by Mike Soden
I often compare my mindset as a CEO of a bank to my mindset as an independent investor today. In both positions I can only be judged by the financial scorecard that reflects my gains and losses. I have no hesitation disclosing that I lost millions during this chaotic period on investments in Bank of Ireland, Royal Bank of Scotland and Allied Irish Banks (AIB). Having crystallised my losses, I have actively managed my financial position through trading in shares and foreign exchange to recover a large percentage of my capital and dividends. I would hope this activity reflects a mindset of market awareness and a penchant for action. My fingers are on the pulse of the market and all I can hope is that this keeps me better informed for investment decisions. I firmly believe that, had I still been in banking, I would not have remained in denial for long, or, if appearances are anything to go by, at least not as long as Ireland’s executive directors.
CHAPTER 1
Birth of a Crisis
It may appear strange at first glance that we need to go back to the Great Depression of 1929−1933 to find a major contributory factor to the financial crisis in Ireland today. How banking changed and evolved over the past eighty or so years owes a lot to the Banking Act of 1933, more commonly known as the Glass–Steagall Act, which was passed in the US as a reaction to the collapse of a large portion of the US commercial banking system. The repeal of this Act in 1999 helped create the banking environment that allowed for the international financial crisis that began in 2008.
While recessions are experienced throughout the world from time to time, a depression is a rarity. Defining the difference between these two economic terms is not easy for one simple reason − a universally accepted definition does not exist. A recession is when your neighbour loses his job, but a depression is when you lose yours, or so the line goes.
The standard definition of a recession is a decline in the GDP of a country for two or more consecutive quarters. It is an unsatisfactory explanation as it does not take into consideration changes in other variables such as unemployment rates or consumer confidence. An economic recovery that doesn’t lead to more employment is merely a mirage. Also, using quarterly data makes it difficult to pinpoint when the recession begins and ends.
There are those who would define a recession as a fall in business activity until it bottoms out, following a period when it had reached its peak. When business activity begins to rise again and an expansionary period is experienced, the recession has come to an end. By this definition, the average recession lasts about one year. Many economists would agree with this.
The term ‘recession’ was developed to differentiate periods like the Great Depression from smaller economic declines, implying a relatively simple definition of a depression as a recession that lasts longer and sees a larger decline in business activity. So, in the context of changes in GDP, a depression occurs when real GDP declines by more than 10 per cent.
The Great Depression came about in the context of massive speculative trading coming off the back of a five-year bull market. The bull market came to an end in September 1929 and trading climaxed on Black Thursday, 24 October 1929, with almost 13,000,000 shares being traded. Panic selling followed on Monday and Tuesday, 28 and 29 October 1929, which concluded in total losses of US$30 billion – ten times the federal budget and more than the US spent on World War I. Personal and corporate savings fell from US$15.3 billion to US$2.3 billion.5
Protectionism was unlikely to have been a main cause of the Depression but it surely helped the spread of its effects throughout the developed world. Increased tariffs, intended to protect local manufacturing and farming communities, fostered global protectionism and resulted in world trade declining by 60 per cent between 1929 and 1934.6
It is often overlooked that the last depression by our definition in the US was during 1937−38, when GDP declined by 18.2 per cent.7 The effects of these economic circumstances made the US economy dependent on the war machine and military expansion to fill the domestic coffers. The sector that would create the greatest economic stimulus was armaments. Commentators have broached the subject that the US decision to enter World War II was based somewhat on economic motives. But perhaps this is a cynical take on what lay behind the political decisions at that time.
In the 1930s people were not exposed to technology in the way we are today. For example, the time it took to report one quarter’s GDP figures or the previous year’s figures would have been measured in months if not years. However, the evidence was clear that there was a depression being experienced by the length of the dole queues and the number of soup kitchens. The hardships and misery experienced in the 1930s laid the foundations for a more sympathetic response to the plight of the less fortunate in the US thereafter. People whose wealth had evaporated and whose life savings were depleted or were lost in a banking system that was not prepared or robust enough to withstand the fallout of the economic disaster were faced with a bleak future.
In the period leading up to the Depression, a five-year bull market had created a highly competitive market in both debt and equity. The equity markets were primarily the preserve of the investment banks, while debt was the principal focus of the commercial banks. During this time, a combination of greed and pressure from investors for increased returns prompted the commercial banks to ease into the investment banks’ preserve of equity. In times of economic growth the commercial banks found themselves providing major US corporations with equity, loans, board memberships and a variety of advisory activities. The equity of the commercial banks was now inextricably linked to the future prospects of these corporations. When the economy turned for the worse, the banks were faced with enormous conflicts of interest as they held various roles with their corporate customers, from equity stakeholders to lenders. As the need for more capital grew in the early days of the Depression, decisions were made to increase the commercial banks’ shareholdings in corporations suffering from the downturn; deposits were now being used in the higher risk area of corporate equity rather than in the traditional loan markets.
This injection of the banks’ capital and deposits into corporate America was the rock on which commercial banking perished in the Great Depression. The banks had to follow bad investments in companies with increased loan facilities in the hope that the companies with deteriorating balance sheets and profit and loss accounts would recover. When circumstances got worse, they were faced with the same decision again − to increase the loans or see their equity written off in bankruptcies. In many instances, the equity, loans and many other forms of support were written off, which led to the collapse of such corporations and, in turn, the banks themselves.
A retail bank acts as a principal in the context of dealing with customers. When people deposit money in a bank they are actually lending the money to the bank. In the event the bank lends this money on to a borrower who fails to repay, the bank’s capital is used to absorb these losses and hence the depositor does not lose out. Unfortunately, if the bank’s capital is not adequate enough to absorb cumulative loans and investment losses, the depositor’s funds are put at risk.
The other side of this equation is the role of investment banks. These banks don’t use depositors’ money as they are not licensed to raise deposits from the retail market. They attract funds from investors who, through due diligence, are able to evaluate the underlying risks of investments undertaken by the investment banks. The investment banks receive substantial fees for their efforts. In this situation, the investor lends (debt) or invests (equity) in the opportunity presented by the investment bank directly with the issuer. In the event of the issuer failing to repay, the original investor will lose some or all of his investment. The relationship of the investment bank to the investor is one of an agent and not a principal. Thus, there is no recourse by the investor unless malfeasance can be proved.
This area of corporate debt and equity has been a financial battleground for commercial and investment banks over the years. The Glass–Steagall Act of 1933 se
parated the activities of commercial and investment banks. It also provided for the foundation of the Federal Deposit Insurance Corporation for the protection of bank deposits.
Over the next sixty-six years efforts were made to repeal the Glass–Steagall Act. Cases were made for and against its repeal. In 1987, the major US banks actively lobbied Washington to repeal the Act as they wanted to expand their corporate strategies by offering what were viewed as essential products to their major customers. This business activity was viewed as an enormous potential revenue generator for the banks. The arguments raised for the preservation of the Act ranged from conflicts of interest leading to the abuses to which the Act was a response in the first place, to protection of depositors and questions as to whether commercial banks were equipped to handle the risk profile of securities, which was different to that of loans. An amendment to the Act enabled the commercial banks to enter the underwriting of corporate equities in a limited way at this time.
On the other hand, well-structured arguments against the preservation of the Act were put forward, with regard to depository institutions that were operating in a deregulated financial market in which the lines between loans, securities and deposits were not well drawn. The commercial banks were losing market share to securities firms which were gradually expanding their presence in the raising of debt and equity for sovereigns, corporations and financial institutions. The argument of the banks for the repeal of the Act was not about good customer service; it was about tens of billions of dollars in revenue. However, if the Act was repealed, would the banks, as new entrants in this particular market, be winners or were the risks so complex that they might have to pay a very heavy entry price?
On 12 November 1999 the repeal of Glass–Steagall was signed into law by President Bill Clinton after years of lobbying by the various interested parties. As part of the background noise to all the debates was the promise that the securities industry could be used to provide mortgages to millions of poor Americans who might otherwise not be able to own their own homes. This was high on the agenda of all Democrats but none could imagine what the toxic mix of subprime debt, structured investment vehicles (SIVs), credit default swaps (CDSs), collateralized debt obligations (CDOs) and derivatives would lead to.
The repeal of the Act enabled commercial lenders such as Citigroup, the largest US bank in 1999, to underwrite and trade the fastest growing instruments in the history of the financial markets. The author Elizabeth Warren, one of the five outside experts who constitute the Congressional Oversight Panel of the Troubled Asset Relief Program (TARP), has commented that the repeal of this Act contributed to the global financial crisis of 2008−2009. The year before the repeal, subprime loans were just 5 per cent of all mortgage lending. By the time the credit crisis peaked in 2008, they were approaching 30 per cent.8
An interesting aspect was that, a short time after the repeal of the Glass–Steagall Act, new, complex products were created which enabled millions of families in America to purchase and own their own homes. What had changed? Commercial banks, which once would not have considered this subprime market as a suitable credit risk, were now pouring billions into it. The investment banks created vehicles that were wrapped in credit default swaps, had very modest amounts of equity and were rated AAA by the large rating agencies. The funding of these vehicles was often through the excess deposits that were in the vaults of the commercial banks − a tragedy in the making. The rating agencies fundamentally replaced the traditional credit process in the banks. No longer did questions of a borrower’s ability and willingness to repay need to be addressed, as the answers were implied by the AAA rating assigned to the mortgages by the rating agencies.
The origins of complex products can be traced back some thirty years when some colleagues of mine at Citicorp Investment Bank Ltd in London carried out the first ever derivative transaction. Shortly thereafter, I was also involved in carrying out these transactions and eighteen months later I became global head of derivatives in New York. There was a team of us in London and New York who forged bonds in both professional and friendship terms. This transaction in 1980 was the birth of a new industry in financial instruments. In the early days of derivatives no one could have ever imagined the potential of these new products. The term ‘financial engineering’ was introduced at the time to describe the creation of these transactions because of the very complex nature of most of them. Originally there were two types of derivatives or swaps: interest rate and currency.
In their simplest form, swaps were to facilitate the customer who wished to raise fixed-rate borrowings but could only do so at prohibitive rates, and thus was left with the alternative of having to pay a variable rate. The uncertainty of variable rates often forced capital projects to be reconsidered or deferred due to the customer’s inability to budget accurately for the total cost of the finance over the period of the loan. Necessity is the mother of invention. Banks were able to identify customers wishing to borrow floating or variable rate funds but who had the capacity to raise fixedrate funds inexpensively. Some of these customers had enormous capacity to raise fixed interest funds at preferential rates in the capital markets. These capital market issuers were normally governments, major corporations or financial institutions. At a prearranged price, two borrowers could swap their interest payments, fixed for floating, and so the birth of the derivatives (swaps) market occurred. The financial engineering skills involved in the pricing and structuring of these transactions through the bond markets were finely honed, so that each party got what they wanted at a cheaper price due to the perceived credit rating of each party to the transaction in the marketplace.
As customers became more educated in the area, the deals grew in size and frequency. Deals in the early days would be executed for amounts of US$25 million to US$50 million. In 1982, I wrote a paper for Citibank Rese arch which forecasted that this new market had the potential of growing by €1 billion per year. During my time in New York as head of global derivatives this activity expanded beyond all expectations. The expert of the group and managing direc tor of Citicorp Investment Bank in the UK was David Pritchard, an individual whose name became synonymous with the business and the international capital markets. His background as an aeronautical engineer served him well through a most illustrious career in financial services before he retired as vice-chairman of Lloyds TSB. He was brought onto the board of AIB in 2007 and is chairman of AIB (UK) Ltd today. There is unlikely to be a better financial brain or experienced bank director in the country and I hope his talents will be used extensively in the restructuring of the banking system in Ireland.
The derivatives market broadened from being based on interest rates and foreign currency in the early years to encompass equity and credit default swaps. Little did the minds behind the first derivatives realise that they would become a multi-trillion dollar business. The origins of the derivatives business was in a corporate finance environment where financial solutions were sought for customers who wished to reduce the cost of borrowings or increase their yields on investments. Sophisticated mathematical programmes were developed and the efforts in the early days to get two customers with equal but opposite positions disappeared with the creation of a marketplace better known as the warehouse in each bank. In effect, government bonds were being used as a counterparty in a transaction. The expansion of the market was attributable to the fact that, through a variety of hedging techniques and financial programmes, a level of liquidity was created that no one could have visualised early on. Many point their finger at this financial area as having the potential to cause the next global financial crisis. This could be the case, but the precautions that are being taken and considered by the regulators and market participants should reduce the likelihood of a catastrophe. There is no telling, however, how foolish people can act through the motive of greed. These markets in derivatives are now truly global with a large menu of products that provide governments, corporations and financial institutions with the tools
to manage their balance sheets more effectively by limiting their risk exposure. The risk management element of derivatives has given way to the weight of trading in the provision of liquidity in these instruments. A single derivative may be traded a thousand times in its life.
The traditional distribution network for mortgages in the US was through the branches of national, regional and local banks. Mortgage brokers had a modest input into this market compared to what they ended up with when the floodgates for mortgages were opened through the creation of structured investment vehicles. With these new vehicles, access to credit was ever present. Families were approached with all forms of, often complex, mortgage offerings. Homeownership, everyone’s dream, was now possible for thousands. The corruption in the selling of mortgages became everyday practice. Families were approached with an offering for a mortgage to buy a new home and at the end of the discussions they were on their way to owning a fully furnished house with a new car in the driveway. These were the 100 per cent plus (subprime) mortgages with initial monthly repayments less than the mortgagee had previously been paying for rental accommodation. How could this be? The mortgagers offered low interest rates for the first two or three years, which would be re-priced upwards to two or three times (or some other multiple) the original rate in due course. But when you are sitting in your new home with a new car in your driveway, it is difficult to ponder anything other than your good fortune.
The day of reckoning always arrives. People who had lived a dream for a couple of years could only watch as the bailiffs arrived to repossess their homes because they could not afford to meet their increased monthly mortgage repayments.
As demanded by the politicians in Washington, the pace of loan modifications was accelerated, which spared hundreds of thousands of families from the hardship of losing their homes. Financial competitors were cooperating with one another to get troubled homeowners to contact their mortgage providers or servicers and, in turn, to find a way to accommodate the requirements of both parties where possible. In an Irish context this might be considered as NAMA 2. To put this into context, these moves to protect the mortgagees occurred in 2008–2009 when Ireland was already in a depression but still waiting for action to be taken.
