The future of finance

Leviathan of last resort

State subsidies and guarantees are once again corroding the financial sector and creating new dangers

Apr 12th 2014
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EVER since Lehman Brothers went bankrupt in 2008 a common assumption has been that the crisis happened because the state surrendered control of finance to the market. The answer, it follows, must be more rules. The latest target is American housing, the source of the dodgy loans that brought down Lehman

Plans are afoot to set up a permanent public backstop to mortgage markets, with the government insuring 90% of losses in a crisis. Which might be comforting, except for two things. First, it is hard to see how entrenching state support will prevent excessive risk-taking. And, second, whatever was wrong with the American housing market, it was not lack of government: far from a free market, it was one of the most regulated industries in the world, funded by taxpayer subsidies and with lending decisions taken by the state.

Back in 1856 one of this newspaper’s editors, Walter Bagehot, blamed crashes on what he calledblind capital”—periods when credulous cash, ignoring risk, flooded into unwise investments. Given not only the inevitability of such moments of panic but also finance’s systemic role in the economy, a government had to devise some special rules to make finance safer. Bagehot invented one: the need for central banks to rescue banks during crises. But Bagehot’s rule had a sting in the tail: the bail-out charges should be punitive. That toughness rested on the view that governments should as far as they could treat financiers like any other industry, forcing bankers and investors to take as much of the risk as possible themselves. The more the state protected the system, the more likely it was that people in it would take risks with impunity.


That danger was amply illustrated in 2007-08. Having pocketed the gains from state-underwritten risk-taking during the boom years, bankers presented the bill to taxpayers when the bubble went pop. Yet the lesson has not been learnt. Since 2008 there has been a mass of new rules, from America’s unwieldy Dodd-Frank law to transaction taxes in Europe

Some steps to boost banks’ capital and liquidity do make finance more self-reliant: America’s banks face a tough new leverage ratio. But overall the urge to regulate and protect leaves an industry that depends too heavily on state support.


Turning in his grave


The numbers would amaze Bagehot. In America a citizen can now deposit up to $250,000 in any bank blindly, because that sum is insured by a government scheme: what incentive is there to check that the bank is any good? Most countries still encourage firms and individuals to borrow by allowing them to deduct interest payments against tax. The mortgage-interest subsidy in America is worth over $100 billion.

Even Bagehot’s own financial long-stop has been perverted into a subsidy. Since investors know governments will usually bail out big financial firms, they let them borrow at lower rates than other businesses. America’s mortgage giants, Fannie Mae and Freddie Mac, used a $120 billion funding subsidy to line shareholders’ pockets for decades. The overall subsidy for banks is worth up to $110 billion in Britain and Japan, and $300 billion in the euro area, according to the IMF. At a total of $630 billion in the rich world, the distortion is bigger than Sweden’s GDP—and more than the net profits of the 1,000 biggest banks.

In many cases the rationale for the rules and the rescues has been to protect ordinary investors from the evils of finance. Yet the overall effect is to add ever more layers of state padding and distort risk-taking.

This fits an historical pattern. As our essay this week shows, regulation has responded to each crisis by protecting ever more of finance. Five disasters, from 1792 to 1929, explain the origins of the modern financial system. This includes hugely successful innovations, from joint-stock banks to the Federal Reserve and the New York Stock Exchange. But it has also meant a corrosive trend: a gradual increase in state involvement. Deposit insurance is a good example. Introduced in America in 1934, it protected the first $2,500 of deposits, a small multiple of average earnings then, reducing the risk of bank runs

Today America is an extreme case, but insurance of over $100,000 is common in the West. This protects wealth, and income, and means investors ignore creditworthiness, worrying only about the interest-rate offer, sending deposits flocking to flimsy Icelandic banks and others with pitiful equity buffers.

The overall effect is not just to enrich one industry, but to mute the beneficial effects of finance. Healthy financial markets speed up an economy, channelling credit to firms that need it. They can also make an economy fairer and more competitive, providing the funds for those without them to challenge incumbents. Modern finance is a more slanted system in which savings are drawn towards subsidies and tax distortions

Debt-fuelled housing goes wild while investment in machines and patents runs dry. All this dulls growth.


Blame the grandparents


How can the zombie-like shuffle of the state into finance be stopped? Deposit insurance should be gradually trimmed until it protects no more than a year’s pay, around $50,000 in America. That is plenty to keep the payments system intact. Bank bosses might start advertising their capital ratios, as happened before deposit insurance was introduced. Giving firms tax relief on financing costs is sensible, but loading it all onto debt rather than equity is not

And still more can be done to punish investors, not taxpayers, for failure. A start has been made with “living wills”, which describe how to wind down a megabank, and loss-absorbing bonds, which act as buffers in a crisis. But Europe is far behind America here, and the issue of how to resolve huge, cross-border banks remains.

The chances of politicians withdrawing from finance are sadly low. But they could at least follow Bagehot’s advice and make the cost of their support explicit. The safety net for finance now stretches well beyond banks to undercapitalised clearing-houses and money-market funds. Governments should report these liabilities in national accounts, like other subsidies, and exact a proper price for them. Otherwise, they have merely set up the next crisis.


Top economists warn Germany that EMU crisis as dangerous as ever

Council on Foreign Relations compares Germany's hardline stance with US policy towards Britain at the end of the Second World War

By Ambrose Evans-Pritchard, in Berlin

6:55PM BST 09 Apr 2014
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Burnt euro notes, burnt because they were unusable for various reasons, are displayed in the money museum of German Bundesbank in Frankfurt, Germany
Professor Michael Burda, from Berlin's Humbolt University, said the eurozone's core problem is Germany's current account surplus  Photo: AP

The eurozone debt crisis is deepening and threatens to re-erupt on a larger scale when the liquidity cycle turns, a leading panel of economists warned in a clash of views with German officials in Berlin.

"Debts above 130pc of GDP for Italy and 170pc for Greece are a recipe for disaster once we go into the next downturn," said Professor Charles Wyplosz, from Geneva University.

"Today's politicians believe the crisis is over and don't want to hear any more about it, but they have not tackled the core issues of fiscal union and public debt," he said, speaking at Euromoney's annual Germany conference.

Ludger Schuknecht, director-general of the German finance ministry, insisted that the debt-stricken states of the eurozone are well on the way to recovery, ending their EU-IMF rescue programmes successfully one by one. There is no need for any major shift in policy. "The strategy has been right. We need to bring down debt and this is now consensus," he said.

Mr Schuknecht, the chief architect of the EMU anti-crisis regime, said Europe's banking union may need tweaking but nothing more. "There are some loose ends. These will be tied in a timely manner," he said.

This optimism is sharply at odds with the view of almost every foreign-based economist attending the event. Charles Dallara, former head of the International Instititute for Finance and chief negotiator for global banks in Greece's debt-restructuring, said little has be done to put the eurozone on a viable footing, even if sovereign bond yields in southern Europe have fallen to record lows.

"We should not be distracted by what is happening in financial markets, and look at the underlying economies in Italy and Spain. The pace of recovery is so slow and painful that is going to be challenging for democracies," he said.

"There has been too much belt-tightening and not enough structural reform. Credit is continuing to shrink in the heart of the eurozone. What is needed is a collective effort across the entirety of the eurozone to boost confidence, with a new package of fiscal measures and an end to austerity. Imagine how powerful that would be," he said.

Benn Steil, from the Council on Foreign Relations, said Germany's refusal to allow the eurozone rescue fund (ESM) to recapitalise banks directly means there will be no back-stop in place to prevent problems spinning out of control if European banks fail stress tests later this year, as expected.

This ignores the key lesson of the US stress tests, where government capital lay in reserve to ensure the stability of the system. "There is the potential for a fresh crisis if they announce the stress tests without the ESM being able to recapitalise banks," he said.

While Mr Steil did not cite specific countries, there are concerns that some Irish, Portuguese, Spanish and Italian lenders may fail tests as they grapple with a backlog of non-performing loans.

"Germany and the creditor states are going to have to decide whether they will accept fiscal transfers or whether it is best to wind down the project and let the eurozone unravel," he said.

Mr Steil compared Germany's hardline stance with US policy towards Britain at the end of the Second World War, when a prostrate UK emerged with the world's biggest debts - though US policy later changed. "We are hearing the same language as in the 1940s. The crisis was all the fault of lax policies in the debtor countries. It was precisely the way the US spoke when it was a creditor," he said.

Mr Steil warned that the achievement of primary budget surpluses in Italy and Greece may prove a Pyrrhic Victory since history shows that heavily-indebted countries are most likely to default once they have crossed this line and can meet day-to-day costs from tax revenue. "This is a good time for Greece to default," he said.

Professor Michael Burda, from Berlin's Humbolt University, said the eurozone's core problem is Germany's current account surplus - more than 6pc of GDP - and flat wages for a decade. "Germany has to become less competitive or the eurozone is not going to survive

You can't just save forever. It's mercantilism and we don't do that kind of thing anymore. All Germany has to do is to make its people happier by raising their wages," he said. 


Fannie Mae and Freddie Mac

The ugly twins of finance

America’s huge mortgage-market distortions seem likely to endure

Apr 12th 2014

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YOU could argue that Fannie Mae and Freddie Mac, twogovernment-sponsored enterprises” (GSEs) in the mortgage business which received the biggest bail-out of the financial crisis, have paid their debt to society. At any rate, the revenues they have generated for American taxpayers since the Treasury took charge of them in 2008 now exceed the $187 billion spent to rescue them. It might be a logical time for the government to stop underwriting Americans’ personal loans. Yet the thrust of the bill to reform their status that is gaining some momentum in Congress is the opposite. For an example of how a post-crash crutch becomes a permanent financial distortion, look no further.

Federal support for mortgages started as part of the New Deal, in 1934. The Federal National Mortgage Association, or “Fannie Mae”, was made private in 1968, and was joined by a twin, the Federal Home Loan Mortgage Corporation, “Freddie Mac”, in 1970. They aimed to ease mortgage finance by buying loans from banks and pooling these into mortgage-backed securities (MBS) which could be sold to pension and mutual funds. They also held MBS directly, funded by issuing debt.


The GSEs’ business was risky, and it rested on implicit state support. A 1996 study valued this subsidy at $6.9 billion. As the GSEs grew, the estimates did too. A 2003 Federal Reserve paper put the subsidy between $119 billion and $164 billion. Around 50% of this went straight to shareholders. But the GSEs were seen to serve the politically popular goal of expanding access to housing, so they enjoyed lower tax rates and lighter regulation than other financial firms. Leverage magnified short-term profits: with equity ratios of just 3.5% their returns on equity hit 20%. Contented congressmen and shareholders ignored the warnings of conservative think-tanks about this cushy arrangement.

At first look a bill sponsored by Tim Johnson, a Democratic senator from South Dakota, and Mike Crapo, a Republican senator from Idaho, seems a reasonable reversal of past mistakes. It treats the GSEs’ infrastructure, the kit they use to pool loans into MBS, as a public utility. The logic is that, as with train lines or water pipes, there are huge fixed costs in building financial architecture. Rather than replicating it, it is better to let private firms access it. The model is akin to the treatment of Britain’s natural monopoliesgas, electricity and telephone systems—following Margaret Thatcher’s privatisations in the 1980s.

Under the Johnson-Crapo plan, Fannie and Freddie would be replaced by the Federal Mortgage Insurance Corporation (FMIC). Banks would use its securitisation services, and be charged a fee to reflect the FMIC’s costs. Strong rules would tamp down risk. For each $100 of mortgage lending securitised by the FMIC, the banks that issued the mortgages would have to hold $10 of capital. The winners would be investors in MBS. 

The FMIC would completely neutralise risk for them. In the event of widespread defaults, the lenders’ 10% capital would offer an initial buffer, with the FMIC backstopping the remaining 90%.

The plan is neatly packaged, but worrying. For one thing the transfer of ownership runs in the wrong direction: privately built plumbing is becoming public. Moreover, it is not clear that this utility is worth having: American home-ownership rates are decidedly mid-table (see chart). Borrowers are able to get 30-year fixed rates, but loans are not especially cheap. Studies show that unsubsidised mortgages are just a fraction dearer than the government-insured sort.

And whereas the FMIC’s benefits are debatable, the costs are not. Stripping all risk from markets removes investors’ incentive to check on the lenders they are buying bundles of loans from. It is true that those making the loans will haveskin in the game”. But shareholders have a poor record in constraining red-blooded CEOs. This is why most other countries are trying to get bondholders to provide more market oversight, not less.

For those who would like to see the government out of the mortgage industry, there is a chink of light. The Johnson-Crapo bill deliberately backs away from the full privatisation under consideration in the House of Representatives and attempted in the Senate three years ago. But it includes a requirement, eight years in, to asses whether the FMIC could be privatised. The problem is that history, and Washington’s enduring fondness for state-supported lending, suggest reasons will be found to keep it in government hands.


April 10, 2014 4:55 pm

American subprime lending is back on the road

Many new loans are going to consumers who previously had little chance of getting funding

Toyota Motor Corp. vehicles sit lined up waiting dealer delivery at the company's logistics services inside the Port of Long Beach in Long Beach, California, U.S., on Tuesday, April 3, 2012. Job gains and buyers who put off car purchases during the recession are driving the fastest three-month auto-sales pace in four years, even as average U.S. unleaded gasoline prices rose 20 percent this year through the end of March. Photographer: Tim Rue/Bloomberg©Bloomberg

A few short years ago, “subprime” was almost an expletive. During the financial crisis, mortgages linked to subprime borrowers – or those with poor credit historycaused devastating losses; so much so that many asset managers declared they would never touch subprime again.

But the financial world has a short memory, particularly when easy money and innovation collide. In recent months subprime lending has quietly staged a surprisingly powerful return, not in relation to real estate, but another American passioncars. Some wonder how long it will be before this new boom causes another wave of casualties, not just among naive consumers, but investors too.

The historical echoes are uncanny. During most of the past decade the amount of car-related debt grew only modestly. Yet outstanding car loans, which totalled $700bn in 2010, have jumped by a quarter in the past three years. This has led to a sharp increase in car sales, benefiting groups such as General Motors.

This upswing is striking, given that many other forms of consumer credit have remained weak since the 2007 financial crisis. Outstanding loans on credit cards, for example, have recently hovered near a 10-year low, and data this week showed they fell unexpectedly sharply, by $2.42bn in February.

But car finance along with student loansjumped in that same month. Even more notable is that this has occurred amid a sharp deterioration in loan quality. Five years ago, subprime loans represented barely a 10th of the total; today they account for a third. A particularly high proportion of GM cars sales are financed by subprime loans
Meanwhile, a 10th of new loans are now going to so-calleddeep subprime”, or consumers who would previously have had little chance of getting funding particularly given that incomes for poorer households have stayed flat or declined, even as car prices jumped.

There are several reasons for this boom. One is the fact that asset managers are currently so desperate to find somethinganything – that produces a return in an ultra-low interest rate world that they are gobbling up all manner of bonds. And investors are particularly keen to buy bonds backed by car loans because these performed better than mortgages during the last credit crisis. This has spawned a widespread (and potentially dangerous) assumption that American consumers are so attached to their cars they will do anything to retain them.

However another reason for the boom is that savvy private equity firms and hedge funds have jumped into the fray, backing a plethora of new car finance companies in the past three years.

These have pushed loans to consumers in creative ways, and it has been a highly lucrative game: consumers can pay almost 20 per cent interest for subprime loans, but finance companies’ funding costs can be a mere 2 per cent, due to voracious investor demand.

Thus far there is little sign that this boom is causing tears. Default rates on car loans remain low by historical standards, at about 1 per cent. Still, if interest rates rise, defaults will almost certainly jump, particularly if incomes remain flat.

Credit rating agencies are starting to get uneasy. Some of the smartest Wall Street players are quietly cashing out. Some financiers are now so convinced that a crunch looms that they are furtively shorting automotive stocks such as GM, on fears that a loan crunch will hit car sales. That may explain why shares in the car company have slid so sharply this year, even beyond what could be explained by the recent embarrassing scandals over faulty ignition keys.

These worries may be premature; people were muttering about the last subprime bubble years before it burst. And the good news is that even if subprime car financing does create a crunch, it will not necessarily cause that much systemic impact, since it is much smaller in size.

But if nothing else, this little saga is a stark reminder that parts of America’s current recovery are built on wobbly foundations. And it is another timely illustrationif any were needed – that cheap money has a nasty habit of creating distortions in unexpected places; even if they do not usually occur in exactly the same place as before.


Copyright The Financial Times Limited 2014