Financial Order Under Stress

17^th August 2007

The Malta Independent - Friday Wisdom

 

Most of my readers would probably have no idea what a hedge fund actually is or what the meaning of ABS, CDO and LBO is. As these are acronyms for financial jargon which is of a rather high level, I will not bother my readers with technical explanations as they would otherwise probably stop reading at this point.

What should however be of interest to readers is that the financial structures represented by this financial jargon is putting severe strain on the world financial order and that our economic well-being depends on financial order stability. Further destabilisation of the world financial order could cause loss of confidence, evaporation of liquidity, withdrawal of investment and ultimately will throw the economic cycle into a recession. This would effect the daily bread of most of us, so even if the subject may not appeal to you directly, I think you should read on.

It started in 2001 when the central banks dashed down interest rates to historical low levels in order to avert a recession following the burst of the tech bubble and the financial scandals of Enron and Worldcom. Interest stayed at an extremely low level until mid-2004 in the US and until the end of 2005 in Europe and has been brought back to “normal” levels since in a very gradual manner. Interest rates stopped rising in the US in the summer of 2006 but are still rising in Europe, Australasia and Asia and before the financial disorder experienced in the last four weeks, expectations were for interest rates to continue rising,

Low interest rates and plentiful international liquidity caused by trade imbalances encouraged easy borrowing fuelling an explosion in real estate prices world-wide and encouraging financial speculators to borrow money at cheap rates to invest in high earning investments. In financial jargon, this is called leveraging.

In the US, the housing market went out of control. Borrowers with bad credit record found it possible to raise 100% mortgages not only to buy their own residence but to speculate on the assumption that prices of houses in the US will continue to rise forever. Many of these borrowers had no regular income with which lenders could justify being satisfied of borrowers’ ability to service the mortgage and crazy schemes were introduced to allow unduly low rates in the initial years to justify the loan with the rate being reset at a high level after the initial teaser period. Unjustified optimism probably convinced borrowers that they could sell the property at a profit before the higher rates were to set it. With euphemism such mortgages were termed “sub-prime”. Garbage mortgages would have been more appropriate.

Lenders were lax in their lending standard because the risk was passed on and spread among investors world-wide. Securitisation of the mortgages enabled mortgage brokers and banks to package mortgages into different levels of default risk and rating agencies obliged by rating as strong investment grade, garbage bonds on which investors carried only a deferred risk of default as the primary risk was subscribed by more daring investors. Still financial garbage was miraculously changed by rating agencies into strong investment grade paper.

Now reality is catching up. Mortgage defaults in the US are increasing alarmingly as residential property values fall below the debt mortgage obligation. Investors who borrowed cheap money to invest in such high yield paper are having their credit lines withdrawn and being forced to sell off their investments at a time when nobody wants to touch them. The liquidity cycle has broken as banks amass as much liquidity as possible to finance bond positions they had underwritten which now have to be carried on their books as the market has lost appetite for all risky assets. At several stages during the last week, the major world central banks had to switch to live mode on their function as lender of the last resort and flushed the banks with ample short-term liquidity in order to keep the inter-bank overnight rate close to the official bank rate.

Lack of visibility as to who is actually carrying the risk from mortgage defaults in the US has caused stress on all values of financial assets which carry any risk. In circumstances of doubts about financial stability, investors take refuge in high-quality short-term sovereign bonds or outrightly in liquid cash or money market funds.

Thankfully, our domestic system does not have exposure to such woes. Local banks invest in very conservative risk-free assets and seem to have no exposure to such garbage bonds, whatever their rating. Banks in Malta are highly liquid with excess capital and with enviable experience of compliance by mortgage borrowers generally. Our inherited culture of thrift serves us well during such unstable times.

There was certainly no sign of stress on 9 August 1997 when HSBC Malta inaugurated the Business Banking Centre in a new building adjacent to their operations centre in the former Centru Ruzar Briffa in Mill Street, Qormi. HSBC management deserve credit for putting their business centre in a place with easy access and adequate parking facilities where business clients can have access to specialised staff who in turn have the backing of their Operations Centre next door. Having the business centre next to but separate from the Operations Centre offers a better solution than the all-under-one-roof-model of the BOV Centre in Sta Venera where a client, to get into a meeting room with his banker, has to compete through the reception with many other visitors unrelated to business banking.

For me it was a dream coming true 10 years late. When as chairman of Mid-Med Bank I had obtained my board’s agreement to buy the same whole premises in 1997, it was to execute the same business model. Local politics however got in the way. The project was aborted prior to execution as the National Audit Office (NAO), in spite of agreement that the price negotiated was fair and reasonable (on the basis of a report made by three independent architects appointed by the NAO itself) thought it fit to go beyond their brief and suggest a total move out of Qormi to what was termed a more prestigious undefined location. It remains the only example I ever met where the NAO suggests spending more money than what was proposed and expressing views on operational strategy on which the NAO hold no brief.

Time is wiser than all of us. Ten years is a lot of time. HSBC, after spending many millions trying to redevelop the Operations Centre on the existent footprint, arrived exactly at the same conclusion my board had arrived at 10 years before. What happened to the critics who saw abuse where there was only sensible business strategy? Their silence deafens.