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Subprime mess highlights need for tough rules

Subprime mess highlights need for tough rules

The events of the past few months in global credit and other asset markets show that the world economy must be shielded from the actions of financiers and that bankers, insurers and money managers must be protected from themselves.
Everyone mentions the need for lower interest rates and government aid to homeowners, but few advocate tougher regulation of the wholesale market. Like the 1980s U.S. savings-and-loan debacle and the technology bubble in the late 1990s, the U.S. mortgage mess offers more evidence that while deregulated markets generate booms, their ability to clean up the aftermath of a bust is less impressive.
U.S. and other financial regulators, under the auspices of the Bank for International Settlements, will have to come up with a common set of rules to avoid a repeat of the subprime meltdown.
It should come as no surprise that economic growth and financial markets suffer when a major asset bubble, such as housing, bursts.
"Nonetheless, the extent, depth and breadth of the damage to financial assets around the world, and the complex way that the shock has propagated through the credit markets, have caught many off-guard," says Mark McClellan, Montreal-based head of global fixed-income strategy at BCA Research Ltd.
In one of the most complex financial blowups, the subprime- mortgage crisis and ensuing credit crunch owe their origins to a single human trait: greed. And there was plenty to go around.
Mortgage Debt
Banks lent money to people they knew couldn't repay it. Others repackaged mortgages as securities - known as collateralized debt obligations - and sold them to investors. That moved low-quality mortgage loans off the banks' books and reduced the incentive to carefully examine borrowers' ability to service their debts.
Lenders \sponsored structured investment vehicles, offering back-up credit lines in exchange for a share of the profits. SIVs sell high-quality, short-term commercial paper and invest the proceeds in longer-maturity, lower-quality assets, making money on the spread.
A modest proposal: Force banks to redesign bonus structures to reflect long-term results and avoid such risky practices.
Rating companies were "co-opted into the process, and granted aggressive ratings in exchange for fees that were multiples of their traditional business," McClellan says. Money managers, hungry for higher returns than those available on U.S. Treasuries, blindly invested in securitized assets, many of which came with coveted AAA ratings.
\Theoretically, that meant an investor could earn a higher return than on government securities with no additional risk. Leveraged buyouts were financed with equally ultra-cheap loans and bonds carrying less-than-stringent covenants. Credit-default swaps evolved into the ultimate speculative tool to bet on corporate credit.
Eager to expand their fee income, financial guarantors got into the act, insuring asset- backed securities and CDOs, which represented packages of securitized-subprime mortgages.
The repercussions from the greed have been staggering and include a possible recession in the U.S. and slowing growth worldwide, skewed monetary policies that have left central banks trying to prop up growth at the expense of not fighting inflation, and a ballooning U.S. fiscal deficit worsened by a desire to bail out homeowners with mortgages.
Huge losses
Big U.S. and European banks - including Citigroup Inc., Morgan Stanley, Merrill Lynch & Co. and UBS AG - have suffered huge losses related to subprime and other mortgage securities and gone hat-in-hand to Asian and Middle Eastern governments for capital. The monolines approached the banks for cash to bolster their AAA ratings, which for MBIA Inc. and Ambac Financial Group Inc., the two biggest, were reaffirmed on February 26.
If the insurers lost their AAA status, the thousands of structured deals they have guaranteed would also be downgraded. That would trigger a fire sale of mortgage-backed securities, especially by institutional investors prohibited from owning lower quality assets, and trash the U.S. municipal-bond market.
One solution to this would be to require insurers to maintain higher capital ratios. And rating assessors could be funded via a tax on all companies, instead of just those seeking a credit evaluation. That would avoid conflicts of interest.
The rising risk aversion emanating from the mortgage crisis has damaged global stock markets. The Standard & Poor's 500 Index has fallen 12 percent since early October, the Dow Jones Stoxx 600 Index of leading European companies 16 percent.
The commercial-paper and auction-rate bond markets have seized up. Interest rates on insured bonds sold by municipalities have surged as much as fourfold this month, and U.S. governors are thinking of asking Congress for aid.
It's tempting just to let banks stew in the consequences of their own folly. But they are too integral a part of the global economy. And letting some fail would further damage growth. A better remedy might be to more tightly regulate derivatives markets and limit the use of leverage. Governments regulate the safety and efficiency of drugs, automobiles and airplanes. Why not financial instruments?
To paraphrase French statesman Georges Clemenceau's comment about war and generals, economies and financial markets are too important to be left to financiers.
Michael R. Sesit is a Bloomberg News columnist.


Updated : 2021-04-16 19:21 GMT+08:00