martin Wolf, chief economist at the Financial Times, and George Magnus, economics advisor to UBS), to rescue Minsky from oblivion and warn of the risk faced by the financial system on which economic expansion had relied. ‘The accumulation of reserves by emerging countries (particularly China), and the investment of these reserves in US bonds, came to be known as Bretton Woods I. In some ways this system is not so different from vendor financing. For instance, if you buy a new fridge at a department store but do not have enough money to pay 100% of the retail price, the store can finance a large percentage of the item’s cost at a given interest rate, so that, for all practical purposes the store sells you the fridge with its own money. On a much bigger scale, neither US consumers nor the US government were able to keep up the level of spending they had taken on (far higher than national savings), so they had to ask for money from abroad, such that the central banks of emerging market countries became the main financers of the US's trade deficit. Paradoxically this finance was used by consumers to buy goods manufactured in those same emerging countries, thus ‘generating the conditions for the vicious citcle. Moreover, by investing these countries’ reserves in US bonds there was an effective reduction in US interest rates, a factor which greatly reduced the cost of buying a home for large swathes of the population. ‘Alan Greenspan expressed his surprise that the interest rates set by his country’s bonds were so low in a context of economic growth (a paradox he dubbed the “savings glut"). However, although there was an awareness of the dangers of this wave of consumer spending and home buying paid for with foreign capital, neither the American authorities nor those in emerging countries took any steps to mitigate the possible harmful consequences. The Fed might perhaps have played a role in mitigating this effect by raising interest rates sharply during 2004-05. However, as inflation was under control, the Fed opted to make gentle increases. This process caused there to be an unusual supply of money, which laid the foundations for the current credit crisis. Soon, the distorted money supply caused asset bubbles affecting property, stock markets, commodities and bonds. However, as asset prices lie outside the scope of monetary policy objectives, central banks did nothing to prevent the risks that these bubbles entailed, The banks welcomed this situation with open arms as it meant they could expand their credit portfolio easily, while reducing defaults and minimising their use of equity, thus encouraging debt, and maximising shareholder returns. The result is that whereas the financial sector accounted for barely 10% of US gross domestic product (GDP) in 1980, by 2007 it produced almost 40% of GDP, thus underpinning the US economic expansion. However, this growth also brought dangerous instability with it, with the potential to affect the global economy. As the remuneration of the vast majority of the industry's employees is linked to short-term objectives, the incentives to focus on immediate profitability and ignore medium-term risks were enormous, worsening the problem created by the excess money supply. Moreover, many banks opted to take advantage of the lucrative business of investing in AAA mortgages offering high returns by obtaining much cheaper finance from short-term financial markets (asset backed commercial paper), thereby obtaining huge profits (short-term debt was issued at a cost of close to 4% for investments in AAA subprime bonds ‘or Alt A® bonds, producing profits of 6%, thus leading to the illusion of its being possible to earn money for free. American mortgages aro divided into prime, which are those which meet certain risk entra, In particular those granted te midale class families and withthe backing of the agencies Fredaie Mac and Fannie Mae; subprime, which are thoseIE Business Schoo! ‘CAUSES AND CONSEQUENCES OF THE CREDIT CRUNCH ec2074 To make matters worse, a number of banks opted to conduct this business off their balance sheet. This meant setting up companies known as structured investment vehicles (giving third parties access to their capital), or conduits (which only had bank capital), charged with investing in these mortgages, and financing them from the money market. They were sponsored by banks such as JP Morgan, Citigroup or Goldman Sachs, which meant that the money market agreed to finance these investments as it assumed that in the event of a problem funding the assets the sponsoring banks would bail out their subsidiaries, even if they were off the balance sheet. The problem that was brewing was that if there were to be a change in the economic cycle of loss of confidence at any time, the money market could dry up, as once investors lost their confidence they would no long distinguish between the instruments sold on money markets that were backed up by good assets and those that were backed by bad ones. The result of this kind of loss of confidence is that solvent companies that use this market on a daily basis to finance critical activities, such as paying salaries, could end up being affected by the contagion and have their finance refused. This happened in the autumn of 2008, forcing top rank companies such as General Electric, which used this market to finance its working capital requirements, to issue bonds. In these circumstances, if the banks had continued to have total control and responsibilty for the loans they were giving, the negative consequences could have been kept under control. However, with the popularisation of the originate-to-distribute model, a large volume of loans were sold to third-parties, undoing the essential relationship between lender and borrower, and creating incentives for the granting of loans without concern for the quality of the mortgage applicant. This context explains why "interest-only" mortgages were granted in which the borrower only repaid interest but no capital during the first two years, or mortgages which required no monthly payments until the end of a grace period, or mortgages for a value exceeding that of the property. In a period in which house prices were rising, all these aberrations could continue to work, but it only needed a ‘small change in the economic climate for the whole system to collapse. It is often forgotten that the Federal Reserve does not have the sole objective of setting interest rates, but is also responsible for supervision of the US banking system. In the light of the outcome, the Fed's failure on both counts is clear. Thus, an essential part of the origin of the crisis can be traced not to ‘wild capitalism” or “market excesses", but precisely to the poor decisions of a government body. WHAT HAVE THE EFFECTS OF THE CRISIS BEEN? “The majority of financial calamities are not out-of-control natural forces but redictable vents." Michael Greenterger Could Clinton's Defence Secretary, Michael Greenberger, perhaps have predicted the fall of financial giants of the likes of Lehman Brothers, Merryil Lynch and almost all the investment banks? Most likely not. If two years ago someone had told him that investment banks as such were going to disappear from the banking business he would probably not have believed it. But the fact is that in February 2007 rumours about Bear Steams’ solvency began to spread, and since then a seemingly endless list of financial institutions have disappeared. Bear Stearns was an example of good corporate practices, information transparency, and attractive shareholder returns. The first problems arose when there began to be an increase in defaults on mortgages financed by Freddie Mac and Fannie Mae. The rumours soon started to spread, as default on Freddie Mac and Fannie Mae's mortgages would cause the value of the assets by which they were backed to collapse. Bear Stearns was heavily exposed to these assets, so the rumours affected it directly. In late 2007 its share price had collapsed and the sale of Bear Steams to JP Morgan was announced. ‘which do not meet these erteria, in general having been granted to lower class families; jumbo mortgages, or ‘mortgages over a millon dollars, which are primarily almed at the upper cass, and Altemative A mortgages, which are ‘morigages given to individuals whose lack of a record makes it impossible fo give them a classiication. in practic, ‘many Alt A mortgages flowed the same patter as subprime mortgages, rolIE Business Schoo! ‘CAUSES AND CONSEQUENCES OF THE CREDIT CRUNCH ec2074 In September 2008 two more major US investment banks ~ Merryll Lynch and Lehman Brothers ~ came crashing down. The former, Merryll Lynch, was bought by Bank of America for 44 billion dollars, and the latter declared bankruptcy. One week later, Goldman Sachs and Morgan Stanley would act out investment banking's last gasp. They both applied to the Federal Reserve to become bank holding companies, which would allow them access to the Fed's funds, but in exchange for their being regulated as commercial banks. The era of Wall Street investment banks was over, and their passing was accompanied by the approval of a rescue plan for the US financial market. On 3 October 2008, with the US election ‘campaign in full swing, an emergency plan that would involve a disbursement of 700 billion dollars, was signed. Under this plan the US goverment intended to spend 250 billion dollars to buy preferential shares, making it a shareholder of the country's biggest banks (nine financial institutions accepted partial nationalisation, with the condition that they could buy the US Treasury's holding back after three years). The remaining 450 billion dollars were initially invested in the purchase of toxic assets. However, this decision was overtumed in mid November as it was considered too difficult to buy these assets. Instead, a direct injection of capital into the banks was opted for, as it made it possible to act more swiftly. What are toxic assets? In general they are mortgage-backed securities with a variely of risks, and which are traded on organised markets. These securities were a key part of the mortgage originate-to-distribute model which we looked at in the first section of this document. The banks took part in the business of packaging mortgages, dividing them into different tranches of risk and selling them on to investors, but they made the mistake of keeping the securities they thought were lower risk on their balance sheet. They would soon notice that these were worth much less than the rating agencies had forecast. And worse still: the markets on which these securities were traded suddenly dried up. Almost overnight the markets became illiquid and there were only sellers, no buyers. And this situation of lack of liquidity and falling asset valuations was the spark that ignited the credit crisis. Paradoxically, Alan Greenspan, the former chairman of the Federal Reserve, had watched the growth of this business and at no time did he take any measures to mitigate the possible risks. The International Monetary Fund's Financial Stability Report on 7 October 2008 highlighted the losses of 1.4 tilion dollars deriving from exposure to US mortgage-backed, consumer-credit and corporate securities. This figure was expanded to 2.2 trillion in an updated version of the report in early 2009. By November 2008 the banks and insurers had recognised losses of 0.9 trillion, and a further 0.5 trillion had yet to emerge. These latent losses were sufficient to make even leading financial institutions insolvent. Imagine for a moment you are playing a ten-hand game of poker. You have been told that three of the players are insolvent and so will not be able to pay back any losses they make. However, no one knows which three players are insolvent. A rational player will stop betting until the insolvent players have been identified. Something similar happened in the credit markets. Until banks' balance sheets have been cleaned up and banks hold reasonable ‘amounts of capital, all the liquidity injected into the financial market by central banks is held back by the banks as they wait for the rest of the losses to emerge. Market globalisation and the widespread acceptance of credit risk transfer instruments had exported the crisis to European financial centres. The assets had poisoned the balance sheets of almost all Europe's financial institutions (which had acquired them as a pure speculation, attracted by their high rating and high returns) and the need for parallel rescue plans for the countries of the (Old World became clear. European economies tured out to be as vulnerable to the credit crisis as the US economy, as like the latter, certain countries in particular also had a high level of leverage, an overheated property market and financial institutions facing serious losses. Part of the problem lay in the disproportionate growth in the size of many banks’ balance sheets. At the start of the 20th century a commercial bank operated with a leverage (ie. the ratio of its debt, primarily deposits, to its equity) of 4 to 1. This ratio increased considerably over the course of the 1980s, and by 2007 many European banks had leverage ratios of over thirty. In the US the aIE Business Schoo! ‘CAUSES AND CONSEGUENGES OF THE CREDIT CRUNCH ] ece-t074 maximum leverage commercial banks were allowed was twenty (investment banks were exempt), this is why the crisis affected US investment banks and European commercial banks in particular so severely. However, since the implementation of the Basel accords, the way in which the solvency of financial institutions is measured has changed, and a new concept called value at risk (VAR) has been brought into play. The capital or equity needed was calculated based on the credit, market and ‘exchange rate risks. Each different type of banking activity has a risk associated with it, such that if the institution's asset portfolio is high quality it requires less capital (Tier 1) than if the assets are riskier. The Basel | system allowed this credit expansion, as it assigned a coefficient to each asset according to the perceived risk. Let's imagine that Dexia included a 100 million euro bond backed by AAA-rated subprime mortgages on its balance sheet. According to Basel, an AAA-rated asset is weighted at 25% when calculating its risk. So, only 25 million euros would be taken into account. As Basel requires 8% equity for each risk-weighted asset, itis possible to back this 100 million euro position with 2 milion euros of equity. In other words, itis leveraged 50 times. If the value of this bond dropped from 100 to 80, the damage would be huge as it would not only swallow up the 2 million euros of capital set aside but also a further 18 million euros being used to back other credit risks. With its capital reserves thus depleted, Dexia was obliged to sell assets in order to meet regulatory requirements. Considered in isolation this might have been a problem for the bank ‘concerned, but when the risk, which had been sold all around the globe, affected many large banks simultaneously, which all set about selling assets in a market in which there were no buyers, it caused huge falls in asset prices, forcing the banks to sell yet more assets. This vicious circle explains the current situation. Will capital requirements be reformulated in the light of recent experience, such that it would be possible to talk of a bank risk management policy beyond that dealt with in the Basel accords? In the next few years we will probably see a thorough rethink of the way in which risks have been measured following the Basel accords. ‘As a result of what has happened it will be necessary to place limits on leverage such that bank's solvency is not placed in jeopardy. As we have seen in the previous paragraph, in recent years the percentage of debt on banks’ assets has been excessive. The regulatory capital requirements have proven to be inadequate. The downturn in the markets and consequent loss of value of banks’ assets has led to a shrinking of their capital to the extent that they no longer have the level of solvency required by regulators. To a greater or lesser extent all European countries have fallen victim to the oredit crisis. The two economies with the most costly rescue plans are the United Kingdom and Germany. In the United Kingdom: RBS, one of the world's biggest banks in terms of levels of assets is being recapitalised by the government; HBOS and Lloyds (the fourth and fifth biggest banks in the United Kingdom) have received cash injections from the government; and Northern Rock and Bradford and Bingley (two of the world’s biggest banks in terms of the number of mortgages granted) have been declared insolvent and nationalised. For its part, in Germany Hypo Real Estate has had to be rescued with a credit line from the government of 35 billion euros. Financial institutions in France and Belgium have also suffered the consequences. Fortis (Europe's eleventh biggest bank) has been sold and part-nationalised, while Dexia has had to be recapitalised The rescue plans in Europe follow along the same lines as those in the United States, 1. they are intended to recapitalise the system, either through the total or partial nationalisation of countries! financial institutions, or by giving public guarantees. Capitalising institutions will be a fundamental factor in guaranteeing many banks’ solvency and thus enabling them to continue in business. However, to avoid similar situations occurring in the future it will be necessary to take additional measures such as: i) reforming the financial system to strengthen its integrity and avoid conflicts of interest with analysts and rating agencies; ii) demanding more responsibility from boards of directors, and reducing the incentives for short-term decision-making; iii) reviewing banking regulations, the concept of solvency and supervising situations of excess liquidity to avoid cyclical bubbles from appearing; iv) raising awareness in the world's various economies of the need for international supervision; and v) giving more valIE Business Schoo! ‘CAUSES AND CONSEGUENGES OF THE CREDIT CRUNCH ] ece-t074 transparency to the system with a clear mechanism for accounting for assets and close supervision of credit derivatives. THE COSTLY EFFECTS OF THE CRISIS WILL HAVE SERIOUS CONSEQUENCES: The 2007 credit crisis will go down in history as one of the most complex financial crises ever, necessitating the reconstruction of the international financial system. In 1971 Richard Nixon announced the end of the gold standard with the words: “The American dollar must never again be a hostage in the hands of international speculators." Will we one day be reading another phrase describing how Americans speculated and exported credit risk instruments? Is it true that financial calamities are predictable? Predictable or not, what is clear is that the last two years have been giving us some important lessons for the future. ACCOUNTING IMPLICATIONS OF THE CREDIT CRISIS. TOWARDS A NEW CONCEPT OF FAIR VALUE To sketch out the implications for accounting, let's start by looking again at the case of Bear Stearns. Confirmation of the rumours about Bear Stearns’ solvency came with the presentation of its annual report in March 2007. The central topic highlighted by the report was that marking the bank's assets to market so as to recognise them at their fair value would mean a loss (the drop in value of an asset is reflected on the accounts as a loss which results in an immediate reduction in equity) which would put the bank on the verge of bankruptcy. But how had this come to pass? ‘Accounting standards were harmonised by applying International Financial Reporting Standards. International Standard no. 39 establishes the valuation standards for financial instruments. This standard classifies financial instruments according to their nature (tradable investments, investments in the portfolio of assets held until maturity, loans, etc.) and assigns different valuation methods accordingly. The various different types of financial assets a bank may hold on its portfolio, which as we have just mentioned relates to their nature and intended purpose, are the following: first of all itis worth mentioning those which in accounting terms are called trading assets. Assets of this type are bought by the bank with a view to obtaining a short-term return. The accounting rules indicate that they should be valued at market prices, and changes in their value reflected in their valuation. Imagine, for example, that our institution purchases a hundred Repsol shares at the start of the year. When the bank buys the shares it will include the one hundred Repsol shares bought at 25 euros a share on its balance sheet as financial assets. The balancing item at time zero is the cash paid. However, what happens eleven months later when each Repsol share is worth just 15 euros? The standard in this case is clear: the loss of value represented by Repsol's falling share price must be reflected on the institution's balance sheet, with a reduction in the value of the asset and a loss will be registered in the profit and loss account. A second category of asset includes those assets deemed to be available for sale. These are referred to as assets held for sale. How do these assets differ from trading assets? As the standard says, the difference lies in the purpose for which they were bought. If we go back to the previous example, but assuming that in this second case our institution buys the Repsol shares without aiming for a short-term return, but a strategic investment in Repsol. Thus the shares are held on the bank's portfolio with no immediate prospect of their being sold. What are the accounting consequences of their being included in this new category? Although the accounting rules again oblige us to recognise the asset (ie. the shares) at market value, the impact of the loss of value is not charged against the profit and loss account but against other accounts. The aim is to avoid harming the earnings if there is no prospect of the asset's being realised in the near term. a3IE Business Schoo! ‘CAUSES AND CONSEQUENCES OF THE CREDIT CRUNCH ec2074 According to the standard, the bank's investment strategy decides whether a financial asset is classified in one accounting category or another. This means that with a short-term model the earnings account is more sensitive to variations in asset values. The third category of assets comprises assets held to maturity. Let's assume that on this occasion the institution's portfolio managers decide to invest in treasury bills with the intention of holding the bills until they are redeemed, rather than selling them. The valuation is different from that allowed by the standard in the other two categories. The bills will be valued at their historic cost, with a discount for the effect of time. The way market value is treated takes on special importance in this accounting contrivance. In many cases, particularly in that of over the counter (OTC) derivatives, i.e. those which are not traded on an organised market, such as the stock market, but directly between two firms or counterparties, assigning a market value is no straightforward matter, as there is no organised market for these products. Thus calculations of their value are affected by numerous subjective factors. This has led to a play on words among some theorists, who have asked how fair is fair value?" The credit crisis has demonstrated that in the context of a profound financial crisis, such as that which has been taking place over the last few months, market values are not always a faithful reflection of the underlying economic reality of the assets concerned. That is to say, in a context of sharp falls in share prices, the market price does not reflect the fundamental value. Returning to the previous example, the ten euro drop in the Repsol share price includes a significant loss on the ‘earings account (in the case of an asset bought for trading). With a short-term perspective, however, the share price looks like a good benchmark for their value. But, what happens when the asset that has been bought is not as liquid as Repsol shares? The lack of liquidity becomes a major problem as the lack of selling prices from equivalent transactions means itis impossible to be sure that the price assigned by the market is the best reflection of the asset's economic value. Let's suppose we have bought a house in a small housing estate with three terraced houses. The house cost a million euros. One of our neighbours is obliged to sell his house in under ten days for personal reasons and the only buyer he can find offers him 700,000 euros. The sale causes our neighbour a loss of net wealth, but should the third neighbour and | recognise the same loss? Would this be a fair value? Probably not, as the loss suffered by the owner of the house that has been sold may have been influenced by his pressing need for liquidity. ‘Aware of the importance of the accounting treatment of transactions and the importance of market, value, US and international regulatory bodies (the Financial Accounting Standards Board and the International Accounting Standards Board, respectively) issued an annex to the international standards. This annex permits reassignments of financial assets between categories, so that if the bank has a portfolio of bonds backed by mortgages that are listed on a market, but it decides to hold these bonds to maturity, it can, for example, pass their value from the trading book to the credit book, thus changing the valuation system applicable from market value to historic cost (many banks did this in the third quarter of 2008, so as to minimise the value of their losses). ‘The consideration of fair value in accounting has been jeopardised and battered by the financial crisis. Perhaps it might have been more reasonable for these losses to have been recognised more gently applying the more traditional approach in effect prior to the Intemational Financial Reporting Standards (the international rules have fed a vicious circle of asset sales and falling prices). But when the opposite happened, i.e. continually rising prices and profits, why did nobody criticise the accounting treatment that was yielding such fat profits for the banks? 14)IE Business Schoo! ‘CAUSES AND CONSEQUENCES OF THE CREDIT CRUNCH ec2074 ARE THE CURRENT BANK REMUNERATION SYSTEMS CORRECT? ‘A second consequence of the credit crisis is that changes are likely in the way banks pay their ‘employees. Current remuneration systems have led to employees taking high risk positions without taking into account the consequences for investors, shareholders, and in the final instance, tax payers. Proprietary traders received a sizeable share of their income in the form of variable bonuses. Thus, the more profitable the trader's transactions on behalf of the bank, the bigger the bonus. Most traders took high risk positions, as risk was associated with returns on trades and therefore with an increase in their bonus. If the deal turned out well, the financial reward would be significant. And if it did not, the trader would lose his bonus, or at worst, be sacked and receive a generous severance payment. What lesson has been learned? Short-term objectives aimed at earning a bonus are harmful to the bank's management policy, to the extent that they put its solvency in jeopardy. Let's assume that branch managers set our variable remuneration according to the number of mortgages granted. With this requirement we would most likely concentrate our efforts on winning new customers, and would probably be less concerned about their future solvency, as, in Keynes's words, ‘in the long term we are all dead." The situations of risk to which institutions have found themselves exposed in order for employees to eam bigger bonuses have been excessive, leading even to some institutions going bankrupt. To avoid this happening again in the future, various institutions have proposed a list of best practice for employee remuneration. These standards try to align compensation policy with the institution's risk-management policy. What are the compensation practices to avoid? 1 Calculating remuneration based on the income reported by employees without taking into account additional considerations regarding their risk; Referencing employees’ bonuses solely to the year's eamings, without taking into account ‘earnings in subsequent periods; Increasing the ratio of variable to fixed income; Paying the whole bonus in cash — itis advisable to employ a mixed remuneration policy, using share option plans or shares in the company, so as to increase employees’ commitment; Variable remuneration, for example in the form of restricted shares (shares which cannot be sold until a given number of years have passed) is useful as a way of aligning employees’ decisions so they are good for the company over the medium term; Absence of specific policies by human resources departments to manage possible conflicts of interest; Inadequate separation of front office and back office tasks, LIMITING LEVERAGE AND COUNTER-CYCLICAL PROVISIONS AS CREDIT _ RISK OFFSETTING MECHANISMS In the preceding sections we have asked what the best way of limiting excessive leverage might be. Where is this leading? Experience has shown that it may be more reliable to measure leverage in its more traditional model, which is to take the ratio of an institution's total assets to its equity. There is the possibility that regulators will start to measure a bank's level of risk not only in terms of its solvency ratio, but also of its level of leverage. National supervisory bodies, in accordance with the stipulations of Basel Il, are empowered to increase the level of prudence required of banks under their jurisdiction. Thus, in order to bolster the solvency of the Spanish financial system, the Bank of Spain obliged institutions to set aside anti-cyclical provisions. What is the aim of these provisions? Obtaining reserves for security a8|IE Business Schoo! ‘CAUSES AND CONSEGUENGES OF THE CREDIT CRUNCH ] ece-t074 (created in periods of greatest expansion) in order to be able to apply them when necessitated by a crisis such as that at present. Correctly applied, this policy makes it possible to smooth out crises, and the provisions are extremely useful. The economies of other countries have observed how these have made it possible for Spanish banks to absorb losses and reduce the risk of insolvency. The registration of provisions of this kind is very likely to be accepted globally ‘Anti-eyclical provisions have generated a debate in international accounting forums. This debate arises from the fact that Intemational Financial Reporting Standards prohibit the setting aside of generic provisions. Financial institutions have justified the accounting treatment of these reserves by means of banks’ risk allocation systems. IMPLICATIONS OF THE PROPERTY CRISIS FOR THE CREDIT CRUNCH: A STABLE MACROECONOMIC ENVIRONMENT So far we have been revisiting concepts already set out in the first part of this document. Let's go back in the fourth instance to highlight the impact of the property market on the crisis and its consequences in various economies. The property bubble that got underway in the United States in 2005, combined with the stable macroeconomic environment and very low interest rates, led to financial institutions relaxing their risk management policies. Imagine you work in the risk management department of a financial institution. A colleague in the trading department asks for your authorisation for a transaction which promises a high yield, but has a significant risk associated with it. Turning down the transaction leads to a confrontation between departments, as given the stability and continuous increase in prices of the underwritten assets, it seems impossible not to recover the assets at risk. Finally, the risk department caves in to the pressure from the operations division and allows the loan to go ahead. In January 2007 the world seemed to be risk free. In a context of stability (four consecutive years of low interest rates and falling credit spreads, i.e. the differences in risk between economic actors were not reflected in the interest rates) it is not easy to determine the potential risk of insolvency. Risk managers are responsible for approving loan applications sent by the people in charge at branches. At the time, the possibility that there could be a lack of liquidity in markets was unrealistic. There was no shortage of institutional investors such as hedge funds, insurance companies and venture capitalists. All these players wanted to invest, and this excess liquidity meant firms, whether good or bad, had no problem obtaining finance. Thus, there were few bankruptcies, and the world as a whole reduced its estimates of future bankruptcies (which translated into minimal credit spreads). Banks' proprietary trading departments took positions in mortgage-backed bonds on the basis that as these assets were entered on the accounts at market value, the profit or loss would show up immediately on the books, and if difficulties emerged, these positions would be easy to liquidate, particularly in the case of AAA and AA tranches. Mortgage-backed assets required very little capital, making them very profitable, As these assets were held on trading books they were subject to less exhaustive credit risk detection processes than assets held on traditional banking books. In a trader's eyes, the risk manager did not generate business for the bank, but was considered almost an obstacle to income generation. Complaints to the risk department were frequent. Even so, the risk department based its analysis of complex products on the ratings given by rating agencies, making for an explosive mixture. The boom years had marginalised the role of risk departments in banking institutions. Giving them back their role is a key part of the proper functioning of the system: On occasions, if a bank had lent too much money to a company, the regulator or risk department opposed fresh loans being given to the same borrower. To get around this obstacle, the bank would buy ‘insurance’ so that if the company to which the loan had been given were to go bankrupt, the bank would obtain compensation. This insurance took the form of instruments known as credit default swaps (CDSs). The bank paid a premium for this protection, and the insurance was sold 16/