Presentation at Bilkent University

31 Oct 2008

Remarks from

Mahmood Ayub

UN Resident Coordinator

 

Dear Members of the Faculty,
Dear Students

As you know, the subject of my talk today is the current global financial crisis.

If you have been following the news over the past few weeks and months, you will have noticed that:

·       Stock markets have plunged in most countries: developed, developing, or emerging market countries.  

·       Banks have stopped lending to one another.

·       And in the meantime, the financial crisis has started to affect the real economy in a major way.

So we need to ask:

·       How did the world end up in such a global mess?

·       What have we learned from this experience?

·       And what can be done to get us out of this global financial crisis?

Basically there were three main reasons for the current financial crisis:

·       Low interest rates and easy availability of cheap money

·       Insufficient regulation

·       Poor performance of Credit Rating Agencies

Let me elaborate.

Let me first talk about low interest rates and cheap money.

After the collapse of the internet and tech bubble, the American economy needed a stimulus. So the Federal Reserve Board flooded the economy with liquidity.

Normally extra money in the economy would not be a problem if it could be used productively. But the economy had already over-invested.

So the low interest rates and easy access to funds encouraged reckless lending:

·       Sub-prime mortgages that included zero down payments, no documentation.

·       Buyers made to feel that if they did not get on the bandwagon, they were “missing out”.

And of course to some extent, investing in real estate seemed very attractive: home prices in the US doubled between 1996 and 2005.

The real problem was that there was a shift in mortgage lending toward the less creditworthy, marginal borrowers—the so-called sub-prime borrowers who should not have qualified for the loans, but independent brokers—who gained from having as many contracts as possible—bent the rules.

This degree of sub-prime borrowing is important to note because without it, it is difficult to explain why the crisis broke out in the United States rather than somewhere else. After all, housing prices were also rising rapidly in many other countries. But these countries did not go as far in channeling funds to marginal borrowers as the US did. Between 2003 and 2006, the share of sub-prime mortgages in total mortgages in the US tripled!

Let me come to the second factor behind the crisis: namely insufficient regulation.

During the Bush-Greenspan years, there was an excessive—almost ideological—emphasis on deregulation. This ideological position held that regulation was not only not necessary, but also harmful. Bank managers were themselves the best “self-regulators”, according to this thinking.

The administration did not want to accept the fact that the market by itself is not enough. Government must also play its role.

At the U.S Congressional Committee hearings about two weeks ago to discuss the factors contributing to the global financial crisis, Alan Greenspan-- once viewed as the infallible architect of U.S prosperity—was severely criticized for his long-held views that markets can self-discipline, and that central banks should not try to prick bubbles in the price of houses or tech stocks.

So mortgage brokers originated mortgages that were sold to others.

Borrowers were told: “don’t worry about your rising home payments because home prices will go up, and you will be able to take out equity from your homes to buy your car, pay your children’s fees, or take a vacation”.

For the mortgage brokers and the investment bankers, these financial instruments were great: they ensured sizeable fees for themselves, especially through refinancing.

So, mortgage brokers and investment banks were effectively gambling with other people’s money. And when the housing market started tumbling, the tax payer ended up footing the bill.

Let me finally talk about the third factor behind the current crisis, namely the poor performance of credit rating agencies.

Rating agencies rated mortgage-backed securities as triple-A—the highest rating against default probabilities. As it turned out, these securities had much higher default probabilities than suggested by their triple-A rating.

What went wrong? Why did this happen?

The answer is that there was a problem of wrong incentives. Credit rating agencies were heavily involved in the consultancy business, so that a firm like Moody’s made a great deal of money in 2005 and 2006 from consulting on securitized products. They were essentially getting consulting fees from entities that would later ask them to rate their securities. So independent credit assessment went out of the window.

SO TO SUMMARIZE, loose money, absence of effective regulation, and poor performance of credit rating agencies were a toxic mixture, and it exploded.

But it didn’t stop there in the United States.

Thanks to the dark side of globalization, Wall Street was able to sell off its toxic mortgages around the world. Almost half of the toxic mortgages were exported.

AND NOW THE FINANCIAL CRISIS IS HAVING AN IMPACT ON THE REAL ECONOMY.

The real incomes and purchasing power of American and European countries is declining. This means that the demand for imports from ( as well as tourism to) emerging market and developing countries is decreasing.

So, for example, Turkish exports and tourism receipts are being hit by the recession in Europe and America.

So even when the financial sector comes under control, the economic crisis in the form of recession, will take some time to be controlled—may be 1.5-2 years.

LET US NOW COME TO THE SECOND PART OF MY PRESENTATION: NAMELY HOW DO WE REMEDY THE SITUATION?

As you have noted from my presentation so far, the world, especially the US and Europe, is facing a dual problem:

·       First, a liquidity problem, under which because of the crisis, banks are not lending to one another, so that even good projects cannot find financing.

·       And second, a macroeconomic problem, under which demand for goods and services has declined dramatically.

SO HOW DO WE GO ABOUT FIXING THIS SITUATION?

Basically, there are six important actions that will need to be taken, and of course some of these have already started to be taken.

FIRST, BANKS NEED TO BE RECAPITALIZED

With all their massive losses, banks have insufficient equity. When banks suffer a deterioration in their balance sheets, and so have a substantial contraction in their capital, they have two choices:

·       Either they can cut back on their lending in order to shrink their asset base, and thus restore their capital ratios.

·       Or they can try to raise new capital.

However under the present situation, it is highly unlikely that banks will be able to raise capital at a reasonable cost. So the governments need to provide equity, as indeed they are doing.

SECOND, THE AVALANCHE OF FORECLOSURES NEEDS TO BE STOPPED

After the injection of funds, it will be important to stop the foreclosures.

In the US so far this year, more than a million home foreclosures have taken plane—of which 750,000 in the third quarter alone. Another million foreclosures are foreseen during 2009 in the absence of action.

Governments will need to help people stay in their homes—for example by starting to guarantee home mortgages to persuade lenders to ease the monthly financial burden on struggling home-owners. For example a lender would get a government guarantee that troubled loans would be repaid. In exchange, the lender would be required to significantly drop the interest rate, reduce the principle or extend the life of the affected loans.

THIRD, A STIMULUS PACKAGE THAT WORKS NEEDS TO BE PASSED

Helping Wall Street and stopping foreclosures are only a part of the solution. The US and European economies are headed for a serious recession. They need a big stimulus  in the Keynesian fashion.

·       Investment in infrastructure and technology will stimulate the economy in the short run but will also enhance long-term growth ( relatively poor state of infrastructure in parts of the US).

·       Support should be provided to state and local authorities so that they can maintain their planned expenditures, and thus avoid contraction of the economy.

FOURTH CONFIDENCE SHOULD BE RESTORED THROUGH REGULATORY REFORM.

·       Reform is needed of the flawed incentive structure that provides excessive rewards to CEOs.

·       Second, it is not just the level of compensation. It is also the form of compensation, which consists of non-transparent stock options which provide incentives for bad accounting to falsely show higher profits.

FIFTH, EFFECTIVE MULTILATERAL ACTION NEEDS TO BE TAKEN

As the global economy becomes increasingly more integrated, we need better global oversight.

·       There is need for more integrated global action. During the crisis, some governments provided blanket guarantees for their deposits. And so money started flowing to what looked like safe havens. Other countries had to respond.

·       During his address to the UN General Assembly in September, President Sarkozy called for a world summit to lay the foundations for more state regulation to replace the current laissez faire approach. Time may be right for a new Bretton Woods type approach, including the establishment of a new global regulatory agency. The November 15 meeting in Washington of the G-20 countries could be a good start to this process.

AND FINALLY, REFORM OF THE CREDIT RATING AGENCIES IS NEEDED.

There is urgent need to eliminate the conflict of interest between the agencies’ normal function of rating, and their consulting services. One way is to separate the rating business from the consulting business completely, as was done with the accounting industry after Enron.