Global Crisis and Unregulated Debt in New Zealand

Over the last two to three months we have seen the global financial system shake and totter; we have seen some private banks nationalised; we have seen governments make very large sums of money available to support financial institutions; and we have seen central banks around the world rush to offer deposit guarantees in an attempt to restore confidence in the banking system. What I want to do tonight is explain what has happened, what I think will happen next, and what should happen when it is all finished.

Everyone agrees the global financial crisis started in the United States subprime mortgage market. That market targets potential homeowners who have insufficient income, insufficient savings or an insufficient credit history to borrow funds in the prime mortgage market. Subprime mortgage holders are therefore risky borrowers, and they must pay a higher interest rate than those who can access funds from the prime mortgage market.

In recent years, the standards for subprime mortgages became more and more relaxed. People with no savings, for example, were allowed to borrow a second mortgage to provide the full deposit for their first mortgage. People with no credit history were offered mortgages with an interest rate set very low for two years, after which time it rises to higher market rates, to encourage them to borrow funds they could not really afford. And so on.

What about the other side of the market; who was agreeing to offer their funds under these terms? This is where the real problems started. Because of the risks involved, the original lending institution would spread its risk by repackaging the loans into financial assets known as derivatives for sale to investors looking for high returns. In many cases, the derivatives were accompanied by assurances about the quality of the original loans, with a promise to buy back any loans that subsequently proved to be less than the assured standard. Sometimes there were several stages of repackaging and investment, so that the ultimate holder of a derivative could be well removed from the organisation that made the original loan.

As subprime loan standards were relaxed, financial institutions also became reckless about evaluating the genuine risks involved in their derivatives. This situation remained hidden while the underlying problems could be covered by rising house prices, but the rising house prices were themselves being sustained by the increased demand being created through the subprime market. Such a system had to unravel eventually, and this is what has happened.

Initially the crisis was thought to be an American problem, with the rest of the world largely unaffected. This turned out to be untrue for two reasons. First, the scale of the U.S. problem is simply huge. I have read a report, for example, that quotes Moody’s as estimating that 15 million high-risk mortgage loans were made in the US between 2004 and 2007, of which two-thirds are likely to end up in default. There are 1.5 million dwellings in New Zealand, so we are talking about the equivalent of 6 or 7 countries the size of New Zealand not being able to keep up with their mortgage payments. This is human suffering on a huge scale.

Second, the repackaging of the bad loans into derivatives involved banks from all around the world. This means that no one knew who ultimately held the bad debts, and so no one was sure what institutions, if any, were not at risk of failure. That uncertainty is reinforced because we also don’t know how bad the bad debt problems in the subprime market really are. This will depend on how low real estate prices fall, but we won’t know whether property prices have bottomed out until the mortgage lending market is again stable.

Consequently, financial institutions are unable to trust each other, nor are they willing to lend to each other. And if the banks don’t trust themselves, how can ordinary depositors or borrowers trust any of them? And so the crisis became a credit crunch. Banks became very cautious, hoarding what cash reserves they had to see them through the crisis, rather than continuing to offer credit to fund new business ideas. As banks restricted credit, economic growth slowed and so the crisis has probably triggered a world recession.

What will happen next? The first thing to say is that time will pass; eventually a floor for property prices will be determined and institutions will start lending funds again. If the market is left to its own devices, however, this may take a long time and in the meantime a lengthy world recession would cause hardship to millions of people. Hence, governments are being asked to shorten the process by using taxpayer resources to fill the gap created by the loss of trust in financial institutions.

This is why governments are bailing out financial institutions that otherwise would fail. This is why central banks backed by governments are guaranteeing bank deposits and inter-bank loans, and this is why policy advisors are exploring schemes that would reduce the number of mortgage holders forced to default. These policies are designed to shore up trust that has been severely weakened by the directors, managers and officers of the financial institutions themselves.

There is an irony in this, of course. Financial markets are replete with people who in normal times are scathing about government and its involvement in economic affairs; yet the only institution with the size and integrity able on this occasion to save the financial markets from the consequences of their own actions has been central government. This is not to say that governments can do no wrong; of course they can; but perhaps this experience will give some balance in public debates about the benefits of good government in our modern age.

I want to finish by reflecting further on the question of trust in financial markets. You will all know that Alan Greenspan was Chairman of the Federal Reserve in the United States during the period when the subprime mortgage market and the derivatives market were developed. On 23 October this year, Greenspan appeared before the Committee of Government Oversight and Reform to discuss the credit crunch.

In his prepared remarks to the committee, Greenspan explained that ‘those of us who have looked to the self-interest of lending institutions to protect shareholder’s equity (myself especially) are in a state of shocked disbelief.’ He described this as ‘a flaw in the model that I perceived is the critical functioning structure that defines how the world works’.

Translating, Greenspan and other policy advisors at the time assumed that bank directors could be relied upon to protect their shareholders’ interests. This reminds me of the old joke about the economist trying to work out how to open a can of baked beans, who says, ‘Assume I have a can opener in my hand’. The assumption has turned out to be unfounded, and there are now widespread calls for greater government regulation to prevent a reoccurrence.

Indeed many commentators are seeking to blame the current crisis, not on the financial institutions themselves, but on governments for failing to regulate financial institutions to stop them from doing what they did. I don’t accept this. People running banks are professionals and we should be able to insist that professional people maintain professional standards without any need for regulators to tell them continuously what they can and cannot do.

In this regard, I think New Zealand has an important message for the world, because until very recently we have had two very different approaches for regulating financial institutions. In particular, banks were supervised by the Reserve Bank while finance companies were comparatively unregulated.

In the case of banks, the approach of the Reserve Bank has been to insist that bank directors behave professionally. Twice a year, every registered bank in New Zealand is required to publish a General Disclosure Statement signed by each director of the bank and, in the case of a bank incorporated overseas, the bank’s New Zealand chief executive officer. The Statement must include:

whether the bank has systems in place to monitor and control adequately the banking group’s risks and whether those systems are being properly applied;

whether the bank has complied with its conditions of registration over the period covered by the disclosure statement;

whether the banking group’s loans to connected persons are contrary to the interests of the banking group; and

that the information contained in the disclosure statement is not false or misleading.

As the Reserve Bank observes, this requirement strengthens the incentives for directors and CEOs to oversee, and take ultimate responsibility for, the sound management of their bank. In contrast to Alan Greenspan, in New Zealand we have not assumed that directors will behave professionally; we have demanded it in our legislation and regulation practice.

Although many finance companies have failed in the last year, so that the Reserve Bank Act was changed in October to bring them under the Reserve Bank’s supervision, New Zealand’s banks in contrast continue to operate strongly despite the international crisis. I think New Zealand’s system for its banks is the right approach to take.

The responsibility for responsible behaviour by banks must lie with the bank’s directors and senior managers. We have no hesitation demanding this from other professionals such as health or education professionals; the current crisis shows the global consequences of failing to demand it from financial professionals.