Meltdown in US economy and subprime mortgage loan crisis

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A. K. N. Ahmed
A recent report in The Wall Street Journal exposes the casualness of operations of this institution. Since 2001 FDIC has been managing Superior Bank, a failed bank that it took over that year. However, even with the FDIC supervising Superior Bank's day to day operations, the latter funded more than 6700 subprime loans to another bank knowing fully well that the loan pool was inherently risky, afflicted by serious deficiencies such as lending to unqualified borrowers, inflated appraisals and poor verification of borrowers' income
Subprime mortgage loan crisis has been reigning supreme in US financial market for about two years and still shows no sign of abating. Just about one year back it seemed reasonable to hope that the mortgage crisis would be contained. This crisis has spread through the entire financial spectrum of not only in USA but around the globe.
When the mortgage market crashed, it was plain that billions of dollars of real estate loans would not be repaid leaving enormous holes in financial sector balance sheets. But for a while there was a pious hope that with billions of dollars the Chinese and Arab governments will rush in to fill up this gap and everything would be alright again. Sure enough, at the first stage US financial institutions like Citicorp, Bank of America, Meryl Lynch raised billons of dollars in fresh capital from Sovereign Wealth Funds (SWF) all over the world.
But after these capital infusions the real trouble started when it was found that the banks, by manipulating their balance sheet figures had hidden their subprime mortgage loans. The foreign institutions which came forward at the first stage to help US retreated and closed their wallets. If lack of transparency was the first reason, the second reason was oil and food prices inflation that compounded it. This shock frightened consumers in US and abroad, and slowed their spending rate. It put The Federal Reserve in US and other central banks in Europe in a fix wondering whether they would combat inflation or fight recession. Even now they have not been able to come out of this bind.
The sum total of the whole situation is that no one is able, even now to say, whether rock bottom of the crisis has been reached, what is the likely amount the holders all over the world of the so-called especially structured instruments, banks, financial institutions, private equity and hedge funds and individuals are likely to unload in the market and within what time frame. The so called guesstimate made by various experts in the field changed very often only to remind ordinary citizens of the story of the blind philosopher trying to catch a black cat in a dark room where there is none.
According to one commentator, an interesting comparison of the crisis can be made with Hurricane Katrina which symbolically has now stranded many innocent citizens, including rich persons, on the roof crying out to the government and various regulating agencies for help. When one looks back, one can find that this crisis, like Katrina, is a turning point in public perception of the competence of the government or lack of it in providing emergency help to the people they need. People have also seen through their experiences that government moves only when the few rich people at the helm of the financial world cry wolf, and not when people underneath groan and cry for help. Because of the nefarious activities of the investment banks, commercial banks and other mortgage institutions, in search of maximizing their private profits. Even more troubling, housing prices have dropped 20 percent from July 2006 highs with very likelihood that housing could contract another 15 to 20 percent - essentially wiping out more than $4 trillion in housing values. This could be the biggest hit since the Great Depression to American's most important asset.
After having discussed the magnitude of the current crisis let us now discuss how and why it has happened and who are responsible for this calamity. Briefly the main reasons for subprime mortgage crisis are the following:
Mortgage bankers and loan officers encouraged borrowers to buy more homes than they could afford and to accept mortgages they did not understand. They tried to transfer their risks to others through bewildering ways of options, swap structural instrument vehicles, collateral debt securities, variable interest entities, auctioned securities etc. for trading in Wall Street stock exchange and subsequently through other stock exchanges abroad.
Credit rating agencies provided AAA and AA ratings almost freely to securities against these pools of new types of extremely risky loans without trying to find out their intrinsic worth and without statistical basis for estimating potential loss on the loans. During investigation of these misdeeds by a congressional committee representative, Christopher Shays, was forced to comment "when the referee is being paid by the players no one should be surprised when the game spins out of control". Other internal documents suggested that the analysts knew that they were overrating.
Corporate America itself - the main machine of speculation - enthusiastically elevated its accounting system into fine art. They refused to notice any speculation in the profits they earned. On the contrary, through creative expression of these earnings such as one term charges, creative expression of write-offs, forward looking statements about the improvement of business trends, stock options they continued to deceive the investors. Major auditing firms also joined this bandwagon and in consideration of payment of handsome fees started singing from the same music sheet and signing their client's statements as correct. A recent Wall Street Journal analysis of fees openly paid in 2001 to auditing firms by most of the 30 companies in the Dow Jones Investment Index shows that 73 percent of the total $725.7 million reported was for services other than audit. This widespread malpractice could persist and grow because of the other two parallel developments in USA. They are demographic and technological. The baby boomers' growing awareness that investment for retirement was becoming critically important fostered a need for making quick money to save enough. Wall Street did its part to fuel this feeling by supplying the rationalization as well as the mechanism to the eager masses. Side by side the impressive progress of technology aided by computers, internet led the masses to believe that with their newly acquired knowledge of finance and markets they were now the master of their destiny and could invest for themselves by themselves, forgetting the simple fact that in any financial transaction one's gains have to be losses to others. The role of Microsoft Windows in creating this euphoria can not be over emphasized.
Finally, the role of various bank regulators is absolutely disappointing. To start with, The Federal Reserve kept its interest rate low when the bubble was growing and acquiring critical mass well past the point at which it should have been raised. It also failed miserably in its regulatory functions. Mr. Greenspan and then Mr. Bernanke failed to ring the alarm bell. Reading or listening to Mr. Greenspan now, we would never know that this Fed Chairman kept interest rate too low for too long who denied that there was a housing bubble until it burst and who refused to use the powers given to the Fed by the Congress. It is difficult to understand how Mr. Bernanke, an eminent economist and the author of a celebrated treatise on the Great Depression, forgot to take away the so called "punch Bowl" while the party was in full swing and what his batch of very competent economists were doing when the current crisis was gaining strength.
The role played by FDIC is also coming up for criticism. A recent report in The Wall Street Journal exposes the casualness of operations of this institution. Since 2001 FDIC has been managing Superior Bank, a failed bank that it took over that year. However, even with the FDIC supervising Superior Bank's day to day operations, the latter funded more than 6700 subprime loans to another bank knowing fully well that the loan pool was inherently risky, afflicted by serious deficiencies such as lending to unqualified borrowers, inflated appraisals and poor verification of borrowers' income (Wall Street Journal, July 23, 2008). Then again, only recently, after taking over a few more failed banks, it is coming up for help to meet shortage of funds, and the Federal Reserve had to provide a big line of credit to keep it going. FDIC has also been unable to explain why it did not try to replenish its depleted funds by re-imposing charges on the banks enjoying its protection of their deposits and why earlier, it had to exempt some banks from payment of fees.
Federal Housing Authority failed to take any steps when investment banks and mortgage companies went on a spree of sanctioning subprime loans and when Fannie Mae and Freddie Mac - the two giant mortgage refinance corporations, originally set up by US government and later on privatized, were engaged on employing their funds in buying up subprime securities from the market with the hope of making quick bucks instead of providing refinancing housing loans given to the needy and prudent borrowers. These two organizations were also reported to have spent a considerable sum of money on lobbyists in order to persuade Congress members to close their eyes and seal their ears from these activities which took place under the watch of a watchdog agency.
Securities and Exchange Commission also refused to regulate hedge funds even after the failure of Long term Capital Investment Fund during the last dot com crisis ten years back on the plea that such funds are owned by very rich people and it is not the duty of the government to salvage them without realizing that the fall of hedge funds may have great impact on the larger market. Now a gloomy picture of hedge funds is emerging and as a commentator has said, Hedge Funds "annus horibillis" is getting worse. According to Hedge Funds Research, lenders are calling back their deposits and some hedge funds have their money locked up with Lehman Brothers, which has recently gone into liquidation. Their ability to bet on "price declines" has also suffered, thanks to partial or complete bans on "selling shorts" in markets around the globe. SEC has also miserably failed to detect when international banks were functioning with very high leverages with borrowers' fund and with no or little capital of their own and when auditors signed their accounts without any murmur. On the contrary, SEC took initiative to ease the discipline imposed by Sorbane-Oxley Act in respect of full disclosure of their activities and the fat compensation given to their top executives. Furthermore, according to a recent report given by its Inspector General, SEC failed to maintain its neutrality in its treatment with Peqnot investigation differently from other similar institutions (New York Times, October 7, 2008).
Various state governments in USA, at long last are coming forward to prosecute some financing institutions on the charge of predatory loans. Only recently Mr. Cuomo, Attorney General of New York, has gone after some predator company to claw back some of the fat compensations given to executives taken by AIG taken over by the government. The question naturally arises, where they have been so long? The conclusion that emerges out of the above narration is that regulatory agencies were not only negligent, unmindful of their duties but they suffered from a faulty and inadequate outlook of their functions. They seem to believe like the FBI that they have to be active only when a crime has been committed. It is not their business like the CIA in the good old days, to anticipate mischievous actions in order to prevent them.
The writer is a former governor of Bangladesh Bank