Notes from the Panopticon

Moral Hazards

The first sign of corruption in a society is that the end justifies the means. ~ Georges Bernanos (1888-1949)

Between a rock and a hard place

The term "moral hazard" has been around for a long time. It popped into consciousness most recently when Mervyn King, governor of the Bank of England, invoked it to explain why it is not always a good idea for the government to bail out a bank – specifically Northern Rock.

It's like this. People are grown-ups who navigate through the world by taking risks, some of which work out and some of which don't. This is especially true of the banking business. If the risks taken don't work out and the bank finds itself up s*** creek without a paddle, there will be a nasty fall out. Ordinary people with money in the bank will get hurt. If the government bails out the bank using tax payers' money, then the next bank will be less careful, believing that – if the worst comes to the worst – the government will pile in to save it. Risky business practice will become the norm and we shall all go to hell in a hand-basket.

But a big problem remains. We, the poor bank customers, do not have the resources or the understanding to know whether a bank is acting prudently or not. And we would not be given the information on which to base a decision even if we asked for it. So we have to rely on government regulatory systems to check things out for us. Hence the dilemma when government watchfulness fails.

Law of unintended consequences plus

There are many other moral hazards we need to worry about, most of them relating to government activity. It's a bit like the law of unintended consequences but, in the case of moral hazard, the dangers created are evident at the start. The hazard is created by the wilful folly of decision makers.

Loans for honours

Let's start with a topical one. Donations to political parties. For the benefit of readers outside the UK, the Labour government has twice been caught flouting the rules on accepting political donations. The first time, they broke the spirit but not the letter by accepting loans instead of gifts and offered to repay the lenders with honours. The second time, the jury is still out. The claims and counter claims about who did what and who knew what when are the typical spats that go on between politicians when they have broken the rules and been caught out. "I didn't know and didn't mean it" is a feeble response which would not be accepted as a defence in court. Yet that is exactly what we are getting from the politicians who frame our laws.

Why should politicians get away with breaking the law while expecting the rest of us to obey it? Perhaps it's because they have power and the rest of us don't. And it's probably why David Blunkett (former Home Secretary) seemed so indignant when he was caught using public money to pay for his girlfriend's train tickets. The moral hazard here is that respect for law is eroded when the powerful show a blatant disregard for it (if, that is, they think they can get away with it).

Drug culture

And then there is legislation against drugs. Celebrities do not even try to hide the fact that they break the law – and those same celebrities are feted by the political clique and even by royalty. The moral hazard here is obvious. On the one hand, ordinary oiks caught with drugs receive, at the very least, a criminal record and a good chance of going to prison. Their life chances are often ruined, while the rich and famous continue to smoke and snort with impunity.

Politicians bemoan the decline in respect for law and order; they berate an ill-disciplined youth for its failure to behave responsibly. But how can you persuade disadvantaged young people to respect the law when, at the same time, the politicians who frame the laws (and their celebrity friends) fail to do so? You see what I mean by moral hazard.

Slush funds

Which brings me to laws that are unenforceable. The war on drugs is costly both in financial resources and in wasted lives. The demand for drugs cannot be stemmed. Organized crime finds it has a lucrative business and a good percentage of the population is happy to ignore the law. What is it about governments around the world that they cannot break the habit of banging their heads against this particular brick wall? They know they are not going to win (just as the US failed to stop alcohol consumption in the 1920s). Instead they have created a moral hazard. Lakes of illegal money are used to corrupt politicians and officials and, in some states of the world, to subvert entire governments.

Criminal records for all

Moral hazard also comes from the efficient enforcement of regulations that are routinely ignored. Such a high proportion of drivers have been convicted of speeding that many of them accept the status of convicted criminals as normal, not something of which they should feel ashamed. This situation should not be accepted with equanimity and at least the government minister who was caught driving while using a mobile phone was convicted and fined. But he still attempted to mitigate his crime by claiming that he was dealing with important affairs of state at the time.

The hazard here also undermines respect for the law. Unless criminals represent only a small minority of the population, then criminality becomes normal, fear of punishment loses its sting, and punishments become harsher to enforce the law. We end up in a situation where you might as well be hung for a sheep as for a lamb. If I am fined for putting my bins out on the wrong day, why should I leave it at that? I might as well do some fly tipping as well. Not a big deal in comparison with the other examples, but corrosive all the same.

Less is more

According to the Liberal Democrats, "Since 1997 this government has passed 365 acts of Parliament and more than 32,000 statutory instruments." This has introduced well over 3000 new criminal offences. When the government was caught out in the loans-for-honours fiasco, it responded by introducing yet more legislation and has now tangled itself up in that.

The most horrific part of the unfolding saga is not the facts of the case, but a statement by Wendy Alexander (leader of the Scottish Labour Party) in which she rejects any suggestion of "intentional wrongdoing". Her statement clearly shows that an important politician no longer feels bound to obey the law. "I did not mean to do it" may be a mitigating factor – but it is definitely not a defence.

So the government itself has fallen victim to the barrage of moral hazards which it created.

Slippery slope

Mervyn King thought long and hard before the rescue of Northern Rock was put in place. One assumes that an assessment was made and he accepted that the failure of the bank would pose a greater danger than the moral hazard created by the rescue package. Would that the government made more decisions in this way. If only it would think harder before creating so many new laws.

And there is little evidence that society is improving as a result of all this legislation. Prisons are overcrowded and convicted criminals are released early to make room for new ones. Middle-class criminals discuss the hazards of life with 9 points on their driving licences (next strike and the licence is gone), petty thugs wear ASBOs* as a badge of honour, and government ministers wriggle when they are caught on hooks of their own making. The investigation of a major corruption case is abandoned when a dodgy ally threatens to take its business elsewhere. A self-confessed drug user sings at the funeral of the Princess Diana in front of a congregation that included past, present and future prime ministers, the assembled royal family and a world-wide television audience.

The legal structure has started to creak. Respect for the law is flying out of the window at all levels of society – including the political classes. There is ever-present danger of the endemic corruption which dominates so much of the world. In the map below, the darker the red, the more corrupt the nation. Frightening isn't it?

• An ASBO is an Anti-social Behavior Order. It can be requested by the police, or a local authority and is imposed by a judge without a trial. The person on whom it is imposed is restricted from acting in certain ways or being in certain places. Violation of the ASBO can result in a prison sentence. So it acts as a method of punishing an individual without needing to prove that they have committed any crime other than violating the ASBO.

A really simple explanation of the sub-prime mortgage crisis

A bank is a place where they lend you an umbrella in fair weather and ask for it back when it begins to rain." ~ Robert Frost 1874 –1963

I originally posted this article on August 31. But it has suddenly become very topical so here it is again. My prediction that we are in for a bumpy ride was right – hold tight everybody.

The Northern Rock crisis demonstrates how vulnerable financial markets are to the interdependence of the institutions. It would appear that NR was not directly affected by the sub-prime crisis; they had not invested in any of the dodgy derivatives that are causing such problems (And which are described below).

However NR decided to expand their mortgage book (I understand by +50% in the first eight months of this year), a risky strategy in a housing market which had already seen such an enormous rise in prices. And NR did this by borrowing from banks which have been caught up in the sub-prime crisis.

These banks are suddenly finding big holes in their assets and can lend no more – and they too can be accused of acting recklessly. They may argue that they have abided by the rules but this is not an excuse. They have made dodgy investments using our money. Only constant vigilance by fund managers when they buy securities will prevent them falling into traps set by the greedy. They must look at what lies beneath.

The world's banking system is threatened by meltdown. It is unlikely that governments will allow this to happen, but the crisis will see the collapse of a few financial institutions and many people will be hurt. And this will happen even if a safety net is put in place. So we should try to understand what has gone wrong. It happened like this.

Risk of default

Banks lend money to people to buy homes, cars and so on, as well as to businesses to help them operate. These loans are secured by the borrower's income flow, which should be high enough to pay the interest and, eventually, to repay the capital as well. The lending bank assesses the risk that the borrower will default and, on the basis of that judgement, it may charge a higher rate of interest or require additional collateral security. The banks charge fees, in addition to interest, to make this assessment.

Asset Backed Securities

From the early 1990s, banks in the US decided to sell on the risks they had taken to other institutions, packaging them into asset-backed securities (ABSs). In this way, the originating banks get back the money they have lent. They can therefore make more loans, while their original risk is passed on to others.

The institutions – ordinary banks and building societies around the world – that buy ABSs can choose how much risk to accept because of the way they are packaged. ABSs are divided into tranches.

Buyers of the top tranche (the lowest risk) are entitled to the first part of the capital to be repaid. For example, if they are entitled to 60% of the capital, their investment is safe unless 80% of borrowers default and only half the money is recovered through repossessions (50% of 80% is 40%). In this example, since 60% of the money is safe (the money to which they are entitled), these investors lose nothing and all losses are borne by investors who bought the lower tranches. The risk of an 80% default is so small that credit rating agencies feel justified in giving these securities their highest AAA rating and major institutions feel confident in buying them.

The second tranche of securities might be entitled to the next 10% of repayments. For these investors to lose money, 60% of the loans would have to default and lose half their value (50% of 60% is 30%). So 70% of the money remains, 60% for the first tranche holders and 10% for the second tranche. Again, the risk of a 70% default is unlikely and could warrant an AA rating for the second tranche.

Wipe out capital

When you get to the bottom tranche, investors might only be entitled to the last 4% or so of the money. So just 8% of the loans losing 50% of their value would be enough to wipe out all the capital belonging to this group. These securities get a low rating (perhaps a maximum of BBB) because of their high risk. Only specialist institutions such as hedge funds who are accustomed to managing high risk would invest at this level. They are attracted by the much higher interest rates offered by bottom-tranche ABSs to make them worth owning.

Collateralised Debt Obligations

Investment bankers don't earn huge salaries for nothing. They had another trick up their sleeve to make even more money. They took the lowest tranches of ABSs and packaged them into Collateralised Debt Obligations (CDOs). The tranching process was repeated with these securities and – somehow – the credit rating agencies were persuaded to give the top tranche an AAA rating (perhaps because these securities were entitled to the first 75% of repayments). But the flaw should have been obvious: the underlying assets only had a rating of BBB or lower. The advantage to the sellers was obvious – they could get away with offering a low rate of interest on high risk securities because of their low risk rating.

So fund managers at major banks, who should have known better, were drawn into buying over-rated assets. They were following their rules by buying AAA-rated assets, but they were walking on very thin ice. With the structure of CDOs, if the underlying assets (the whole portfolio of original mortgages) lose more than 5% of their value, losses start to affect all AAA-rated CDOs, many of which have been bought by the major international banks. Already dangerous – but there is worse to come.

Improper checks

US banks have been altering the methods they use to check the riskiness of borrowers. They have also changed the way they structure their loans. Here are a couple of things they did:

• Interest charged at adjustable rates became common. The worst were exploding adjustable rates. Clients were offered very low teaser rates which, once the introductory period was over, could be raised significantly, resulting in repayments increasing by 25% or more. This is now the main reason for home owners falling behind in their mortgage payments.
• In order to speed up the process of lending money, loans were offered without the borrower having to provide documentary evidence of income. Research has shown that 60% of borrowers overstated their income by more than 50% on their application forms.

The effects of these changes are:

• Poorly substantiated loans in the US are estimated to account for 47% of loans made in the past year, compared with 2% in the year 2000.
• Average homeowner equity in the US has fallen from 22% in the year 2000 to 13.5% in 2006.

Sub-prime crisis is only just beginning

The sub-prime crisis is only just beginning as the large number of people who overstretched themselves by inflating their incomes when applying for loans face the prospect of a sharp rise in repayments as their introductory rates expire in the next couple of years. Estimates suggest that 20% or more of the sub-prime mortgages made in 2006 will default. Since there is already a glut of properties on the market, there is a risk that recovery of capital will be affected by lower prices.

The top tranche of CDOs have a higher credit rating (AAA) than the lowest tranches of ABSs (say BBB). But compare the following figures and the problem becomes crystal clear. Buyers of the lower tranches of ABSs face a real risk. Studies suggest that 20-30% of all loans (the assets which underlie their securities) will default and lose 30% of their value, a cumulative loss of 8-10% of the total value of the loan book. Enough to put the capital of lower level ABSs at risk. But buyers of the top tranche of CDOs are facing an even bigger risk. Their capital is threatened by a cumulative loss of just 5%. And these investors are high street banks and the like who have been attracted by the AAA ratings.

Dodgy investments

So the die is cast. Those CDOs are out there. Not only in investment houses like hedge funds, which are set up to deal with high risk, but in high street banks, building societies, savings and loans. These institutions have discovered that big holes are appearing in their balance sheets and, one way or another, they will need to be plugged. This means that your "safe" cash deposits – and mine – have been used by our friendly banks and building societies to buy these dodgy investments. We are in for a bumpy ride.

www.uwe.ac.uk/csa/saws/ 

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