The usual suspects? Or the usual bullshit?

In a book review of three books (The Economist) each attempting to explore the cause of 2008’s global “credit crunch” we are told that it’s simply not fair to lay the blame at the door banks. In a telling section we are sternly lectured that “It was the Basel accords on bank capital ratios………that helped push the banks into securitising sub-prime mortgages.”

This is an outrageous statement.

The Basel accord the reviewer is referring to is the Basel II agreement of 2004. [EDIT: I stand corrected. It’s Basel I] The overall purpose of this agreement was to define a framework allowing regulation of capital reserves held by banks to cover financial and operational risks. The so-called “third pillar” of Basel II related to how much banks must disclose to the markets, based upon their overall exposure to risk. A slightly more down to earth description of this is that bank must exercise more accurate pricing for risk, or in other words raise their prices for high risk lending. Which seems sensible as far as it goes.

In summary, Basel II encouraged (or, indirectly, forced) banks to become more price-sensitive to credit risk. No more, no less. Yet our reviewer tell us that this “pushed” banks into “securitising sub-prime mortgages”.


Well let’s just hold off a moment and be sure we understand the deliberately unhelpful terminology here: “securitising”. The Economist is normally a paragon of clarity and unnecessary jargon, so it’s rather surprising that they slip this in without any help to the reader. Securitisation is a very complex, large subject, and I do not pretend to understand every last subtle nuance. But I do know enough to understand the fundamental concepts. In the context of mortgage lending, securitisation is all about raising funds by selling risk. Nothing wrong with that, in principle. However another key element of securitisation is, as the banks would have it, to more fairly price the underlying risk they are selling. That’s the idea. But one man’s fair price is another’s unfair price – and clever securitisation of risk can, in reality, be used as vehicle to hide risk. In some forms of securitisation this technique is explicit: repricing “traditional” credit risk by, for example, factoring in future cash flows. But the line between unavoidable complexity and intentional obfuscation is very very fine indeed, and banks knowingly exploit this by securitising based upon inexact, by definition, valuations.

But let’s veer back to the original gripe: the securitisation of sub-prime mortgages. Well whatever your view of the art (I hesitate to call it science) of securitisation of mortgages, subprime or otherwise, what is new about it? In the US it started in the early 1970’s, and galloped along thereafter pretty successfully. So what? It’s not new and it has, until recently, been at least adequately successful.

The whole mention of securitisation is a nonsense: what the reviewer seems to mean is that Basel II pushed banks into the sub-prime mortgage market, securitised or otherwise. So just how DO you “push” a bank? Well, let’s not be willfully dumb: what he’s alluding to is that since Basel II required banks to be more price-sensitive to risk in general, they could now choose to lend to higher risk customers than before, albeit with a correspondingly appropriate (i.e. higher) price. Note that little word: “could”. It’s important. I could sell my car for 1 Euro. I’d be a fool, but I could. I could pay 100 Euros for a loaf of bread. But who would? None but a fool.

The whole sub-prime (and don’t you just LOVE that word. Sub-prime. So much nicer than “insanely high risk”, dontcha think?) is a joke. The pricing of sub-prime mortgages was so incompetent it boggles the mind: never mind about the creditor’s ability to pay out of future income, just factor in the annual 10% property price increase (whaddya mean that might not always happen? It has for years now!) and, hey presto, the risk has just about gone. So twiddle the risk calculations around a bit and sell on the risk to some punter at the other end of the food chain. Loadsamoney. Take on stupid risk, then pass it on. Brilliant.

“We’re all to blame”

Of course at this point someone will pipe up about others who are “equally” to blame. Not least the person who borrowed the money in the first place and, less commonly, the institution (and, trickling down, ultimately, the “small people”) who chose to carry the risk. Someone was dumb enough to take out a sub-prime mortgage, and some other person (or institution) was dumb enough to buy the risk at too low a price. Surely they are culpable, or at least equally so, as the bank in the middle?

One end of the chain

There was a time when people trusted banks as advisers, rather than seeing them as pure profit-centered machines, intent on success at any cost. That view might have been rather naive, of course, but if only because banks were indeed more careful about taking on risk they did have a reciprocal benefit of preventing misguided individuals from taking on stupid financial risks themselves. People taking on high-risk mortgages (I’m fed up with the ‘sub-prime’ euphemism) are very often the poorest, less-educated sections of society and they are, frankly, being exploited. Yes, that a subjective judgment, but it’s a pretty clear case. Capitalism is not unfettered – we have regulations and laws to prevent the exploitation of individuals. Capitalism itself does not require them, but what we might recognise as a civilised society most certainly does. As it pertains to how they interact with individuals, many (most?) types of institutions are regulated to ensure some sort of balance in the transaction. Banks used to be the same. But increasingly they side-step (who lets them… another big question, but let’s limit things a bit for practical purposes) such limits on their behaviour in order to pursue profit.

And the other end

So while we have banks selling ridiculous mortgages to foolish people, at the other end of the financial chain we have institutions merrily gobbling up these subsequently-securitised gambles as fast as they can lay their slobbering chops on them. And who are these institutions? Some shadowy group? Some group of companies lurking in the background? Why no, they are… banks. Very often the same banks who are selling them. It’s a wonderful merry-go-round, with banks ever more incestuously gearing up their exposure to increasingly high risk. But in the tradition of the Emperor’s New Clothes, almost no one will stand up and put a stop to it. You cannot break the chain – to even utter the thought that the whole system might be in peril would be to put it at risk. Waffle waffle by me, and the word I’m really struggling for suddenly comes to mind: it’s a bubble. A classic, text-book bubble. Tulips one century, crap mortgages in another.

So who cares?

I do.

I care about the real people, with real children and real lives who will be shattered by losing their homes. Their ignorance has been ruthlessly exploited and they will pay a fierce price.

I care about the governments and financial regulators who have stood by and allowed this to happen, totally complicit in the “never mind the obvious longer term, for now things are simply fantastic!” elective blindness. They have failed us.

I care about the untold billions of my taxes which will go to bailing out (that’s a market term for “saving those who should not be saved”) the banks concerned, yet will rarely actually be used to save the evicted family out on the street. It will instead be used to pump new “profit” into these incompetent institutions.

I care about the fact that voters are too apathetic to rise up and throw from government those who allow this to continue.

Just how bad does it have to get before people demand change?

5 comments to The usual suspects? Or the usual bullshit?

  • Tim Ramsey

    I recently came accross your blog and have been reading along. I thought I would leave my first comment. I dont know what to say except that I have enjoyed reading. Nice blog.

    Tim Ramsey

  • The economist, paraphrasing Soros, is referring to Basel I not Basel II. Basel II is still being implemented. In the US, all but 10 or 11 banks will continue under Basel I. Under Basel I, the well-known phenomena is called ‘regulatory arbitrage:’ it absolutely encouraged off balance sheet and seeking of riskier loans by lack of differential capital charges. Basel II is currently in various stages of adoption globally.

  • Thanks for the input re Basel I versus Basel II. The reviewer did not say, and hence I assumed Basel II.

    However my general point remains: Basel I and/or II may encourage certain behaviours which in turn make it tempting to take unreasonable risks. On the basis that banks are not actually forced to take on such risks, then I still point the finger directly at them.

    Typically dodgy motoring analogy coming up: the car manufacturers may “encourage” me to drive very very fast by making available cars with insanely high top speeds. But when they cut my body from the smoking wreck, is it really their fault? True, they might have done more to discourage me, but I was the idiot. 🙂

  • But that’s not the reviewer’s point, which is important. Nobody is *really* pointing the finger at regulators (i.e., your car manufacturer). In my view, the regulators are the only folks who’ve escaped unscathed. Unlike the bank, which suffers market penalties, nobody monitors their performance. Reviewer is saying: many want to find a solution in better regulation (a “better” Basel II) but, missing the lesson of Basel I, they are not aware of the unintended consequences. He is saying, beware “mo better” regulation.

    Re the car, it’s more like you are driving a NASCAR race, in a car owned by a team (shareholders, Board). Your job is to drive fast (maximize RAROC). What is a bank? management, shareholders, Board, bondholders, employees? You crash, CDO collateral and CDS intra broker dealers aren’t even on the scene. Some victims (shareholders, laid off employees) are obvious some are not. Casting blame is non-trivial.

  • David comments above that the banks suffer “market penalties”. Oh that they did!

    Take Northern Rock in the UK: market penalty? Nope. Taxpayers bail it out and the execs get fat severance packages. Last week, in the US, we’ve the potential catastrophe of Fannie Mae and Freddie Mac. And the “market penalty” was… A $200 billion (plus or minus, no sod really knows) donation from the US taxpayer. With penalties like those life must be sweet for a bank.

    While I, pragmatically, support the rescue of those institutions, it turns my stomach. On the one hand the only reason it’s needed is that they are large enough for their failure to have a snowball effect and take down many other banks too. And then the governments compound their feebleness by doling out our money without fully nationalising the banks concerned.

    Here’s billions of dollars (or pounds, or euros) as a gift from the proud citizens. Please now carry on as normal. Let us know if you need some more.