Way back in 2005 there was stability and growth in most western economies. The US economy appeared to be rolling on reasonably satisfactorily. A loose monetary policy operated by the Fed under Alan Greenspan’s stewardship had operated since the “dotcom” problems of a few years earlier. In Ireland, there were signs that the economy was under some strain and there was much talk of soft landings.

Problems with sub-prime lending in the US have resulted in a worldwide shortage of liquidity which has become known as the credit crunch. The credit crunch brought with it a downturn, firstly in the construction-related industries, then progressing into stock exchanges worldwide and finally into consumer confidence. The US problem had become a global problem.

Many of the western economies suffered fallbacks in economic growth so quickly that they were taken by surprise. The full extent of the current economic cycle has not yet played out, but many of the lessons from it are very clear at this stage. The solutions are not quite so obvious.

Bankers, especially US bankers, cannot be trusted

The roots of the credit crunch are firmly embedded in widespread bad lending practices by US banks. The basic banking virtues of business prudence and risk management were recklessly and irresponsibly abandoned in favour of market dominance and short-term profits.

Securitisation of credit risk is dangerous

The factor which controls the lending practices of bankers is the fear of credit losses. Through securitisation, a US banker can pass on those risks to a financier (probably another bank or a managed fund). In those circumstances the control fails and lending can be done with reckless abandon (note: when securitisation happens in Ireland, the risk is normally held by the original lender.) However, when the bank or finance house purchasing a book of securitised loans fails to undertake due diligence, the risk can be catastrophic.

Fannie Mae and Freddie Mac were set up to provide liquidity to the banks. They packaged (or repackaged) bank loans and guaranteed the buyers of such packages against default. They were seen as the rescuers of the banks when credit became scarce. But who rescues the rescuers when they are in trouble? Normally if a bank is in trouble, the Fed will come to the rescue – but it will only accept assets such as Treasury Bonds as collateral. In this situation the Fed was forced to accept what amounted to corporate guaranteed debt from the ailing twins themselves – a complete lowering of Fed standards.

Credit Rating Agencies have not done their job

The raison d'être of a credit rating agency is to provide its subscriber institutions with an independent assessment of the risks associated with the subscriber. A reliable assessment provides comfort to any other organisation which is exposed to that subscriber. To ensure reliable ratings, banks provide the rating agencies with high levels of access to market and financial information, management practices and procedures and any other information necessary to make such assessment.

The rating agencies failed to recognise and to report on the risks associated with portfolios which included substantial securitised sub-prime content until it was too late and losses had crystallised. With the benefit of hindsight, it is now obvious that investors placed too much reliance on the ratings of those agencies – but if the rating agencies cannot be trusted, then who can?

US Financial Regulation is not “fit for purpose”

The “dogs in the street” in the US knew that mortgages were being granted to NINJAs (No Income, No Job or Assets) and that such a situation could not be sustained. However, no effective regulatory action appears to have been considered until the proverbial horse had bolted. Even then the appointment of Henry Paulson as Treasury Secretary on 1 April did little to calm nerves. Paulson is a banking industry leader and he will be concerned with maintaining the competitiveness of the industry.

It will be a few years before Paulson’s grand plan for an integrated scheme of federal and state policing agencies takes effect. "It's like saying to Katrina victims stranded on the roofs of homes 'don't worry - if you can just hold on a few years, we've got a good plan for restructuring emergency response'," said one critic.
International Financial agreement may be required.

It is now very clear that financial systems of the world are intertwined to such an extent that a serious problem in one major economy is a problem for the world economy. In such circumstances in the long run, it would seem inadequate that regulation in each country is designed solely around the needs of that country. There is a clear need for some form of international agreement between national regulators on broad principles. Without such agreement, countries may be tempted to introduce less demanding regulation to boost financial activity in their countries.

It has become starkly evident, however, in recent times, that banking regulation obsolesces quickly. Governments must retain the ability to act swiftly. International negotiations are not well suited to rapid action. Therefore a “Financial United Nations” is not an appropriate model.

Is there a credit-card crunch coming?

The amount outstanding on credit cards in Ireland has been increasing rapidly. It appears that about 50% of customers pay off their balances within the statement period, without interest. By definition, these tend to be those customers with smaller balances. Anecdotally, it appears that there is a very substantial increase in the number of customers with “hard-core” credit card borrowings where they have maxed out their credit limit and are not reducing their outstanding balances. As the economy drops, and energy prices rise, these people come under increasing pressure and some, perhaps many, will default.

Market reform is necessary

The various rules and practices of financial markets must be examined. In particular the ability to take enormous risks with small funds is a risk too far, exaggerating both bubbles and crashes. Short selling, short buying, CFDs, spread betting, and many forms of market derivatives must be examined, and where appropriate, outlawed.
Confidence must be rebuilt
Banking, the financial markets, and both domestic and global economies are built on confidence. That confidence has taken a hammering. Normality can only be restored if confidence is restored.

Although many may question his policies, Alan Greenspan was a master of confidence building. His personal esteem and charisma was instrumental in restoring market stability following the downturns of the ‘1990’s and of the dotcom bubble. His successor will have a more difficult task.

Confidence in the Irish economy and particularly in the Irish banks and major corporates, has led to extraordinary drops in market capitalisation of those companies. The economies of the US, UK and Ireland, amongst others, appear at the moment to suffer from a lack of strong leadership. In the vacuum, responsible and irresponsible information get equal billing in the media. The requirements now are:
- Effective leadership
- Effective (but not stifling) regulation
- A few pieces of good news
- Media must play their part

There is no suggestion that the above represents a comprehensive list. What makes the current situation unique is that it cannot be attributed to just one cause, i.e. it is the combination of circumstances that brought us to where we are now. It will take some time – perhaps years – before the new order is created. Hopefully then economic progress can return.