• Site Map
• Campus Map
• A-Z Index
• Staff Intranet
• Contacts

Dr Charles Chew

The Subprime mortgage crisis goes global

It was inconceivable a year ago that I would be discussing the subprime mortgage crisis. Simply put, a subprime mortgage is just a housing loan made to someone with a weak or troubled credit history.

I knew in early 2007 that the financial system was flawed, but it seemed incredible that the events then were to play out as they did. As we pull back the veil on the players who created the subprime disaster, we see how greed and fraud had overtaken the housing and the general finance industries.

Millions of home mortgages especially subprime ones have been bundled into securities and sold to banks, financial institutions and other investors in the US and globally causing an avalanche of financial disasters. There has been a chain reaction causing the world economy to slow down, property prices to fall, and credit to tighten. The true extent of this crisis, I believe, is still unknown.

Governments world-wide including our own seem to think that the solution to the subprime crisis is in bailouts. It is easy to argue that in the short time, bailouts should indeed play some role in our response to the crisis. However, over the long term, bailouts may bring about what economists would term “moral hazard”. Moral hazard has its origins in the insurance industry. It postulates the idea that investors are more likely to take risks if they are insured against loss. If your home is insured against theft, you are likely to be less “careful” and less likely to shut your windows or lock your doors because you know that the consequences of any robbery will be borne by the insurance company.

According to economists, the same principles apply to financial markets. If people know that the government will bail out institutions for their losses, for example, they will take bigger investment risks. When the Federal Government assisted financial institutions during the collapse of the stock market in 1987, the mortgage funds in1998 and the technology stock in 2001, it laid the groundwork for moral hazard, which economists say led to the recent financial meltdown.

Accordingly, the Government suspects that its bailout of the subprime crisis, although effective in the short term, would only set the stage for bigger financial problems in years to come (when recovery is evident) when investors will again take greater and greater risks.

In the meantime, the world’s leading rating agencies (Standards & Poor, Moody and Fitch) as “gatekeepers” have recently testified in the US Congress that they have failed to anticipate the severity of the credit meltdown, despite the fact that their staff had privately feared for several years that some parts of the mortgage securities market were worth next to nothing.

The credit agencies have given flatteringly high investment grade ratings (eg AAA) to millions of subprime low-quality home loans. These mortgage-backed loans are repackaged into securities and being highly rated, are enthusiastically snapped up by banks and investors in the US and all over the globe thereby spreading the contagion.

One remedy is for the big auditing or accounting firms to enter the credit rating business as new gatekeepers thereby creating real competition in the ratings field. Ratings based on an audit-like inquiry by the credit agency makes much more sense than our current system under which the rating agency’s letter grade which tends to be high is wholly based on facts provided by the issuer who subscribes to the agency. Because of the influence of the credit rating agencies world wide, there should be global regulation of these agencies.

Credit default swaps (CDS) are the most widely traded form of credit derivatives which are rated by the credit rating agencies. They are bets between two parties on whether or not a company will default on its bonds. Thus, a credit default swap is a contract between 2 parties, one of whom is giving insurance to the other that he or she will be paid in the event that a financial instrument such as a bond or loan will fail.

It is, in effect, an insurance contract, but people are very careful not to call it that because if it were insurance, it would be regulated. So a substitute word called a “swap” is used, which allows it not to be regulated. As a result, contracts can be traded — or swapped — from investor to investor without anyone overseeing the trades to ensure the buyer has the resources to cover the losses if the security defaults. Although defaults are rare, they tend to occur at the same time and are usually highest during a recession which we are heading towards.

A meltdown in the CDS market has potentially even wider ramifications than the subprime crisis. The CDS market exploded over the past decade to 62 trillion dollars. The US Fed bailout of Bears Stearns in March 2008 was made, in part to keep the unknown risks of that bank’s CDS from setting off a global chain reaction that might have brought the whole financial system down. This is because banks have been suspecting that CDS could spread the credit risk around the world.

There should be greater monitoring of international developments regarding the regulation derivatives markets including CDS and hedge funds in Australia, through the Australian Securities and Investments Commission (ASIC), the Australian Prudential Regulation Authority (APRA) and the Reserve Bank.

The Government’s original decision on unlimited guarantee was hastily made and not a well thought out decision. Neither Britain nor the US chose an unlimited guarantee. It may be better for the Government to have adopted a guarantee limit of, for example, $100,000 (which happens to be the Opposition Leader’s figure) to avoid the adverse consequences of the present crisis. In England, the government needed a quid pro quo to bail out bankrupt mortgage bank Northern Rock, that is, only in return for the bank's stock.

This deposit guarantee covered funds in banks, building societies and credit unions. There was no limit and no fee for the guarantee. That policy proved to be unsustainable, and the Government tried to unscramble to patch things by changing the policy on 24 October when the Treasurer announced a limit of $1 million above which fees would be charged for the guarantee. The guarantee only applied to banks and other Authorised Deposit Institutions (ADIs) and not to mortgage and other investment funds.

The industry’s biggest mortgage fund players are reeling from the effects of the government’s bank deposit guarantee, with Colonial First State, Perpetual and Axa Asia Pacific Holdings joining Challenger Howard Mortgage Fund in freezing redemptions locking up investors’ funds including (unfortunately) those of retirees. This is done in order to stop the flow of investors’ cash from the mortgage funds (which are not covered by the guarantee) moving to the safety of the big banks.

The present financial crisis arises from the defects of “extreme capitalism” which have produced a market failure demanding huge government interventions to overcome the toxic mixture of “greed and fear”.

The lesson we can learn about the current subprime problem is that it can be the genesis of a financial renaissance. There should now be more regulation, especially quality regulation, and less innovation. This is the end of free-wheeling economics of Thatcherism and Reagonomics but a revival of Keynesian principles where government intervention if judiciously exercised can be beneficial. There should be an urgent overhaul of the international financial system and stricter regulation in the face of dramatic losses on financial markets in an ailing world economy.