Teaching ethics to my Yr 10 class I have used the sub-prime crisis as an example. As with behavioural economics the conventional view of finance assumes that markets are efficient and that the price of shares, bonds and other financial instruments are a reflection of the fundamental economic values that they represent. Behavioural finance is all about understanding why and how financial markets are inefficient. If there is a difference between the market price of a share or bond and its fundamental value then in conventional economics no one can make money in financial markets by exploiting the difference.
Global Financial Crisis
In July 2007 a loss of confidence by US investors in the value of sub-prime mortgages caused a liquidity crisis. Sub-prime mortgages were loans that were high risk and many mortgage holders unable to meet their repayments. The mortgages were pooled into what was know as a Collaterised Debt Obligation (CDO) which were sliced into tranches – safe – okay – risky. Investors tended to buy safe tranches as they were rated AAA by the rating agencies. However the rating agencies were very generous in their assessment of these investments as they were paid by the banks who created the CDOs. Banks also were able to take out insurance on the CDO even if they didn’t own them. This was called a Credit Default Swap (CDS).
The flow chart (above) and video (below) shows how Goldman Sachs sold a CDO called Timberwolf to investors and proceeded to bet against that investment by buying insurance from AIG so that when the CDO failed they got a pay out from them. As you maybe aware AIG sold a lot of CDS’s and ultimately had to be bailed out by the US government. However a significant portion of the bailout money went to the banks that had created the problem.
Below is another very good clip from the Big Short that explains how the mortgage market brought down the financial system. Good references to CDO’s in which celebrity chef Anthony Bourdain compares fish to finance?
Here is a list of the latest ratings by the three main rating agencies. Notice that Australia and the three Scandinavian countries have top ratings. The UK lost its top rating from Moody’s but maintained the top rating from the other two. New Zealand comes in further down with a top rating from Moody’s but has lost its top grade from the other two. When you get to B status your are talking high risk or junk status and this is quite evident with the PIGS counties.
If you have watched the movie documnetary ‘Inside Job’ you will remember that these 3 credit rating agencies also rated high risk investments – sub-prime mortgages – as AAA, up to a week before they failed. The same could be said about their rating of investment company Bear Stearns.
Ultimately they could have ‘stopped the party’ but delayed ratings reports and made junk status investments AAA rated. But as they testified in front of congress their advice to clients are opinions ‘just opinions’ – I wonder do they share the opinions of those that lost huge amounts of money, including sovereign investments. Recently they downgraded Greece and Spain in the knowledge that the servicing of the debt would now become more costly for those countries and stifle any sort of recovery in the near future.
I enjoyed reading John Cassidy’s article in The New Yorker about America’s justice Department charging Standard & Poor’s with fraud over the rating of mortgage backed securities between 2004-2007. The case revolves around the activities of two teams at S & P:
1. A team that rated residential-mortgage-backed securities (RMBS),
2. A team that rated collateralised debt obligations (CDO’s).
These investment were based on subprimes mortgages taken out by borrowers who couldn’t pay – NINJA’s Non Income No Job or Asset. The Wall Street firms that produced these securities paid rating agency S & P big fees to rate them:
US$150,000 for RMBS’s
US$500,000 for CDO’s based on mortgages
US$750,000 for synthetic CDO’s based on derivatives tied to mortgages
Between 2005 – 2007 S & P CDO division made US$460m
The government claim that:
1. 2004 – 2007 S & P deliberately limited, adjusted, and delayed” changes to its statistical models and ratings criteria for subprime securities that would have resulted in the firm issuing lower ratings.
2. March and October of 2007, when it was perfectly clear that the housing bubble had burst, the firm “knowingly disregarded the true extent of the credit risks associated with” securities it rated.
One S & P employee was quite explicit in his views of what was happening in the RMBS market. In March of 2007, a person identified as “Analyst D,” who had studied a series of RMBS. issued in 2006, wrote an e-mail to several colleagues with the subject line “Burning Down the House—Talking Heads.” This is what it said:
Housing market went softer
Strong market is now much weaker
Subprime is boi-ling o-ver
Bringing down the house
CDO biz—has a bother
Leveraged CDOs they were after
Going—all the way down, with
Hey you need a downgrade now
Huge delinquencies hit it now
Bringing down the house
See the live version with David Byrne and Talking Heads – 1984
The Greek economy, burden with huge government debt, continued to adopt stringent austerity plans in order to secure a bailout from the European Union. Although markets received the news of an emergency package for Greece with a positive view one wonders if anyone actually understood the package in the first place. Greece is getting a further €109bn in soft loans from the eurozone and the IMF over the next 3 years taking its overall package to around €200bn. Credit rating agency Moody’s downgraded Greek debt to junk status on the grounds that default is virtually certain. This also affects other economies in the Eurozone (Italy and Spain) as they now know that bailouts from northern countries won’t be forthcoming if they have to take “haircut” (loss).
Will it work? I am not sure as Greece’s debt-to-GDP ratio will still be around 130% and there are few “engines of growth” available to get the economy back on the rails. But is this situation that Greece finds itself in a surprise to any of us?
Tax evasion a Greek national pastime
For years Greek governments have struggled to collect enough taxes to fund their spending. The gap between what tax payers owed last year and what they actually paid was approximately 33% of total tax revenue – about the size of the country’s budget deficit. The “shadow economy” in Greece accounts for approximately 27.5% of GDP and this culture of evasion has the effect of burdening those that are honest and pay their taxes. Greek officials are well known as easy to bribe with cash and there has been little enforcement especially around election time. According to James Surowiecki in “The New Yorker” Greece, with Bulgaria and Romania, is seen as the most corrupt country in Europe.
It is a vicious cycle – as tax evasion is prevalent everywhere people trust the system less, which makes them less inclined to pay taxes. Therefore the government makes up the shortfall by raising taxes on those who do. This then increase the motive to not pay taxes at all. A social inclination toward tax evasion is hard to eradicate and Greece needs more than a policy shift but a cultural one. One wonders how they were able to afford to host the Olympic Games in 2004?
The recent downgrade of the US economy by credit rating agency Standard & Poors shouldn’t have come as a surprise. S&P indicated that even if the debt deal was approved they would still go ahead with the downgrade if there wasn’t a reputable policy of fiscal contraction to reduce debt. But agencies are all to aware of the critcism that they got over the credit crisis and will be mindful of this.
Conflict of Interest
Rating agencies are paid by the people whose products they grade and they are competing against other rating agencies for the business. Subsequently the rating agencies were being played-off against each other by the bankers in this market and this led to a systemic decline in standards and willingness not to check the underlying information as thoroughly as possible for fear of losing the deal. Even the rating agencies themselves admit mistakes were made is assessing sub-prime debt and that there were issues to do with data quality from their sources of research. However one has to consider whether the world have been better off if credit rating agencies had not existed as pension funds, bond funds, insurance companies etc would have had to do a lot more of their own research on what they were buying.
But consider the following:
Bear Stearns – rated A2 a month before it went bankrupt
Lehman Brothers – rated A2 just days before it collapsed
AIG – rated AA within days of being bailed out
Fannie Mae & Freddie Mac – AAA rating before being bailed out by the government
Citigroup – A2 before receiving a bail out package from the Government
Merrill Lynch – A2 before being sold to Bank of America
A2 is considered a good investment grade
Below are the ratings that each company uses.
The Prime Minister of Luxembourg, Jean-Claude Juncker, has called for a European credit rating agency to be established in opposition to Standard & Poors, Moodys, and Fitch. Recently the head of the European Central Bank, Jean-Claude Trichet, referred to the 3 agencies as an oligopoly.
There is a belief that a European agency would be able to judge better the medium-term outlook for European countries. A couple of examples of ‘bad calls’ that could trigger unforeseen events throughout debt the markets include:
– Moodys cut Portugal’s government debt form ‘investment grade’ to ‘junk’ status saying that the rescue package wouldn’t restore stability.
– S&P stated that the rescue package for Greece would impose losses for holders of Greek debt and therfore constitue a default.
– S&P had issued a warning about downgrading Italy’s debt. This was done before a planned austerity programme had been released.
The real concern amongst politicians is the fact that it seems to transpire that the decisions of a small bank of credit analysts who decide on a country’s credit rating have immediate real-world consequences. All this reminds of the movie documentary “Inside Job” and the interviews with the credit rating agencies, see below. Some interesting comments about opinions.
The April Economic Overview publication from Westpac Bank published a feature article focusing on why New Zealand has relatively high interest rates. A paper written by Treasury came up with two views:
1. The Risk Premium View
2. The Excess Demand View
The Risk Premium View
Interest rates in different countries can diverge with different perceptions of risk or inflation. Although New Zealand’s inflation or exchange rate are not volatile in relation to other countries, there is unusually high levels of nationla debt. While our government debt is relatively low in comparison to other countries it is our overall debt which is running at 80% of GDP which is causing concern. This would tend to push up interest rates higher than other countries with lower debt levels, while also pushing the exchange rate lower than it would otherwise be. The graph below plots the average inflation-adjusted interest rates against net foreign debt for a range of countries, suggests that this is broadly true.
The Excess Demand View.
The exchange rate can increase especially as investors look for higher yields as a country might have higher intesest rates – known as the ‘carry trade’. Investors will pile into higher-yielding currencies only up to the point where the exchange rate has become sufficiently ‘overvalued’ for its expected depreciation to offset the prospective interest rate gains. Elaborating on the carry trade idea the significant amount of aggregate demand in the NZ economy has kept the NZ$ high. This strong level of domestic demand has been to the detriment of savings and has also meant that the Reserve Bank has had to keep interest rates above those countries that have higher savings rates. Furthermore increases in domestic demand have meant:
– a higher trade deficit
– significant foreign debt
– an overvalued exchange rate
Is saving the answer?
Saving is not by itself the panacea however there is a high liklihood that there could be lower interest rates and a lower exchange rate. Higher savings would also be rewarded with lower borrowing costs but contrary to the first point, lower foreign debt servicing costs and a more positive report from the credit rating agencies the NZ$ would be inclined to appreciate.
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