The world’s three major private credit-rating agencies (CRA) Standard & Poor’s, Moody’s and Fitch are using their power to prevent low-income countries from restructuring their debts and stimulating their economies. Credit rating agencies realise that developing economies who engage with private creditors, which is part of the G20 Common Framework for Debt Treatments, run the risk that those creditors will incur losses and therefore CRA downgrade the developing country’s credit rating. The Common Framework is supposed to help debt-ridden countries and are the best chance for developing countries to reduce their liabilities but a ratings downgrading damage their prospects.
Standard & Poor’s, Moody’s and Fitch control more than 94% of outstanding credit ratings. They are basically an oligopoly influencing financial portfolio investments, the pricing of debt and the cost of capital. Their authority is also enhanced by the SEC (Security and Exchange Commission) who see them as the official CRA. Below are the ratings that each company uses.
We’ve been here before – conflict of Interest and the sub-prime crisis of 2008 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.
Remember before the credit crisis AAA investments mushroomed between 2000-2006 see graph below.
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
Although a few years old now the mini-documentary below is very good and features many notable economists and economic thinkers. They basically look at the issue of financial stability, or the lack thereof, and discuss what is at the core of the problem. It includes Joseph Stiglitz, Gillian Tett, David Tuckett, Stephen Kinsella, John Kay, David Weinstein, Steve Keen and Dirk Bezemer. I have used this post to try and bring some reality to a lot of prescribed economics courses at high school level.
The economic environment is said to be determined by agents or economic decision-makers. Today, an economy is a much more intricate machine which aims to allocate scarce resources to satisfy the utility of economic agents such as individuals, firms and government. The dominant model for many years has been “Dynamic Stochastic General Equilibrium” (DSGE) and it takes all the characteristics of an individual (this person is typically called the representative agent) which is then cloned and taken to represent the typical person in an economy.These agents make supposedly perfect decisions by optimising, working out the kinds of mathematical problems in an instant. However the rise of behavioural economics has shown that cognitive errors are now assumptions in many aspects of economics namely – heuristics, confirmation bias, overconfidence and distorted probability weights.
According to a paper entitled “Mindful Economics: The Production, Consumption, and Value of Beliefs” by Roland Bénabou and Jean Tirol research has shown that beliefs often fulfill important psychological and functional needs of the individual. Examples include:
confidence in ones’ abilities,
hope and anxiety reduction,
Therefore people hold beliefs because of the value they attach to them, as a result of the tradeoff between accuracy and desirability. As a consequence of this some of the beliefs do not consider prior knowledge of conditions or events that might be related to their beliefs – Bayseian Updating – this refers to people who are willing and able to modify their beliefs based on new, objective information. This non-Bayesian behaviour includes ignoring signals about their beliefs and denying what in turn will be the reality. Nevertheless motivated beliefs will respond to costs, benefits, and stakes involved in maintaining different self-views and world-views which leads to self-sustaining “social cognitions.”
Overconfidence Bénabou and Tirol suggest that overconfidence is the most common indicator of the motivated beliefs experience. Overconfidence can be seen as quite damaging although moderate confidence can be quite useful as it often enhances an individuals ability to act successfully on their own behalf and work well with others. Research has shown that psychologically “healthy” people display some degree of overoptimism and biased updating, while it is primarily depressed subjects who seem to be more objective.
If beliefs are shared between parties they may magnify each other and there is a tendency to follow the herd, especially if information is uncertain, incomplete, and asymmetric (some people are more informed than others). Basically, in a world of bounded rationality (the limits of the human brain in processing and understanding information), herding makes sense to most people. Herding is a fast and frugal heuristic (short-cut) that has been used by both human and non-human animals across the millennia. Some behavioural economists see herding as irrational because people aren’t basing their decisions on objective criteria. If herding is seen as rational it can result in price cascades leading to excessive booms and busts in the prices of financial assets. Case and Shiller (2003) surveyed the expectations of homeowners during the real-estate bubbles of 1988 and 2003. In both cases, 90 percent of respondents thought housing prices in their city would “increase over the next several years,” with an average expected gain for their own property of 9 to 15 percent per year over the next ten years.
The strategies of self-deception and dissonance-reduction used to protect valued beliefs are many and varied, Bénabou and Tirol group them into three main types: strategic ignorance, reality denial, and self-signaling.
Strategic ignorance is when a believer avoids information offering conflicting evidence.
Reality denial refers to troubling evidence that is rationalised away: house-price bulls might conjure up fanciful theories for why prices should behave unusually, and supporters of a disgraced politician might invent conspiracies or blame fake news.
Self-signaling is when the believer creates his own tools to interpret the facts in the way he wants: an unhealthy person, for example, might decide that going for a daily run proves he is well.
People derive utility from a sense of belonging to communities and having a positive self-image. Optimistic beliefs can also be valuable motivators to overcome self-control problems, as well as helpful in strategic interactions. In order to maintain this level of utility people tend to disregard Bayesian updating and are not willing to modify their beliefs based on new, objective information. Even if they did consider new information they will manipulate it to align with what their beliefs are.
Overconfidence is the most common indicator of the motivated beliefs experience and this can be impacted by the behaviour of others. Their confidence is often reinforced when people know that other people, including experts, and the rich and famous, are doing the same. In a world of bounded rationality, such behaviour may make sense – even though it can result in errors in decision making.
“To err is human; so is the failure to admit it” – The Economist June 10th 2017
“Mindful Economics: The Production, Consumption, and Value of Beliefs” by Roland Bénabou and Jean Tirol. Journal of Economic Perspectives—Volume 30, Number 3—Summer 2016—Pages 141–16
Thanks to colleague Paul Chapman for this article from Mercer ‘Health Wealth Career’. Its looks at the 10 lessons learnt from the GFC and 3 thoughts from what we might expect in the future.
Lesson 1 – Credit cycles are inevitable. As long banks are driven by growth and profit margins their decision-making inevitably leads to greater risk and poorer quality. The growth from 2005-2008 was generated by leverage.
Lesson 2 – The financial system is based on confidence, not numbers. Once confidence in the banking system takes a hit investors start to pull their money out – Northern Rock in the UK.
Lesson 3 – Managing and controlling risk is a nearly impossible task. Managing risk was very difficult with the complexity of the financial instruments – alphabet soup of CDO, CDS, MBS etc. A lot of decisions here were driven by algorithms which even banks couldn’t control at the time. Models include ‘unkown unkowns’
Lesson 4 – Don’t Panic. Politicians learnt from previous crashes not to panic and provided emergency funding for banks, extraordinary cuts in interest rates and the injection of massive amounts of liquidity into the system. The “person on the street” may well not have been aware how close the financial system came to widespread collapse
Lesson 5 – Some banks are too big to be allowed to fail. This principle was established explicitly as a reaction to the crisis. The pure capitalist system rewards risk but failure can lead to bankruptcy and liquidation. The banks had the best of both worlds – reward was privatised with profits but failure was socialised with bailouts from the government. Therefore risk was encouraged.
Lesson 6 – Emergency and extraordinary policies work! The rapid move to record low policy interest rates, the injection into the banking system of huge amounts of liquidity and the start of the massive program of asset purchases (quantitative easing or “QE”) were effective at avoiding a deep recession — so, on that basis, the policymakers got it right.
Lesson 7: If massive amounts of liquidity are pumped into the financial system, asset prices will surely rise (even when the action is in the essentially good cause of staving off systemic collapse). They must rise, because the liquidity has to go somewhere, and that somewhere inevitably means some sort of asset.
Lesson 8: If short-term rates are kept at extraordinarily low levels for a long period of time, yields on other assets will eventually fall in sympathy — Yields across asset classes have fallen generally, particularly bond yields. Negative real rates (that is, short-term rates below the rate of inflation) are one of the mechanisms by which the mountain of debt resulting from the GFC is eroded, as the interest accumulated is more than offset by inflation reducing the real value of the debt.
Lesson 9: Extraordinary and untried policies have unexpected outcomes. Against almost all expectations, these extraordinary monetary policies have not proved to be inflationary, or at least not inflationary in terms of consumer prices. But they have been inflationary in terms of asset prices.
Lesson 10: The behavior of securities markets does not conform to expectations. Excess liquidity and persistent low rates have boosted market levels but have also generally suppressed market volatility in a way that was not widely expected.
Are we entering a period similar to the pre-crash period of 2007/2008? There are undoubtedly some likenesses. Debt levels in the private sector are increasing, and the quality of debt is falling; public-sector debt levels remain very high. Thus, there is arguably a material risk in terms of debt levels.
Thought 1: The next crisis will undoubtedly be different from the last – they always are. The world is changing rapidly in many ways (look at climate change, technology and the “#MeToo” movement as just three examples). You only have to read “This Time is Different” by Ken Rogoff and Carmen Rheinhart to appreciate this.
Thought 2: Don’t depend on regulators preventing future crises. Regulators and other decision makers are like generals, very good at fighting the last war (or crisis) — in this case, forcing bank balance sheets to be materially strengthened or building more-diverse credit portfolios — but they are usually much less effective at anticipating and mitigating the efforts of the next.
Thought 3: The outlook for monetary policy is unknown. The monetary policy tools used during the financial crisis worked to stave off a deep recession. But we don’t really know how they might work in the future. Record low interest rates with little or no inflation has rendered monetary policy ineffective – a classic liquidity trap.
Source: Mercer – September 2018 – 10 Years after the GFC – 10 lessons
Below is an excellent video by Gillian Tett of the FT looking at banking culture. She discusses the ‘flaw’ in Alan Greenspan’s thinking and how culture has been overlooked at the cost to the global economy 10 years on from the financial crisis. By understanding the role of culture in banking, are we more resilient to another crisis now? She also talks of trust in the modern economy and in order to build it you must understand it and how human culture works. And once trust or credit is lost it is very hard to regain.
A Buttonwood piece in the Economist (30th September 2017) looked at how central banks can trigger the next financial crisis. Deutsche Bank have looked into long-term asset returns in developed markets and suggest that crises have become much more common. They define a crisis when a country suffered one of the following:
a 15% annual decline in equities;
a 10% fall in its currency or its government bonds;
a default on its national debt; or
a period of double-digit inflation.
Pre the Bretton Woods system of fixed exchange rates and a central bank’s limited ability to create credit, very few countries suffered a shock in a single year. But since 1980 there have been numerous financial crisis of some kind. Under the Bretton Woods system a country that expanded its money supply too quickly would encourage an increased demand for imports which would ultimately lead to a trade deficit and pressure on its exchange rate; the government would react by slamming on the monetary brakes. The result was that it was harder for financial bubbles to inflate.
But with a floating exchange rate a country has more flexibility to deal with economic crisis as they don not have to maintain a currency that is pegged to another. A weaker currency makes exports more competitive and imports more expensive. But it has also created a trend towards greater trade imbalances, which no longer constrain policymakers—the currency is often allowed to take the strain. See flow chart below.
As well as companies and consumers taking on debt, government debt has also been rising as a proportion of GDP since the mid-1970’s:
Japan – a deficit every year since 1966
France – a deficit every year since 1993
Italy – only one year of surplus since 1950
This has resulted in significant credit expansion and collapse – by allowing consumers to borrow more money the cost of assets (esp. houses) is pushed higher. However when lenders lose confidence in borrowers ability to repay they stop lending and mortgage sales follow. This is then reflected in the credit rating of borrowers. In order to try and rectify the problem the central banks intervene and reduce interest rates or buy assets directly. This may bring the crisis to a temporary halt but results in more debt and higher asset prices.
Deutsche Bank suggest that could mean another financial crisis especially if there is the withdrawal of support from central banks who saved the global economy when the GFC started. Indicators suggest that this may be the case:
US Fed – has pushed up interest rates and cut back on asset purchases
ECB – likely to cut asset purchases next year
Bank of England – has recently pushed up interest rates
However rates are still at a stimulatory level and developed economies have been growing for several years. According to Deutsche Bank any kind of return to “normal” asset prices from their high levels would constitute a crisis. This would then force central banks to once again lower interest rates again but they will not want to appear to be the ambulance at the bottom of the cliff every time this happens. Remember the bailouts of AIG and the investment banks. It seems that the investment banks are happy to privatize the reward but socialise the risk – when it all “turns to custard” they need to be bailed because they are too big to fail. The question that people are now asking is what is the vulnerable asset class? Mortgage-backed securities was the cause in 2008.
Below is another great video from PunkFT. Financial crises start with significant increases in asset prices followed by a severe correction and a collapse. But with more debt and more credit the market is unstable and although they have never been higher the yields have never been lower.
Thanks to more and more debt driving yet more and more credit, making everything more and more unstable. Today, for example, markets have never been higher. Yields have never been lower.
The early warning signs
These economic crises are easy to spot and they follow a familiar pattern. The warning signs are:
1. A bank grows very quickly and issues poor quality loans against nominal yields. It uses leverage to do this and fails to be aside reserves for possible future losses.
2. Normally the share price of these banks would plummet but in fact the opposite happens – the share price is driven up. As the bank takes more and more risk to generate more return, the market gets giddy, and they drive up the share price.
3. We don’t learn from our mistakes. The Global Financial Crisis suggests that the economy is following the contours of typical recession but that it is more severe. Subsequently forecasters who have tried to make resemblance to post-war US recessions are “barking up the wrong tree” and are of the belief that conventional tools like expansionary fiscal policy, quantitative easing and bailouts are way to go. The real problem is that the global economy is badly leveraged and there is no quick fix without a transfer of wealth from creditors to debtors. Ken Rogoff (co-author of ‘This Time is Different’) suggests that the ‘Second Great Contraction’ is a more realistic description of the current crisis in the global economy. The “First Great Contraction” was the Great Depression of 1929 but the contraction applies not only to output and employment, as in a normal recession, but to debt and credit, and the deleveraging that typically takes many years to complete.
If everybody else is doing it and getting rich, why, the CEO asked himself, shouldn’t I? The real cause of banking failures and systemic collapse lies with ethics at the top. And human nature tells us that bad ethics drive out good ethics.
Another good video from Paul Solman of PBS ‘Making Sense of Financial News’.
In his new book, “The End of Alchemy,” Mervyn King still worries that the world banking system hasn’t reformed itself, eight years after its excesses led to collapse. He states that it’s easy with hindsight to look back and say that regulations turned out to be inadequate as mortgage lending was riskier than was thought. Furthermore, you are of the belief that the system works and it takes an event like the GFC to discover that it actually doesn’t.
Paul Solman asks the question that a large part of the problem that caused the GFC was the Bank of England and the US Fed were not able to keep up with the financial innovation that was going on in both of these countries. King refutes this by saying that there were two issues that were prevalent before the GFC:
Low interest rates around the world led to rising asset prices and trading looked very profitable.
Leverage of the banking system rose very sharply – Leverage, meaning the ratio of the bank’s own money to the money it borrows in the form deposits or short-term loans.
Central banks exist to be lenders of last resort. Problem: Too big to fail. And that’s what began happening in England, just like America, in the ’80s and ’90s. There needs to be something much more robust and much more simple to prevent the same problem from happening again. King makes two proposals:
Banks insure themselves against catastrophe by making enough safe, secure loans so they have assets of real value to pledge to the Central Bank if they need a cash infusion in a hurry.
Force the banks to keep enough cash on hand to cover loans gone bad as during the crisis banks didn’t have enough equity finance to absorb losses without defaulting on the loans which banks have taken out, whether from other bits of the financial sector or from you and I as depositors.
He finally states that the Brexit vote doesn’t make any significant difference to the risks facing the global banking system. There were and are significant risks in that system because of the potential fragility of our banks, and because of the state of the world economy.
Here is a chart that I use to explain how mainstream economists before the GFC tended to view debt – loss to creditors but gains to debtors = a zero sum game. However this has been shown to be fundamentally wrong since the GFC.
Since 2008 the financial sector has been the target for a lot of criticism especially when you think the sub-prime mortgage crisis, the bailing out of banks and the recent manipulation of interest rates and currency rates. The Journal entitled Nature had an interesting piece of research on the banking culture and how it primes people to cheat
Individual bankers behave honestly — except when they think about their jobs.
A study of investment managers and traders at a major international bank suggests that the financial industry’s culture encourages dishonest behaviour, but that the individuals themselves are not inherently dishonest.
In the latest study, published online by Nature magazine, researchers enlisted the help of 128 employees from a large international bank. At the start of the tests, half the participants were quizzed about their jobs and their company, to prompt them to think of their identity as bank employees. The other half answered questions about their hobbies.
The participants were then asked to toss a coin ten times, unwatched by the researchers, and to report the outcome. They could earn money if they reported flipping more heads than tails — and up to US$200 if they reported flipping all heads or all trails.
The first group reported flipping heads 58.2% of the time — significantly higher than would be expected by chance alone. The control group reported tossing 51.6% heads.
The team tried to replicate the pattern in other groups of people — for example, priming students to think about banking. But they did not see the same effect on the participants’ honesty levels. The results show that this banking-related priming effect seems to be specific to people who work as bank employees, suggesting that the culture of the banking sector is to blame.
Paul Krugman in the ‘New York Review of Books’ wrote a very informative review of Tim Geithner’s book “Stress Test: Reflections on Financial Crises”. Although I have not read the book Krugman does put across a strong view that the stimulus to end the US economy’s free fall was too small and too short-lived given the depth of the slump.
We can think of the economy as a patient who was rushed to the emergency room with a life-threatening condition. Thanks to the urgent efforts of the doctors present, the patient’s life was saved. But while the doctors kept him alive, they failed to cure his underlying illness, so he emerged from the procedure partly crippled, and never fully recovered.
Something went very wrong with the US economy in 2008. But what?
Quite early on, two somewhat different stories emerged about the economic crisis.
1. A classic bank run of enormous proportions. And there certainly was a very frightening panic in 2008–2009.
2. The large overhang of private debt, in particular household debt.
What’s the difference? A financial panic is above all about confidence, or rather the lack thereof, and the overriding task of policy is to restore confidence. However confidence will not overcome the problem of debt overhang. It needs policies like sustained fiscal stimulus and debt relief for families.
Financial panics arise institutions promise their creditors ready access to their funds but are unable to pay them. This is because they invest in assets that are relatively illiquid, and this works only when a small fraction of a bank’s depositors try to pull their money out on any given day. When this does happen the bank is forced to sell assets – usually at fire sale prices – in order to raise cash – and this can break the bank. And this in turn means that when investors fear that a bank may fail, their actions can produce the very failure they fear: depositors will rush to pull their money out if they believe that other depositors will do the same, and the bank collapses.
The point is that a financial panic is very much a case of self-fulfilling prophecy. And it needs a “lender of last resort,” providing banks facing a run with cash, so that they don’t need to engage in desperate fire sales.
So why was it so hard to organise an effective response to the 2008–2009 panic? One answer is that the Fed was set up to deal with conventional banks, and had neither a clear legal mandate for nor much experience in bailing out shadow banks. Fear of bank losses led to 3 ideas that needed to be debated.
1. Some who warned of “moral hazard”—that bailing out banks would reward bad actors, and encourage future irresponsibility.
2. Some who were in favour of nationalization argued that the banks needed to be bailed out. The idea was that the government, in return for taking on big risks, should temporarily acquire ownership of the most troubled banks, so that taxpayers would profit if things went well.
3. Some thought that the financial crisis should be treated more or less as an ordinary lender-of-last-resort problem—that temporary nationalization would hurt confidence and was unnecessary, that once the panic subsided banks would be OK.
Whatever the reasons, however, the stress test pretty much marked the end of the panic. The graph below shows several key measures of financial disruption—the TED spread, an indicator of perceived risks in lending to banks, the commercial paper spread, a similar indicator for businesses, and the Baa spread, indicating perceptions of corporate risk. All fell sharply over the first half of 2009, returning to more or less normal levels. By the end of 2009 one could reasonably declare the financial crisis over.
But a funny thing happened next: banks and markets recovered, but the real economy, and the job market in particular, didn’t. It’s still very hard to find a full-time job—both the number of long-term unemployed workers and the number of people unable to find full-time jobs remain far above pre-crisis levels.
Balance Sheet Recession
The best working hypothesis seems to be that the financial crisis was only one manifestation of a broader problem of excessive debt—that it was a so-called “balance sheet recession.” This is where households have taken on high levels of debt and at some point face pressure from creditors to ‘deleverage’, reducing their spending in an effort to pay down debt. But by doing this they reduce consumer spending in the economy and this can turn into a self-reinforcing spiral, as falling incomes make debt repayment even harder.
However a balance sheet recession cannot be cured by restoring confidence. Fiscal stimulus and debt relief are required by the government to reduce private debts and allow debtors to spend again. The private sector is not in a position to do so.