Strategy sought to regain trust of investors

The need of the hour in the global economy is to rebuild trust in the market so that many with liquidity, who are sitting on the sidelines, are encouraged to invest again, said a renowned international economist in Sharjah yesterday.

In a lecture at the American University of Sharjah, Dr Bruce Yandle, Professor of Economics Emeritus at the Clemson University, USA, gave detailed analysis about the financial crises and its implications on the economy of the US and the world, and outlined probable solutions and tips.

He said in order to find effective solutions for the problem, economists should look into the causes.

A recession, according to the definition by the USA's National Bureau of Economic Research (NBER), is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales, said Yandle.

"Notice, the NBER does not say a recession is two consecutive quarters of negative GDP growth, even though that may be a shorthand interpretation of their more complete definition," he said.

In fact, each of the 32 recessions recorded by the NBER since 1832 has lasted at least six months, he said, adding that the two most recent ones – July 1990-March 1991 and March 2001-November 2001 – lasted eight months. The current recession, which started in December 2007, has lasted 13 months, as of January 2009. And, it is difficult to speculate how much longer it will last, he said.

Yandle, who has served in Washington on two occasions, first during the Ford and Carter Administrations and later under the Reagan Administration, blamed the currently implemented ratings system of companies for driving a considerable number of companies to bankruptcy.

"There are three federally- approved financial instrument rating agencies that place their ratings on all debts issued by major US firms, as well as international firms. These ratings, such as AAA, AA, B and junk, signal quality to investors," he said.

Many investors are required by contract and charter to invest only in higher quality debt issues, he said.

Citing an example, he said that in 2005, Moody's, a leading credit agency, expanded its business of rating mortgage-backed securities significantly. Revenues obtained from this activity raised Moody's operating margins above those of companies like Exxon, he said.

Moody's and other agencies provided their highest ratings to a new Wall Street product, Collaterised Debt Obligations, which actually contained a mixture of sub-prime and prime mortgage backing. These higher ratings were later revised downwards, in some cases falling to the lowest junk category rating, Yandle said.

He said Moody's revenue from rating structured financial instruments, which include mortgage-backed securities, rose from around $400 million (Dh1.46billion) in 2003 to more than $800m in 2007. Along the way, debt-carrying high ratings began to look more like junk. As a result, the rating credibility fell, and financial institutions could no longer rely on the ratings when deciding whether to lend to another financial institution, he said.

This is when the term "toxic assets" entered the vocabulary, Yandle said.

A Moody's managing director is reported to have put the situation this way in a September 2007 internal management survey, Yandle quoted: "These errors make us look either incompetent at credit analysis or like we sold our soul to the devil for revenue, or a little bit of both."

Put another way, he said, a key trust-forming device was biased and no longer reliable. Credit markets tightened.

Biased credit ratings do more than mislead investors – they can also bias the amount of capital required by financial institutions.

Quoting several sources, Yandle said: "For every dollar of equity that insurance companies are required to hold for bonds rated AAA, $3 is needed for bonds rated BBB, and $11 is needed for bonds rated just below investment grade (BB). For banks, the sensitivity of capital requirements to ratings is generally even more extreme."

He went on to point out that "regulatory reliance on ratings makes the rating agencies the de facto allocators of capital in our system".

Mark-to market accounting standards posed another problem, Yandle said. These standards were supplemented by the American Securities and Exchange Commission (SEC) rules as interpreted by the US Federal Accounting Standards Board, he said.

Among the rules was the Fair Value Accounting Standard, which specified mark-to-market methods of evaluation for bank assets. Mark-to-market evaluations are intended to provide transparency to investors and are more meaningful in the normal course of doing business when markets for securities under scrutiny are functioning than are historic cost or cash-flow evaluations. But when markets lock up, trade ceases and asset evaluations can only occur when a financial institution goes through bankruptcy, then the beneficial aspects of mark-to-market become more questionable, Yandle said.

US stocks slid more than four per cent after US authorities scrapped plans to buy up toxic mortgage securities, he said.

US Treasury Secretary Henry Paulson said buying up toxic mortgage debt was not the most effective way of repairing America's battered financial system and government money could be better spent on continuing to buy ownership stakes in troubled American banks, according to Yandle, who added that Paulson also ruled out using the $700bn government rescue package to help out struggling US car companies.

US stocks plunged amid deepening economic worries, with the Dow Jones Industrial Average losing 4.7 per cent.

Yandle said this proved that the proposal of any new law or regulation ought always to be listened to with great precaution, and ought never to be adopted till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention. It comes from an order of men, whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.

Yandle said people of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. It is impossible to prevent such meetings by any law consistent with liberty and justice. But though the law cannot hinder people of the same trade from sometimes assembling together, it ought to do nothing to facilitate such assemblies; much less to render them necessary, he said.

A regulation that obliges all those of the same trade in a particular town to enter their names and places of abode in a public register, facilitates such assemblies, Yandle said.

A regulation enabling those of the same trade to tax themselves in order to provide for their poor, their sick, their widows and orphans, by giving them a common interest to manage, renders such assemblies necessary, he added. And incorporation not only renders them necessary, but makes the act of the majority binding upon the whole.

Yandle said all these factors have created lack of trust in the financial market and investors and the public are counting on the government to find solutions.

To rebuild the trust the government should intervene and relax rules, such as of rating. As well, legislations should be issued to allow the government, for example, to bailout, or provide financial support to firms in trouble, such as Lehman Brothers, he said.

In the US, states based on energy resources such as gas faced minimal impact of the crises compared with those whose economy was based on property, he said.

Property prices have increased in certain states and those states are now facing severe recession, which is expanding geographically and has affected several areas, he said.

Citing another example, Yandle said for decades, Fannie and Freddie – the common names for the US Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation respectively – fulfilled the American dream. Consumers took out loans from banks, which in turn sold those loans to Fannie or Freddie. Then the mortgage giants repackaged those loans and sold them to investors, guaranteeing the mortgages would be repaid.

As home ownership grew universal, Fannie and Freddie prospered. Their CEOs, Daniel Mudd and Roger Syron, together earned around $30m in 2007, according to CBS news reports, Yandle said. But as they fattened, critics say they got greedy, underwriting too many home loans that never should have been made, he added.

Fannie Mae and Freddie Mac lost a combined $3.1bn between April and June last year. Half of their credit losses came from these types of risky loans with ballooning monthly payments, Yandle said.

"Just how did Americans come to lose $10trn in real estate and stock wealth? And why are our children and grandchildren on the hook for as much as $8trn in federal bailout money? These are some of the most important questions of our time. Yet the mainstream media, plagued by monopartisan bias, are not providing the public honest answers.

"Take, for instance, a recent front-page article in the Washington Post, under the headline, 'How the US Department of Housing and Urban Development (HUD) Mortgage Policy Fed the Crisis'. The piece correctly fingers HUD for helping fuel-risky lending at Fannie Mae and Freddie Mac. But the newspaper starts its analysis in 2004 (in fact, the first sentence begins, "In 2004 . . . "), making it seem as if the Bush administration crafted 'affordable housing' policy and created the sub-prime market," Yandle said.

"The Post knows better. The Bush HUD merely continued a politically correct policy launched by the Clinton administration. For the first time, President Clinton ordered HUD to set quotas for Fannie and Freddie to buy huge portions of Community Reinvestment Act loans and other low-income mortgages made to borrowers with poor credit. The Post failed to mention this key fact.

"By 2000, fully half of the mortgage giants' portfolios consisted of these risky loans, most of them sub-prime mortgages. In effect, the Clinton HUD set a time bomb that would explode years later with the collapse of home prices, which happened to occur on Bush's watch," he said. "At the same time, HUD pressured the federally subsidised giants to lower their loan-to-value ratios and other underwriting requirements to accommodate minority borrowers. HUD Secretary Andrew Cuomo even admitted that the administration was mandating a policy of 'affirmative action' lending."

Less than two years later, Yandle said, Freddie partnered with Wall Street investment banker, Bear Stearns, to issue the first securitisations of low-income loans, he said.

Speaking about the Gulf, Yandle said the situation in the UAE and the GCC differs from that in the US.

The banking and financial sectors in this region are more likely investors than lenders. The profitability of a transaction is directly assessed by the bank or financer and not through a third party, he said.

"In times of crises, leaders always think for money supply. Whenever the bubble was big, the greater the fall and the more severe the problem," Yandle said. "We need to learn from a series of crises that we have faced and to come up with and adopt a system that would minimise risks in such circumstances."


Reasons behind crisis

- A national commitment to the "American Dream" – home ownership for all. The Affordable Housing programme.

- The Federal Reserve's relaxed monetary policy: Easy credit and low interest rates

- Globalisation of securitised debt

- The rating firm monopoly: The role of Moody's, Standard & Poor's, and Fitch

- Credit default swaps and municipal bond insurance

- Monetary action that triggers higher payments

- FASB mark-to-market rules

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