A TALE OF COMPLICITY
de Silva Wijeyeratne, G. (2009). A tale of complicity. LMD. October 2009. Page 143. Volume 16, Issue 3. ISSN 1391-135X.
Gehan de Silva Wijeyeratne on a less publicised aspect of the credit crunch
By August 2009, the credit crunch was a well documented story. I had been following for over two years an event which had led to a recession which had been feared could be worse than the great depression of the 20th century. I had read countless articles and even watched a mini documentary which explained it using a cartoon script. It had been well documented that banking giants in the UK like the Royal Bank of Scotland had come close to collapse because of an absence of prudence in lending to customers in the USA. In brief and over simplistically, the chain of events went something like this. In the USA, lenders gave money to people who did not have a source of income. They bought cars, etc and financed a lifestyle built on pack of cards. These loans, especially household loans or packages were bundled into special purpose investment vehicles which issued Mortgage Backed Securities. These were credit rated by independent credit agencies. There were enough good loans mixed into the bad ones to ensure a credit rating was received which covered up how poor the overall portfolio was.
Whilst house prices kept going up and people could sell property, it did not matter if people could not service their loans. But when prices cooled of and re-possessions became the norm, the property market turned illiquid. Even banks with good collateral suddenly found that the value of the security was less than that of the loan. Even if it was not in negative equity, they were still stuck with assets they could not sell. Suddenly, the Mortgage Backed Securities held by investors were found to be near worthless. For a while banks in the UK made significant gains in trading in MBSs. As their values plummeted, they were left with a gaping hole in their balance sheets.
MBSs are difficult assets to price. I remember in the late 1990s when I was in the Group Risk team at Abbey National we declined to participate in an MBS offering being lead managed by Long Term Capital Management (LTCM). This did not go well with the trading teams. LTCM were then the dream team in financial markets counting amongst their principals Myron Scholes, a Nobel laureate for his work on the Black-Schole option pricing model. We were concerned with the assumptions behind the prepayments speeds of the MBS and felt that the valuation was not prudent. Some months later LTCM collapsed spectacularly because the markets had failed to behave rationally running up losses on a significant arbitrage they had played. We breathed a sigh of relief that we had steered away from the proposed MBS transaction although that had nothing to do with the collapse of LTCM.
However, the present credit crunch seems to have less to do with the complex pricing of MBSs and more to do with a simple lack of prudence. Loans have been made which simply should not have been made. In August 2009, I was surprised to hear another angle to how the UK Banks became unstuck. Hitherto, I had believed that their problems arose largely from the poor credit policies in the USA which had rendered their assets of little value. At a party in Colombo, I met a friend who had resigned a few years ago from a UK bank. He had been a personal financial advisor and had become uncomfortable with what he had seen as a growing practice to overstate the income of borrowers. Say for example a self employed person earns 25,000 sterling. If he is lent three times this amount, he could be given a mortgage of 75,000. It would be difficult to purchase property anywhere in the UK with such an amount. The advisor could fudge the ‘know your customer’ forms and estimate that the earnings were say 50,000 or even more. Now the customer can be given a large enough loan to buy property. The customer’s capacity to service the loan was ignored because in a rising and liquid market the customer could sell out, settle the loan and make a tidy profit. Everyone was happy. Except that the rise in property which saw UK properties trebling in value between 1999 and 2007, came to a halt.
On my visits to the UK, I always stay in touch with a few of my former colleagues from the financial sector in the UK. I asked them if it was true that there was such malpractice taking place at the level of the financial advisers. They all confirmed it had been true. Perhaps the losses were not as big as from the MBSs issued on US property mortgages, but nevertheless significant enough. It also seems that there has been a failure in internal audit and maintaining staff integrity. It is easy to see how this spiraled up. The more money was lent, the better off the customer thought he was with potential capital gains. The advisors earned more commission and the bank also earned more money. Everyone was happy in a rising market.
Perhaps the banks have learnt their lessons. In August 2009, I was in London for a travel trade fair and I asked my bank to order me a new service card. When I called to collect it I wad told that they had good news and bad news. The good news was that the service card had been delivered. The bad news was that the fraud department had destroyed it, suspicious that a card had been ordered in London by a customer resident overseas. Oh good, I thought, the banks are now being very careful. Then one of the customer service advisors took me in for a chat. He suggested that I upgrade my account to a more secure account. I looked at it. For someone with my profile, it made no sense to take that particular account. But the extra monthly fees would help the adviser meet his sales targets and earn him more commission. It would also help the bank earn enough money to make a profit after servicing the overheads of maintaining offices for several in-house advisors. My advisor was soon going away on another holiday. He had done New York on his last trip. I could see that he would have to generate a lot of fees to maintain a good lifestyle. He will be gone in two years to a better paid job somewhere else and it will be someone else’s problem to deal with any inappropriate advice he has given. To be fair, when I said the upgrade was not beneficial to me, he immediately abandoned the idea. But I could see how the sales driven culture, will soon bring another boom and another bust. The lessons may have been learnt. But applying them is not easy or costly as it requires stronger internal audit, a stronger risk management culture and above all the right people with the right values. All I can do is hope that when the next crash comes along, my bank will be considered too big and too important by the UK government to be allowed to fail.