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Seven credit crisis warnings the experts ignored

10 October 2008 Gareth Stokes

The world has faced countless disasters since the beginning of time, both natural and manmade. There’s not much that governments can do about earthquakes, hurricanes and other acts of God; but they can draw up and implement plans to minimise the impact on

Ignoring the warning signs

Where there’s a manmade disaster we can usually spot an early warning sign. The rest of the world knew that Germany was a trouble maker; but respected that country’s sovereignty until it was too late. And the Titanic’s captain was warned about the possibility of large ice-floes; but chose instead to power ahead under full steam in order to set a new record for a trans-Atlantic crossing. On closer analysis there were plenty of early indicators that the global economy was heading for a crash too. We’ll examine seven of the 19 ‘warning signs’ identified by Reuters journalists, Sean Farrel and Sean O’Grady.

The first warning sign we’d like to look at is the search for yield. Reuters didn’t use the word “greed” to describe the phenomena; but they may as well have. Banks and other financial institutions were unhappy with the interest earned on ‘safe’ assets like US Treasury Bonds and other deposit mechanisms. Knowing that risk and reward are directly related they set about creating riskier assets in order to earn higher returns. One of these risky practices has since lent its name to the credit crisis – sub-prime. The second warning sign is the emergence of sub-prime lending, which resulted in millions of dollars (at high interest rates) being lent to individuals with little hope of every repaying the loans. We think of this as the primary cause of today’s credit crisis though Reuters suggests it was merely a “visible symptom of a 10-year debt binge!”

Warning sign number three is the frenzied behaviour of individual borrowers as they sought to maximise return on the ‘cheap’ money they were borrowing. Reuters uses the word leverage to describe the practice of using low-interest money (always borrowed) to chase after better returns in riskier asset classes. How could anyone miss this development and why did no-one step in to put a stop to it?

The snowball effect

There were people who realised that the situation was getting out of hand. But by that time the problem had already snowballed to such an extent that it was easier to let it roll down the hill than trying to stop it. This lead to a kind of moral hazard as senior officials chose to let market forces run their course rather than intervene. “Fear of the consequences made [Bank of England governor, Mervyn King] unwilling to help stricken banks,” said Reuters. In truth there’s not much that could have been done at this point. The crisis developed over a much longer period than most observers realise.

Warning sign number five should have come from the so-called mark-to-market accounting provision. Under this requirements banks had to use market prices to value the assets on their balance sheets. But the assets they had created were so complicated that accurate market valuations were near impossible. This helped them on the way up; but created huge holes on their balance sheet as these ‘worthless’ sub-prime debt backed securities were exposed.

Financial authorities and regulators

Sixth on the list is the role played by industry regulators. “From London to New York and Reykjavik regulators failed to rein in the excesses of the financial industry,” says Reuters. The consensus was that the free market system would ensure that transactions took place within sensible parameters. But they never counted on the ingenuity of the greedy bankers who structured the deals. Things are so serious that even entire countries (like Finland) now stand at the brink of bankruptcy!

The final aspect we’ll pick up on in today’s article is the role of financial services authorities. One of the earliest victims of this global financial contagion was the UK-based mortgage lender, Northern Rock. It first sent distress signals in September 2007 – and was only taken under government’s wing in February this year. The Financial Services Authority (FSA) has since admitted it wasn’t doing much in the line of monitoring of banks’ capital adequacy in the run-up to Northern Rock’s implosion.

The regulation of the financial services industry is a difficult task; but the various government appointed watchdogs cannot keep on arriving too late at the scene. Where money is concerned prevention is the only alternative… That’s because the cure almost always leaves the patient much leaner than before.

Editor’s thoughts: If we consider the many financial collapses in South Africa in recent times we almost always come back to a single human emotion – greed. It’s greed that inspires individuals to mismanage money – and greed that inspires people to give them the money in the first place. Will we ever have a society where the relentless pursuit of material happiness takes a back seat? Add your comments below, or send them to gareth@fanews.co.za

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