Opening the Can of Sardines

“The subprime crisis has caused billions of dollars in losses, but the financial hole could be much bigger if we consider the new United States accounting regulations for the valuation of assets applicable since February 2008.” Professor Jorge Soley talks about this uncertainty to describe the current state of the crisis that has shaken economies all over the world, and whose origins are still unknown.

Why is it that over a year has passed and we are still unaware of the real causes and consequences of the problem? The founder of the CIIF, Prof. Rafael Termes, used to explain this type of situation with an example that dates back to the flourishing black market in the Spanish economy after the country's Civil War. At that time, canned sardines were among the goods that people dealt in. “People bought and sold them and earned a little money in the process. Now and again, somebody dared to open the can to check whether the sardines were rotten. When someone would complain, people said: ‘How ignorant you are! These are for buying and selling, not for opening and eating,’” joked the professor.

In the same way, “subprime mortgages and their derivatives were sold above their real value,” according to a comparison made by José Luis Suárez. “If agents had thought about the underlying asset they were purchasing, they might have realized at the right time that the quality of the asset was not high enough. In the end—though too late—someone opened the can of sardines and discovered that subprimes were not as valuable as they were supposed to be. That was when the crisis broke out,” continued the professor.

“Subprime mortgages were securitized wrongly,” insists Suárez. But this happened to such an extent that an entire market of financial investments was created around these sophisticated products, which as Ahmad Rahnema points out, “had a risk that was very difficult to quantify and value, due to the lack of awareness of what they really were.”

We really do not know the magnitude of the problem. “Banking institutions are taking a very long time to disclose their accounts, so we don't know who has been affected by this type of toxic product. In the mortgages granted by banks, how much principal
has not been repaid? We don't know,” says Pablo Fernández.

As Juan José Toribio, president of the CIIF, points out, “What makes this crisis different from the others is that it is impossible to immediately know the magnitude and intensity of the problem. This is due to three fundamental reasons: although structured products—the origin of the crisis—are no longer listed, they are not necessarily worthless; it is also very difficult to identify the holders of these toxic assets; and, finally, we lack the necessary automatic application mechanisms to deal with the problem.”

Chronicle of a Crisis Foretold

Some precedents suggested that a situation like this could arise. One of these was the fall of Enron six years ago. “This was a company that sold very sophisticated financial products, energy product derivatives. It was well known that they were high-risk products, but nobody could quantify or value it because both buyers and sellers were unaware of the true nature of the products,” recalls professor Rahnema.

In any case, “There is no single reason that explains how we have reached this point,” says Antonio Argandoña, “although the macroeconomic context experienced after the dot-com crisis contributed to some extent.” A series of expansive monetary and fiscal policies were implemented from 2001 onwards, which led to a long period of stability, characterized by higher growth in GDP, higher levels of income and the opening up of some economies.

“Consumption and investment shot up, encouraged by plentiful liquidity, low inflation—in the strictest sense of the word—and low interest rates. This created the atmosphere necessary for a fall in the risk premium and the search for higher returns in other markets,” says Argandoña.

In this context, the American mortgage market grew spectacularly, and the banks started to grant mortgages without a thought for the future—even to clients who had high-risk profiles but who wanted to purchase houses. These lower-quality, high-risk mortgages were the famous subprimes.

Professor Suárez explains that in order to be able to meet the enormous demand for mortgages and at the same time mitigate the risk of clients who had barely met the minimum requirements, financial institutions developed, or resorted to, two means of financing. First, covered bonds—mortgage bonds in the Spanish model—which were guaranteed by the mortgages included in the banks' assets. Second, mortgage-backed securities, created from mortgages taken off the balance sheet, enabled financial institutions to increase their volume of business without increasing their balance sheet risk, thus meeting the capital requirements of Basel II.

“These securitizations made it possible to remove assets from the balance sheet of regulated banks, and to transfer them to other nonregulated institutions in the financial system, such as investment banks, insurance companies, funds or hedge funds,” points out José Manuel Campa.

The bonds were sold on the capital markets and became part of other financial instruments at the next level, which were distributed globally, thereby spreading the risk throughout the system. “The main problem, in short, is that these new and sophisticated structured products were originally based on low-quality mortgages with dubious guarantees,” says Juan José Toribio.

Everything seemed to be going smoothly until 2007, when, “the American real estate market, which had seen rising prices the previous two years, slowed down and reversed to the extent where it led to a real crisis that broke out in the middle of the year,” says the professor.

The decline in sales of new and used homes in the United States created a large stock of unsold real estate, and a sharp fall in prices as a consequence. Real-estate and construction companies quickly started to record losses. Many subprime borrowers, and even a proportion of those not classified as such, stopped paying their mortgage loans and preferred that the lending institution foreclose it. Banks auctioned off the appropriated buildings, which made prices drop even further. “The entire system collapsed spectacularly in a spiral of mortgage foreclosures, auctions, falling prices, nonpayments and further foreclosures,” remembers Toribio.

Professor Suárez adds that this situation significantly damaged investors' confidence, creating “an enormous mistrust of the markets that has led to the current situation.”

From Defaults to a Lack of Solvency

Although the problem was initially one of nonpayment and payment arrears by the holders of subprime mortgages, “it became a lack of liquidity and ended up as a problem of solvency,” according to Prof. Argandoña.

The shift from one phase to the next is easy to understand. As Prof. Toribio explains, when the crisis in the US real-estate and mortgage market broke out, there was no longer a market for the structured products that included these risks, which were not always transparent or known. Their owners were unable to liquidate these investments, and had no benchmark for valuing them on their balance sheets. The banks that had made loans also suffered the consequences. Furthermore, the difficulty in identifying the holders of these toxic assets and the lack of awareness of each bank's real level of exposure led to a lack of confidence between agents in the market. This paralyzed the interbank market and finally led to the current lack of liquidity.

According to Argandoña, “the institutions no longer make interbank loans, meaning that they have serious financing problems. As a consequence, they have drastically reduced credit to their clients, leading to suspensions of payments and spreading the oil slick, which is gradually affecting the entire value chain.”

Although institutions with assets based on subprime mortgages were the first to show losses, other institutions are also suffering from the declining value of assets issued by others, and thus the problem has become widespread. “We are in the phase of discovering skeletons in the closets of many financial institutions, meaning assets with a reduced value. While this is still happening, and it will still take some time, the institutions will not regain their confidence,” predicts Argandoña.

At present, investment banks, insurance companies and even commercial banks are affected. In the United States, Bear Stearns, Fanny Mae, Freddy Mac, Merrill Lynch, Lehman Brothers, AIG, Goldman Sachs, Morgan Stanley and Wachovia are among the casualties. In Europe, Northern Rock, Bradford & Bingley, Fortis, Hypo Real Estate and Dexia have undergone similar bailouts from the authorities, which have assumed their losses with public money.

The Effectiveness of Monetary Policies

In this context, what is the role being played by the monetary authorities? Will these institutions be able to guarantee the future and the stability of the financial system and the world economy?

“There is a considerable difference between the United States Federal Reserve (The Fed) and the European Central Bank (ECB). The latter's powers are restricted to monetary policy; regulation and supervision of the financial and banking system is the responsibility of each country's central bank. However, the Fed performs all these tasks.

As a result, the Fed cut the (federal funds) rates and the discount operations rates in several stages, injecting a substantial volume of monetary base. Initially, says José Manuel Campa, the ECB “decided on a more prudent approach, declaring itself against a cut in the fed funds in the face of inflationary threats." The European banking authority has changed its stance in recent weeks, and cut rates by fifty basis points.

In any event, neither rate cuts nor injections of liquidity turned out to be effective, as, according to Argandoña, “the crisis is not so much a problem of liquidity as one of solvency and confidence. With their measures, the central banks have guaranteed that no solvent institution—with assets that the central bank accepts as a guarantee of its debts—will have to suspend payments due to a lack of liquidity, but none of them has succeeded in lowering the cost of credit for the private sector, or increasing the supply of it.”

Although a range of special provisions have been implemented, such as new credit lines and loans to institutions that are not commercial banks (investment banks and brokers), “these measures only help buy time, reassure clients who want to immediately withdraw their deposits, and arrange bailout plans in an orderly manner for institutions with problems,” Argandoña points out.

In short, attempts are being made to save the financial institutions from a widespread macrocrisis, but are these bailouts justified?

Traditional financial theory says that a bank should be saved whenever its failure endangers the financial system as a whole and threatens to take others down with it. “Investment banks, insurance companies, hedge funds and other types of strictly private unregulated institutions should theoretically fall according to how well or poorly they have operated. The problem is that due to their immense size and involvement in the financial system, their failure would have a very strong impact and would put the system in imminent danger,” says Campa.

Argandoña adds: “When you save one, the reasons for letting another one close its doors carry less weight; among other reasons, because the theory says that you have to save solvent institutions that are going through a difficult short-term liquidity situation, and what we are seeing now are institutions with a solvency that disappears overnight, when the value of their assets disappears as a consequence of another institution's problems.”

With or without bailouts, the economies do not seem to be responding to monetary stimuli. According to Argandoña, this is due to the fact that “there are dozens of holes between the liquidity that the central bank is injecting into the market and the client being granted credit.”

The fact of the matter is that the banks are not interested in increasing their loan capacity, but instead they need liquidity “to cover their own needs,” as they no longer have the sources that traditionally supplied them—interbank loans and investors. “Banks with surpluses do not trust banks asking for credit, and something similar is happening with investors with liquidity; they do not dare lend to the banks for fear that they will suspend payments or go bankrupt,” says Argandoña.

Finally, many solvent companies and families have stopped asking for credit because it is expensive and uncertain, which means that the financial institutions are finding that those coming to them are less interesting customers.

With no credit or liquidity for investment by businesses and consumption by families, and with the strong inflationary pressure of recent months, this crisis is undoubtedly affecting the real economy, which is now entering a tough period of recession.

The loss of purchasing power and the “poverty effect” being experienced by final consumers and businesses are leading to a heavy decline in activity. This has brought along numerous redundancy procedures, and an employment rate as high as that of the 1990s.

Nevertheless, Prof. Campa reminds us that "it is still too early to talk about a deep recession on a global scale. The previous intense period of economic boom encouraged high growth rates, which have now declined significantly. The forecasts for developed countries are for recession in the coming months, and for emerging countries they continue to predict growth, albeit below their trend growth.” For this reason, the fiscal measures taken by governments will be crucial for the future.

Time for Fiscal Policy

According to the textbooks, now would be a good time for an expansive fiscal policy that could be implemented in two ways: 1) by allowing automatic stabilizers to function or 2) by reducing taxes and increasing expenditure, such as on public works programs. However, this policy has its limitations.

“Public works cannot be improvised. They need a gestation period and their positive effect will probably be noticed when the economy is already recovering. Returning income tax, on the other hand, has limited effects and it is not certain that it will increase consumption to any significant extent,” says professor Argandoña.

Argandoña argues that reductions in Social Security contributions may in general be positive, but it is difficult for them to generate employment at a time when businesses are facing falling demand and increasing financial costs. Other initiatives, such as extending the period in which unemployment benefits are received, may help some people, but are extremely difficult to administer and may have harmful effects, such as providing an incentive to live on unemployment benefits instead of trying to bounce back.

Fiscal incentives for investment are also futile in a situation like the current one, with businesses harmed by the fall in demand, increasing payment arrears and the refusal by banks to extend credit.

The US government has presented its own emergency plan, approved by the Senate and House of Representatives, to save the financial system by purchasing some 700 billion dollars worth of toxic assets owned by the banks. Its European counterparts, including the Spanish government, are doing the same, albeit at varying speeds and to varying extents.

Stock Market Fluctuations

While governments and monetary authorities attempt to pour oil on these troubled waters, the stock markets are experiencing extreme volatility which is reminiscent of other “Black” eras.

Javier Estrada warns that “in these last few weeks, the markets have been fluctuating considerably more than usual. There are always catalysts that push the markets in one direction or another and in this case, the crisis generated by the sudden fall in the value of complex financial instruments has had a negative effect on all markets,” he adds.

Prof. Campa reiterates the lack of confidence as a fundamental cause of the volatility in the markets. “Investors are suspicious of what is really hidden behind assets, and this is creating a great deal of anxiety in the markets as well as more volatility,” he explains.

In any event, Estrada points out that the long-term outlook has not changed: the stock markets will rise again, although they will experience a high level of volatility in the short term and perhaps the medium term. “At present, investors feel the need to act, and to make financial decisions. Paradoxically, the best thing to do is to stay put, and to hold onto investments. The worst thing that can happen to an investor is not to be there when the markets bounce back, and since you never know when that will happen, the best thing is to keep the portfolio intact.”

Pablo Fernández says that purchasing shares is a good long-term investment alternative, as their price has now fallen and the long-term outlook is good.

The current situation in stock exchanges and markets is obviously uncertain, but as Estrada points out, “losing is an inherent part of the process.” The economy and the markets always go through cycles. “Those who invest thinking that markets only rise make a big mistake; and it is only a question of time before they discover the harsh reality. We all like earning money, but in the world of investment, winning and losing happen very often. Those who can't get used to that idea should not get involved with the stock markets, and keep their money in secure assets.”

Prof. Suárez finishes by asking for responsibility when investing: “A stricter perspective on investment is a must, including seeking the ratings or opinions of third parties. It is necessary to be prudent, invest in what can be analyzed and after studying it, decide whether to take on the risk," he says.

After the Crisis

Two of the questions arousing the most interest with this crisis are: when will it end, and how will it change the landscape. The first question is very difficult to answer, but Campa suggests that “we are at most halfway through it,” and Argandoña adds: “the crisis is far from being resolved.”

As regards the changes we can expect after the crisis, “a distinction must be made between the short, medium and long term,” says Campa. In the short term, there will continue to be a heavy need for liquidity and a great deal of volatility in the financial markets. In the medium term, a few more institutions will fail, and there will be restructuring movements in some sectors.

Prof. Suárez also backs these merger and takeover operations, especially in the most indebted sectors: “We reached the point where the economy was highly indebted, with an excess of liquidity and inflation, and now we are looking at the other side of the coin. For the moment, the banks will not lend the little cash they have. All the players in the market, including the financial institutions, will show a greater aversion to risk, which will lead to deleveraging throughout the entire economy and will mainly affect the most heavily indebted business sectors, such as real-estate, hedge funds and private equity funds,” says Suárez.

In the long term, we can expect a change in the regulatory model. “Although the process is not yet well defined, and how the regulation will change is still unknown, it will most likely no longer be aimed at specific institutions, and will regulate specific products, regardless of who owns them, whether the owners are investment or commercial banks, or insurance companies,” says Campa.

Campa also suggests that there will be a single regulator in the future. As Suárez says, this trend is justified by the need for a global vision of how institutions operate, as well as regulation that is also global, or at least close coordination by the central banks and the authorities that regulate financial activity.

This will entail changes in the banking sector. According to Jorge Soley, “there will undoubtedly be a new way of banking from now on.” The only institutions to survive will be those with the best risk management, with the most precise operating models and who pay attention to all the procedures concerning credit risks in particular.

“There is a need to get back to the financial basics, where the quality of the agent is key. Also in need of review are the compensation systems for executives and directors, in which the long term should take precedence over the short term. Finally, shareholders must get used to accepting lower but more secure yields,” concludes the professor. Ahmad Rahnema agrees with him, and appeals to the obligation of financial agents to maintain ethical and moral criteria in their work.

The banking business must never, under any circumstances, be a speculative business: this endangers not only shareholders, but also the depositors who have placed their trust in it.

As regards the real estate sector, Suárez feels there will be continuity in the mortgage market. “Mortgages account for 70% of all credits and loans, meaning that it is difficult to find a product to replace them.” However, “as the mortgage market is subject to the fluctuations of the real estate market, it will be necessary to find the proper counterweights,” says the real estate expert.

As for the relationship between the two most important parts of the real estate sector—promotion and investment in assets—Suárez says that “the outlook will not change a great deal; the future still involves specialization.” The professor is referring to the error made by the property developers who, on encouragement by the investment banks, accumulated assets in order to obtain recurrent income and, it was said, to improve their prices on the stock exchange. They ended up making investments that have turned out not to be profitable at all. “Everyone should specialize in what they know how to do,” he says.

According to Suárez, activity in the sector will tend towards reorganization. In particular, restoration will assume a greater role in the future. This has been seen in the US thanks to the Smart Growth movement, which promotes the return of the population to city centers, with the consequent restoration of urban centers.

In terms of the future of the economy, Argandoña warns that a long period of recession is coming, which will have a major effect on families, businesses and above all, the real-estate, construction and financial sectors, and, to a large extent, consumer goods and investment. Businesses involved in exports are somewhat better positioned, especially those operating in markets that are still in reasonable shape, and those with little debt and low levels of dependence on credit.

In summary, we are in the middle of a difficult cycle that will last for some time to come. It is important for governments and monetary institutions to immediately take the measures to deal with this situation and its consequences, and for investors and markets to learn a number of lessons that strengthen and prepare the economy for future setbacks.