Last week the Secretary of the Treasury of the United States announced to the world that the United States financial system would collapse if emergency legislation was not passed by the following Monday. This suggests that the financial problems that had been caused by the collapse of the US mortgage market were probably a bit more severe than had been initially anticipated. Monday has come and gone and New York is still there, Godzilla has not struck, and the financial system is still functioning as can be seen by the fact that one of the major banks managed to raise funds to support an acquisition.

So, what I would like to do this afternoon is to give a short explanation of what the Treasury Secretary thought was about to happen, why he made the proposal to Congress that he did (which as Arturo has suggested was roughly the equivalent of creating a Soviet in New York, or at least Manhattan) and the likely evolution of the kinds of proposals that will be introduced.

The relevance of all this for financing development should be obvious given that the financial systems in developing countries are now more and more patterned on the financial system of developed countries, particularly of the United States as a result of the activities in support of financial stability promoted by the International Monetary Fund and a number of voluntary, independent agencies such as the Basle Committee on Bank Supervision that set standards and codes for the financial system that the IMF supports and disseminates. Thus, the fact that the US system is presumed to be about to implode suggests that we should be thinking twice about the way this advice is given to developing countries and the kinds of financial systems that they might want to develop.

The first point that I would like to make is that there is one substantial benefit from the crisis and that is that one of the US presidential candidates has argued very forcefully that all of the problems in the US financial system are due to corruption. This is an argument that we have heard as an explanation in a number of previous financial crises in developing countries and I think now this sort of comment will be used with more care. It is going to be quite difficult now to argue that financial crises are simply due to corruption. There are more serious causes and these causes are probably not the ones that you will read about in the newspapers. So, I would like to start out by pointing to three of these factors.

The first is a structural problem, and it relates to a problem of what might be called industrial organization. It is the question of whether it is possible to have a regulated financial industry that is capable of generating sufficient profitability to allow it to be treated as if it is a private company that competes with other private companies in capital markets. Because the origin of the crisis that we are experiencing today is due to a profitability crisis for a regulated industry. So the question that we have to face is whether or not this mix that we have in the United States of having the private sector provide what is a public service subject to public regulation is in fact the most appropriate way of providing basic financial services. And by basic financial services we mean a secure transactions system and a safe means for the public to hold its savings.

The second point is that there has been a substantial shift in the organization of the US financial system between the present system and the 1960s and 1970s. Initially the financial system provided financing for productive investment; if you like finance was the handmaiden of industry, providing the possibility for the private sector to engage in the financing and funding of productive investment projects. Income for the banks was generated by net interest margins, the difference between extremely low, regulated borrowing rates and higher rates charged on loans to business. Today we have a system that generates its earnings from what is called arbitrage. This is often represented as ensuring the absence of inefficiency in the financial system but is basically just arbitrage across price discrepancies. The basic function of the financial system starting from the mid-1980s has been eliminating price discrepancies, and more recently creating those price discrepancies so that they could be then arbitraged for profit. This is basically trading activity, buying assets that are underpriced and selling those that are overpriced, and profiting by ensuring that prices converge to their “fundamental” values.

The third point is that in the United States we had separation of the activities of what are called commercial banks that offered deposits and funded short-term business lending and investment banks that provided capital market services such as underwriting of bond and equity issues for business firms and brokerage activities. Another aspect of this crisis is the result of what has been competition between the regulated commercial banks and the relatively unregulated investment banks. This competition has existed ever since the Glass-Steagall legislation of 1933. Commercial banks have attempted to encroach on the activities of investment banks’ financing function and investment banks have attempted to encroach on the activities of transactions and store of value services of commercial banks. Now ultimately it is the commercial banks that have won, for there are no longer any major broker-dealer investment banks in the system. The last two that managed to survive without declaring bankruptcy or having been merged with a commercial bank, have filed to take on the status of what we now call a commercial bank holding company under the Financial Modernization Act so that we no longer have any straightforward investment banks.

This competition between commercial banks and investment banks has evolved through attempts by each of to encroach on the activities of the other through what is described as a process of an increasing degree of competitiveness, or efficiency created by the liberalization and deregulation of the financial sector. There are a number of crucial changes in the financial system that were part of this process of deregulation, One of the first was the elimination of fixed commissions for brokers on equity trading which brought about a very sharp decline in income for broker-dealers. The second was the introduction of shelf registration which meant that investment banks did not have to go through the lengthy preparatory full due diligence process in order to issue and underwrite and sell bonds or equity for a corporate borrower, reducing the need for relationship banking and creating substantial competition amongst investment banks for underwriting business. Again reducing profitability. The third was the reduction and then elimination of regulation Q that had provided commercial banks with virtually free short-term funding so that net interest margins were compresses. And finally the creation of one bank holding companies and then the famous section 20 exemption that allowed commercial banks to enter into certain underwriting and trading in financial securities on the one hand and allowed investment banks on the other to engage in the provision of deposit and other transaction services for the private sector.

Now as I've already mentioned, this took place in the context of a shift from the basic activity of the financial system from financing of productive activity to the arbitrage and efficiency, supported by the increased competitiveness that reduced profitability and led to a search for alternative sources of profits. In general commercial banks increasingly sought profits in the generation of what is called fee and commission income. That is, in charging for the provision of financial services, rather than in providing the financing for the private sector. Now the recent crisis was generated by subprime mortgage lending. Aside from the name giving the definition of the activity of something that is not “prime”, the important point is that this type of mortgage lending was simply another way for commercial banks to generate fee and commission business. The generation of fee and commission business is often represented as the originate and distribute model of banking. Originate and distribute means that instead of the bank raising deposit funds from the public and lending them to business borrowers, what it does is to offer a mortgage to a borrower and then convince a private sector investor to provide the funds for the mortgage. The bank acts as a middle-man that does not take on any financial liability because it does not hold the mortgage on its balance sheet and does not provide the funding itself. But, it does charge a commission for this service and also earns fees on related activities such as servicing the mortgage, insuring it and so forth. So profitability depends on generating as much business as you possibly can and on the size of the mortgage being as large as possible.

The difficulty with the subprime sector as with any other activity that generates income through percentage commissions on originate and distribute business is that if you do not hold the assets on your balance sheet you really have no concern about the credit worthiness of the borrower or whether the lender will in fact be repaid his money. I'm sure you've all heard stories about the weakness of the credit assessment process and the fraudulent activity that went on at individual mortgage originators and banks. Many low income borrowers were convinced to undertake financial commitments on a relatively onerous long-term basis. In particular, many of these mortgages were written on an adjustable basis, which means that interest rates for the beginning of the mortgage, the first two or three years, were extremely low and in many cases zero. After this period the interest rate was “adjusted”, that is reset at the market rate. Now it was not only reset to the market rate, but in order to generate commissions, the borrower was charged a margin for the reset in percentage points. This could be as large as 300 basis points or even higher, which means that if you took a mortgage at 2% and the market rate went up 5% you would end up paying 8%, a 6% increase in your interest rate. Obviously, many of the holders of these mortgages did not recognize the implications of the adjustable rate mortgage because many of these mortgages were marketed as fix rate mortgages, -- that is, they were fixed for the first three years and then fixed for the next 27 years. It was only when the borrower got the new interest rate that he realized that there would be a problem making the payments. It was then that most of these mortgages defaulted. These were the mortgages that were used in the mortgage backed securities, and once the mortgages started to default the residential mortgage backed securities, that is pools of thousands of these mortgages sold as a block, also started to lose their value. Now this in itself would have been enough to create a substantial financial crisis and a reduction in the earnings of the financial system.

In addition these packaged pools of sub-prime mortgages were used in securitized structures in which the securities were bundled into larger packages which had individual pieces called “tranches” representing the first rights on certain proportions of the income from the mortgages. The first claim in this structure was called the super senior tranche and was designed so that a credit rating agency would give it an AAA investment grade rating. It is this rating that allowed the pension funds and other institutions to buy these structured instruments. The remaining income from the structure, if any, was dedicated to lower rated tranches, until the residual tranche, which had the highest return and no rating because it only had return if all the higher tranches had been fully paid. Hedge funds were the major buyers of the middle and residual tranches.

These instruments were also created with a substantial amount of leverage. This means that debt was used in order to create the structure. This means that if the subprime mortgages in a securitized structure start to default, the loss to the structure is not just the value of the mortgage, but has to be increased by the leverage. Thus if say 25 % of the mortgages were non performing then the loss would have to be multiplied by the leverage factor in order to get the total losses that will result for the individuals that were holding the assets that were created by the securitization process. In very simple terms, the triple-A super senior tranches and investment-grade tranches that were supposedly guaranteed to pay off very quickly and with no risk did not, and the AAA tranches soon had virtually no value.

We now get to the explanation of how we got to the crisis last week. Many banks themselves believing that the super senior tranches were investment-grade kept them as investments. That is, the problem was that instead of originating and distributing, they didn't distribute enough.

Secondly, many banks that had set up the securitized structures, once the higher risk tranches started to default, decided that they would support the structures by buying in the AAA tranches of the structures. This meant that many of them increased their exposure to what were effectively worthless assets and this in particular appears to have been the case of Lehman Brothers, which a week and a half ago created the beginning of the current downturn. Lehman decided that there were good opportunities in investing in the super senior tranches, that they had been oversold so that it was sensible to buy them rather than selling them.

Finally, many of the banks that were engaged in an originate and distribute process had substantial amounts of warehouse assets. That is, subprime mortgages that they had originated but had not yet been able to distribute when the crisis struck the market for subprime lending in August 2007.

So the basic problem was not really the problem of originate and distribute but of originating and not distributing sufficiently rapidly. Further, because banks believed that these assets still had value they did not fully mark down the value on their balance sheets when the other tranches of the structures started to default. And this was in part encouraged by the fact that the credit rating agencies that applied these ratings were also very slow in downgrading the super senior tranches, although they were very rapid in downgrading the other parts of the structured securities. The AAA tranches in general, tended to remain AAA or if they were downgraded they would be downgraded from AAA to AA or BB, and still remain classified as investment-grade.

But, as already mentioned, once these structures started to default the entire structure lost its value because of the leverage so that the banks were in fact representing on their balance sheets positive values for assets that had basically zero value.

The second aspect is that the banks were also engaged in selling default protection through credit default swaps. Credit default swaps are simply insurance policies that are not regulated insurance policies; that is, they are guarantees that if the insured security defaults the seller will make good on the value of the security. Again, this is a fee and commission business, and the seller of protection receives a fee, much like an insurance premium that is a percentage of the value insured. Since the banks were selling insurance on AAA securities that were considered risk free, this was considered as free money. Now, if you're an investment bank with a substantial portfolio made up of what are assumed to be AAA subprime mortgage securities and at the same time you are offering insurance on AAA subprime securitized mortgage securities effectively what you've done is to simply double your bet: if your own securities go bad it also means that you are very likely to have to pay up in order to meet the insurance claim on similar securities you have promised to insure. This is basically what happened to the investment banks that had accumulated mortgaged back assets in the hopes that their value would increase.

All of this went on in a period in which there was what we might call cognitive dissonance or basic denial because banks continued to believe that these assets either had value or would eventually recover in value. This view was in fact supported by the United States’ Treasury Secretary’s initial rescue proposals which called for the banks themselves to form a super fund to buy mortgage assets to hold until they recovered in value. The banks declined to participate in this scheme.

If the underlying mortgages have defaulted, and in many cases the houses have actually been foreclosed there may be value recovery on resale, but there still may be no recovery value for the structured securitized assets. This was reflected in the recent sale by Merrill Lynch, before it decided to sell itself, of a substantial portion of its AAA portfolio at a rate of $0.22 on the dollar value of the assets. In fact, since Merrill granted vendor financing to Lone Star, the purchaser, which contained performance provisions that could reduce the actual sale price to as low as 5.5 cents. This gives you an idea of the inflated value of these assets, on balance sheets.

What happened last week was that one of the banks most involved in this business, Lehman Brothers, was allowed to fail. The initial impact was that if Lehman's portfolio had so little value, then the portfolios of other banks probably has similar value. Rather than assuming a positive value, all financial institutions in the system started to look at their own portfolios and said well if it's true of Lehman, then it is probably also true of us.

In addition, Lehman had a large outstanding issue of commercial paper in the market. Money market mutual funds that compete with bank deposits hold commercial paper. The result that the first of the mutual funds that had been created, Primary, had to declare the losses on its investment in Lehman paper. This meant the value of shares in the fund fell below the $1 value that was supposed to have been guaranteed to investors. Investors sold their shares in massive numbers, and the Treasury was forced to grant a blanket guarantee to the asset value of money market mutual fund investors. This led to a rush to shift deposits from banks where guarantees of deposits were limited to $100,000. Banks thus had to scramble to raise funds to repay depositors.

Lehman also did business as a “prime broker”, that is the financial agent of hedge funds and private equity funds. This means they held the assets and cash of these institutions as well as lent them money to lever their portfolios, and made money by rehypothecating (i.e. lending) the assets that they held on behalf of these clients. If you were a hedge fund manager, you were out of business if your prime broker declared bankruptcy. And hedge fund managers started to withdraw their cash from other brokers – in particular from the two remaining – Morgan Stanley and Goldman Sachs. They would need to raise substantial amounts of cash to meet a potential run.

Finally, for those who had used credit default swaps to guarantee their borrowing or had issued guarantees or swaps, further downgrades meant that additional collateral had to be provided. Thus, Lehman set off a rush for cash that led to a freeze in the interbank market; that is, the financing market in which banks lend to each other. All banks knew that if they lent to another bank the money would be used to cover assets that were probably worthless and they probably would not get it back. The difficulties at AIG simply reinforced these problems for it was an institution considered to be rock solid, and shook everyone’s confidence in the system. Further, it was a major provider of debt insurance, and its difficulties meant that it had to come up with substantial amounts of cash to meet collateral margins on its guarantees, as did those institutions that had used AIG’s guarantees that were no longer considered sufficient.

With a collapse of the commercial paper market, that provided the day to day financing of business firms, with a collapse of the interbank market that provides the day to day financing of the financial firms, and with his former firm Goldman Sachs facing insolvency as it lost all of its prime brokerage clients, the Treasury Secretary announced a financial meltdown and this situation is what his bailout proposal was meant to resolve. The goal of that proposal was to allow the United States government to take the place of the banks in his initial proposal, and to buy up to $700 billion worth of assets that are probably worthless. (although, Treasury continues to insist that the cost would be much less if asset values recover and the assets could be sold back into the market at a profit).

This is the proposal that is currently being put to the United States Congress. Notice that the Treasury Secretary put clauses in the draft legislation that would exempt him from personal or financial responsibility for any losses that might be produced by this operation and exempt from any review of that operation. Now it is highly unlikely, number one, that the United States Congress will pass any sort of legislation of this sort that precludes congressional oversight. Number two, it is highly unlikely that this sort of activity is going to provide a solution to the problem that the banks are currently facing. The reason for this is that if the Treasury in executing what is called a reverse auction in order to buy the securities – that is an auction in which the price is bid down rather than bid up -- the price is likely to be something close to the Merrill price of between $0.05.5 and $0.22 on the dollar. Now according to US accounting law once there is a market price for an asset, the financial institution has to declare the value of the asset on its balance sheet. And the price at a public auction run by the US treasury comes as close as you can get to good market value discovery, which means that all banks would then have to write down the currently inflated value of their mortgage backed securities to close to zero and reduce their capital accordingly, making most institutions technically bankrupt. So that the real problem that the system is facing is not the malfunctioning interbank market but the doubts about the capital that the banks have to cover their risks. The problem is a basic recapitalization of the majority of the institutions in the US financial sector. And this is the problem that the proposal does not face’.

It is extremely interesting that there have been private sector solutions to this problem. The first is Merrill Lynch’s decision to sell itself to Bank of America, which does have sufficient capitalization in order to meet Merrill's requirements because Bank of America also has an extensive commercial banking operation and takes deposits from the public which would be available to support Merrill Lynch. The second is Goldman Sachs decision to allow Warren Buffett to provide a substantial amount of capital -- $5 billion -- at extremely generous terms to get secured senior securities and a return of 10% and the right to buy another $5 billion at a price which is approximately four dollars below current market prices, which means that either Buffett is going to get a virtually certain return in the range of 10 per cent to 15% on his investment. So Goldman has effectively decided to recapitalize itself. And the market is telling the Treasury Secretary look, you have not really understood what the problem is, the problem is the question of recapitalization, and it is only if we manage to recapitalize the system will we, in fact, be able to go back to solvency.

This leaves the question of what the financial system will be doing when it does recapitalize. It is clear that the kind of arbitrage business, that the efficiency business, that has currently been providing profitability for the system will longer be the basic source of income. We are still faced with the question of how banks are going to be generating profits that are sufficient to justify the very large capital increases that they are going to have to make. Now if Mr. Buffett thinks he requires 10% to 12% as his minimum rate of return, this gives us a reasonable idea of what banks are going to have to be meeting in terms of market position and it is quite clear that the banks are going to have to find some other source of income activities apart from the arbitrage financing. The second point is that the U.S. Congress is certainly going to require increased regulation and increased regulation in almost all cases reduces bank profitability. So that we will once again, see re-created the conflict between the necessity of private sector returns being earned by private sector financial institutions and the impact of regulation which presumes to create stability in what is effectively a public service but in fact tends to decrease profitability. So the problem that I noted at the beginning still remains a source of instability in the system. It will have to be in the forefront of the discussions on reforming the system.

Now, the final point for developing countries looking at the development of their financial systems. They should note that there are alternatives to the US system and in particular, the alternative is that the financial system and the public functions that the financial system supports need not be necessarily be provided by the private sector. And in many cases they have been provided by governments and the public sector and this is probably a time to review those particular decisions.

November 11, 2008.