Numerous periods of instability and financial crises

During the 1980s and 1990s there were numerous periods of instability and financial crises, characterized by increased credit risk, lack of liquidity and volatility in prices of financial assets. In many cases, inflation of certain assets is observed, along with speculative excesses, poor financial practices and weakness in measurement and risk-control systems.

In the 80´s an external debt crisis erupted and on Monday 19 October 1987 the stock market in Hong Kong fell precipitously, spreading across Europe and US. At the end of the month the falls went from 22 to 46%.  Then, in 1990, the real estate market in Japan exploded, followed by a banking crisis and stagnation.  At the end of 1994 Mexico’s external debt went into crisis, the peso was devalued, and a banking crisis erupted the second half of the decade.  Instability reached Argentina’s economy and its convertibility regime, with a severe banking crisis and a strong recession.  The Asian crisis came later, in July 1997, with devaluation of Thai baht and collapse of its stock exchange, which affected the world economy.  In August 1998 the Russian government devalueded the ruble and unilaterally declared a moratorium on debts with foreign creditors and part of public debt in roubles. That same year North American Fund Long Term Capital Management hedge fund broke, with leverage at levels thirty times its capital and losses of 4.6 billion dollars in less than four months in failed fixed-income bets, which motivated Federal Reserve bailout.

The dot.com speculative bubble was lurking

What would be known as a the dot.com speculative bubble was lurking from 1995 to 2001, a period of rapid rises with the heat of Internet-related sectors.  It was characterized by creation of numerous companies, many of which succumbed quickly. Speculation and abundant capital had encouraged many investors to participate in ever-higher prices.  However, business models lacked solidity, as well as analyses and valuations.  Companies, investment banks, analysts and accountants had promoted the bubble.  Worldcom and Enron broke up with fraudulent accounting practices.  Large investment banks paid millionaire fines and Arthur Andersen ended up disappearing. Its explosion led to a period of global recession in developed economies.

Then we faced a new crisis, originating in high-risk mortgage defaults in US, where housing prices had been going up for ten to 15 years. These mortgages allowed access to housing for families who did not meet the usual requirements.  Thus, at the heat of low interest rates traditional credit packers such as Fannie Mae, Freddie Mac and FHA (Federal Housing Administration) joined investment banks as Bear Stearns and Merrill Lynch.  In this way the volume of sub-prime mortgages reached 640,000 million dollars from 150,000 in 2000, representing 12.7% of the entire living market of residential mortgages in the country.

This debt packaged in tranches with different credit ratings was sold to banks and financial intermediaries, which in turn made them part of credit structures purchased by other institutions and private investors. Their high demand reduced the interest rate differentials demanded.  In fact, the asset-backed debt market-mortgages, asset backed credit, credit cards and others became to 1.5 trillion dollars by June 2007. Among the purchasers of tranches of these structured low-credit-rating products were several hedge funds from investment bank Bear Stearns & Co., which had borrowed from other commercial and investment banks based on hypothetical ratings.  When, due to non-payment of mortgages, the real value arose, Merrill Lynch reassessed the methodology.  The rest of the industry centered of the risks and asked for more collateral, appearing counterpart risks in the system. Even large buyers of these instruments were in Asia.

The credit rating is based on historical data

According to Sridhar Bearelly, CEO of ZAIS Group London (The subprime Crisis: How Did We Get Here? Where Are We Going? © 2008, CFA Lnstitute; SEP 2008), the credit rating of agencies is based on historical data that are not necessarily applicable to new instruments, while investors believed they would not change, when they actually represent long-term estimates of default or loss.  In addition, banks had provided money based on these ratings, instead of their own analysis. “At the end, lenders and debtors did not know each other”.  Bearelly considers that “investors must ask questions, challenge assumptions and avoid dependence on external qualifications”. He also considers convenient for investors to be aware of leverage risky investments when banks are reducing debt.

In the absence of confidence among banking institutions the Federal Reserve had to act as lender of last resort and take additional measures as admission of high-quality credit assets of investment banks to gain access to the discount window, with risk assumption of 30 million dollars in Bear Sterns assets and government disposition to act as ultimate guarantor and subsequently auditor of mortgage entities Mae, Freddie Mac and Federal Home Loan Board. Banks reflected their values downwards on their balance sheets and increased capital in the hope that markets would stabilize, but they were not able to sell damaged assets.  Thus, it came bankruptcy of investment bank Lehman Brothers and acquisition of the Treasury of 80% of multinational insurance company AIG -a counterpart in several default debt insurance contracts-. The fact is that 39% of 4.650 members CFA Institute members worldwide considered that the bailout plan concluded by US Federal Reserve and Treasury, known as the “Paulson plan” was reasonable and necessary, and 19% considered it should went further to prevent the collapse of the market.

The global financial system is better protected if industry professionals first place the interests of their customers

Now, according to Jeff Diermeier, president of CFA Institute, “The objective of self-regulation should not be abandoned: the problems caused by regulated investment commercial banks and sectors are not more regulation but coherent, transparent and better applied legislation”. He believes that higher transparency can prevent manipulation and the early diagnosis of financial illnesses and concludes that “The global financial system is better protected if industry professionals first place the interests of their clients and professionals above short-term business objectives. It is about acting prudently and diligently, accounting whether an investment vehicle is appropriate for a client. Without this daily ethical perspective, the regulator is forced into a continual persecution game”.

José Mª Serrano-Pubul, CFA®.