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Analysis of the Mortgage Crisis: Greed and Fear

Apr 18-2013   



 

     By CUI Aibo

The American sub-prime crisis that has been lasting for more than one year with no expected end date in sight has finally become the greatest threat to the global economy now. Numerous disappointing messages have been coming out of transnational financial magnates' quarterly reports and yearly reports, startling prophesies have been spread out of the news reports and comments of the mass media one after another. In the great terror, have we really understood this crisis? Can China keep sound alone in this crisis? What on earth can people learn from this crisis?

 

In the face of these questions, Beijing International MBA at Peking University (BiMBA) has built up a platform for its students and alumni, to get the most genuine information and enlightenment from the personal experience of senior bankers of both China and the USA.

 

The Crisis in Progress

 

In February 2007, Hong Kong and Shanghai Banking Corporation declared that, owing to the deterioration of the mortgage loan business in the USA, it had withdrawn a higher-than-anticipated reserve for dead loan to cope with the possible loss. The announcement has aroused a great shock. Hong Kong and Shanghai Banking Corporation's domain in the USA has mostly originated from Household it bought in 2003, the earliest independent consumer finance institution in America doing sub-prime loan business. Its business chiefly covered two aspects: the traditional terminal operations closely linked to clients, and the newly established business, namely, repacking the mortgage loans bought by brokers into financial products, such as mortgage backing securities (MBS), asset backing securities (ABS), claim deposit obligation (CDO) and so on. The problem now just centers around the latter. Hong Kong and Shanghai Banking Corporation has already handled this part of problematic assets, and did an all-round personnel replacement and strategic reform to Household at the beginning of 2007. Although the target client group of the subordinate loan has remained unchanged, different approaches and channels may lead to different results.

 

Soon after that, in April 2007, the largest sub-prime lending operator in the United States, New Century Financial, applied for bankruptcy protection. In June 2007, two hedge funds managed by Bears Stern, one of the top five investors on the Wall Street, went into trouble and suffered severe losses, and finally went through bankruptcy liquidation.

 

Till July and August 2007, these events had developed into an overall crisis. In July, the three major credit rating institutions lowered the credit ratings of hundreds of CDO’s, with the most drastic degradation plunging from the highest credit rating to the that of junk bond. In August, the whole credit market almost came to a close, and both the Fed and European central banks took emergent measures to save the market.

 

After August, the situation became worse. In September 2007, Northern Rock Bank of Britain experienced a bank run and managed to survive the crisis only with British governmental assurance of the safety of the loans plus capital injection by British central bank. Afterwards, the Fed took a succession of steps to lower interest rate. In October and November of the year, many more CDO’s were rated down. Influenced by these tumultuous events, Stan O’Neal, CEO of Merrill Lynch, the largest investment bank on the Wall Street, took responsibility and quit his job and, similarly, Charles Prince, CEO of Citibank Group, had to resign ahead of schedule.

 

In January 2008, American Bank invested 4 billion dollars to acquire Countrywild, the largest mortgage lender in the United States, which was once worth up to five times the current value.

 

The crisis currently has two names in China, respectively sub-prime lending crisis and sub-prime mortgage crisis, of which neither is accurate. In fact, as early as last November, the crisis was no longer limited to the sub-prime loan market. Therefore, the U.S. media now call it the “Mortgage Crisis”.

 

Excess Fluidity: Soil of Crisis  

               

Dr. LUO Ning, Senior Credit Analyst, former Vice President of Office of Risk Management, Citi Cards, Citibank North America, is now Senior Banking Comptroller of Department of Bank Regulation of the Federal Reserve Bank in New York and Overseas Consultant and a columnist for the credit card columns of Digital Wealth. He has been working on financial risk management at Wall Street, and is a member with NYSSA, PRMIA, GARP and IAFE.

 

“The crisis, before its explosion in last year, actually had lurked quite a long time since 2005,” said Dr. LUO in his lecture for BiMBA students. The house price had been soaring by 2005, he analyzed, and when the price hike slowed a bit in 2005 some regions already began to have trouble. Then in 2007, the crisis fully exploded.

 

Sub-prime lending means lending of a sub-prime class. The standards for defining sub-prime class lending are different for different varieties of loans. For instance, for credit card operation, a loan of a FICO less than 620 is defined as sub-prime, while the standards for sub-prime housing loans range between 600 and 660 with regards to the specific loan type. The type of sub-prime lending that triggered off the current crisis was the sub-prime housing loans in the United States. Therefore, one needs to know the development of U.S. housing loan market to understand the sub-prime lending crisis.

 

The development of the housing loan market of the United States went through several major stages. The first stage was the New Deal era under the Roosevelt Administration, when FHA and VA were established to provide lending services to low-income groups and military veterans. In 1933, FDIC was established, whereby the deposits of the public became safer. The second stage happened after the Second World War, when the return of a large number of military veterans together with the “baby boom” and the wave of “suburban development” greatly boosted the housing market in the United States. After 1968, housing lending experienced large-scale mortgage-backed securitization and the current FNMA was halved with part of its function going to the newly established GNMA. Afterwards, the FHLMC was established. These three organizations, directly led or sponsored by the federal government, acted as the intermediary on the secondary housing loan market and greatly facilitated the growth and maturity of this market in the United States, liberating the capital of banks for circulation. Of the current total of 8.5 trillion dollars of housing mortgage loans, sub-prime loans account for 40%.

The formation of bubbles took many factors. The first is the low interest rates in a long run. After the collapse of the stock market for shares of technology companies, especially after the 911 event, Greenspan adopted low interest rates in a long time to save U.S. economy, for which he is now blamed. Japan and Europe encountered the same problem. The second is the pursuit of investment returns. The third is slight fluctuation. In a period, hedge funds maintained a high margin level. The fourth is the depressed risk premium. The fifth is the tax reduction policy introduced by the Bush Administration, including lower capital appreciation tax and dividend tax. The sixth is excess fluidity. There are all kinds of interpretation of the reasons for this, such as high capital returns, lower interest rates resulting from large-scale Asian purchase of U.S. treasury bonds, greater fluidity caused by financial derivatives as a “massive destruction weapon” for the financial market, and greater fluidity on the capital market resulting from prevalent re-mortgage loans due to rising house prices. In reality, most houses were not on the market but were evaluated according to the prices of the small number of houses on the market, so when they actually entered the market for sale, the house prices would accordingly change, making it impossible to realize the originally held high prices.

 

In the course, the corporate culture of banks was confronted with great challenges. Drawing on his experience of working at the office of Citibank Group for risk management of credit card business, Dr. Luo described the changes of corporate culture that he personally felt. Though a succession of acquisitions swiftly pushed up the market capitalization value of Citibank Group, the acquired banks were not integrated in the real sense judging from the internal perspective. He especially emphasized that banks, especially their credit officers, need to have experiences accumulated during time of economic recession, which was exactly what Citibank lacked. Recovery of Citibank is far more complex than dealing with the resulting problems on its accounting books, for its corporate culture has almost been ruined. When Citibank is confronted with restrictions such as the prohibition by the Fed, limitation by the anti-monopoly laws, and reputation risks in its practice of successive acquisitions, its performance will inevitably experience quick downturns.

 

Rules Cannot Check Temptation: Origin of Crisis

 

Then, how did the neglected sub-prime housing lending evolved into a time bomb of global economy?

 

LI Fu’an, Director of Department of Business Innovation, Regulation and Coordination of China Banking Regulatory Commission, pointedly questioned why the multinational banks, which are known for their prudence and have numerous professionals, failed to recognize, and prevent, the serious consequence which the indiscreet behavior of certain people on the financial market might cause.

 

One viewpoint holds that commercial banks were not familiar enough with the capital market and their regulation was therefore not fully enforced. Dr. Luo regarded this idea reasonable, but not a satisfactory explanation of the problem. In terms of this familiarity alone, the top five investment banks can be said to have thorough knowledge of the capital market. However, except Goldman Sachs, which withdrew unharmed three months in advance, none of the other four escaped the disaster. Hence, this viewpoint is not convincing enough.

 

FICO is only an index based on statistics about repayment behavior, asset-liability ratio and “hunger” for loans, and cannot properly rate the credit level of housing loans. For the risk of housing loans is not purely credit risk, but more depends on the risks of the real estate market. At the same time, insufficiency of data about sub-prime loans made it hard to obtain reliable results using the models based on statistics. The banks released sub-prime loans at a large scale, without even giving comprehensive consideration to factors like loan ratio and income status. Accordingly, the borrowers could obtain large sums of loans without even having to repay the principal, thus maximizing the levering effect of housing mortgage. When house price was in the rising channel, all participants in the chain benefited and the whole nation lived in exhilaration, while the few sober minds were neglected. Besides, having not experienced any period of “economic winter” for over a decade, people accustomed to the warm weather had gradually loosened their guard and lost their ability to resist cold, becoming “frogs in warm water” and allowing the insidious accumulation of the crisis.

 

Why did the institutions fail to take proper reaction after some people had already perceived risks? Each company had its own special condition. Take Citibank, the biggest loser in this respect by now. Why did it happen? The bank had long failed to make any breakthrough in the consumer credit operation, which provided the bulk of its profit. The bank had previously depended on continuous acquisitions to expand its market capitalization, but as the market became fully competitive, the bank could not sustain its acquisition progression and suffered declining performance. Naturally, when it discovered sub-prime lending as a new growth point of profit, it grabbed it as if it had been a life-saving straw. In addition, Dr. Luo discussed another factor that influences the relationship between an institution and its personnel, namely, salary. In fact, all the personnel, from CEO, CFO to the mid-level staffs, are all being driven by this factor. During the hottest economic boom, there was a saying like this: “it is better do the wrong thing with others than do the right thing on your own.” For testing of any practice takes a long time, but by then the current superintendent will have resigned from the post, together with the duties therein. Till now this reward system has been an established institution, and it is hard to find its substitute in a short or medium term. 

 

LI Fu’an believed that confronted with social instability caused by the adventurous deeds of enterprises, the government will have to give priority to recovery of social stability regardless of the social costs, so the irresponsible “adventurous drivers” and “mad wall-hitters” will be the real beneficiaries while others will only get the benefit of having a smaller loss. To this opinion Dr. Luo expressed his full agreement. The development is too fast and all discreet considerations will be forgotten, so the bubble keeps expanding. Against such a background, it is the cautious people who will suffer. The temptation can overpower any systematic precaution, and the trend of pursuing high reward cannot be checked, for after all, mechanisms have to depend on people for their enforcement.

 

“Rules cannot check temptation,” commented Dr. Luo.

 

Regulation Late for Half a Beat

 

LI Fu’an pointed out that the United States, compared with other countries, has a rather sound regulatory system and a very mature market. Was it simply due to negligence that the United States failed to perceive such serious bugs?

 

Dr. Luo thought that at a time of inflating bubbles, though still useful, the regulatory system has very limited effect. He introduced that the Fed is divided into two layers in structure. The upper layer is the Board of Governors of the Federal Reserve System consisting of 7 members nominated by the President and approved by the Senate. The members have a tenure of 14 years so that their duty can last beyond two presidential terms, so as to avoid partisan manipulation. However, near the expiry of the governors’ tenure, politics would still impose its influence. The lower layer consists of 12 districts. In each district, there is a federal reserve bank responsible for implementing the macro currency policy, regulating local banks, and exercising the right of the national payment system. The district partitioning has much to do with the environmental and political factors in history. 

 

The Fed was established according to the “Federal Reserve Act” of 1913. The First World War broke out in 1914. Then Secretary of Treasury Eugene Meyer actively advocated the establishment of the Federal Reserve System to protect U.S. financial market from the shock, and became its first chairman. For many years after that, Secretary of Treasury always held the post of Fed Chairman. This situation only began to change in late 1950’s when the Congress laid down strict restriction to such arrangement through legislation with a view to increase the Fed’s independence.

 

Dr. Luo made a brief introduction of the organizational characteristics of the Fed. Firstly, in terms of personnel, though a Federal Reserve Bank is a non-governmental organization, 3 of the 9 members on its Board of Directors, including the chairman and the vice chairmen, are decided by the Federal Reserve Board, so the power of its Board of Directors is actually controlled by the central bank. The other 6 members, of whom 3 come from the banking industry and the other 3 from other industries, are divided into 3 groups, each consisting of a banker and a non-banker. Secondly, in terms of funds, the Fed obtains its income mainly from the interest of treasury bonds on its account, of which it spends less than 10% and submits the rest to the Department of the Treasury. Thanks to its independent fiscal incomes, the Fed enjoys a high level of independence in not only personnel but also finance. Finally, in terms of decision-making process, the decision of the Fed is influenced by the districts instead of the chairman alone, which is also one of its important features.

 

Since the occurrence of the crisis, the regulating bodies, especially the Fed, have been receiving criticism from the Congress. Though endowed with sufficient regulatory power, much of the power was not used in reality. For this reason, the Congress once talked about transferring the regulating power to the Federal Deposit Insurance Corporation (FDIC). Under the pressure from the Congress, the Fed put forward a set of new stipulations and measures for regulation of housing loans. However, the punitive measures of the Fed were largely meant for correction after the event, while the prevention relied more on the supervision over non-bank institutions by the states. Nevertheless, out of their considerations to tax income and other factors, the states did not attach sufficient importance to their regulating function in this concern. The financial regulation of the United States was once meticulous and rigorous, but was somewhat relaxed since the deregulation in the 1980’s and 1990’s. Particularly, since the United States entered the new era of “mixed operation” in 1999, new products have emerged in large numbers.

 

Besides, after a new product was introduced, it would take a period for the financial institutions, including the rating companies and the regulatory bodies, to get to know and understand the product. Of the two, the latter has a weaker ability for quantitative analysis. The teams of the federal regulatory bodies for quantitative analysis and model analysis only got established 3 or 4 years ago. Added by reasons concerning financial input, they have quite limited strength compared to the companies active on the market. All these factors have contributed to the “half-a-beat-late” reaction of the regulatory bodies.

 

Impact of the Sub-prime Lending Crisis on and Its Lesson for China

 

The main action that the Fed currently takes is to lend money to the selected banks to keep the fluidity on the market. However, some banks not only have the fluidity problem but also face insolvency and credit risks. The Fed wants to but cannot help them out. Judging from this, Dr. Luo stated, from a pure economic perspective and leaving out political considerations, recession is actually not dreadful and in a certain sense is a healthy cleaning-up process. 

 

This crisis also has serious international impacts. The financial markets of many countries, including France and Australia, have suffered severe setbacks. How to minimize the loss? In Dr. Luo’s opinion, though different countries gradually reached consensus in policy, tone and public opinion during the previous period of common prosperity, they can no longer adopt identical policies because they encounter the problems at different points of time. He proposed three steps: Firstly, each country should take care of its own interests; secondly, notwithstanding lack of consensus, coordination among countries should be enhanced; finally, it must be realized that the greatest challenge today is the lurking threat of global stagnation resulting from capital bubble and rise of labor price.

 

Can China de-link itself from the U.S. market and remain affected by this crisis? Dr. Luo’s answer was negative. Chinese economy, no matter judging from the export (its direct drive) or from the expansion of domestic demands (its indirect drive), will definitely be affected when recession occurs outside the country. As the country most susceptible to blame, plus the influence of political factors, China will very probably become the victim of another wave of global protectionism similar to the one occurring in 1929.  

 

Dr. Luo emphasized that China currently should not place its priority exclusively on economic growth. Whether the economic and social progresses achieved in the past 20 to 30 years can be preserved should be put on the agenda as a very important issue. A large part of Chinese economic growth still means no more than the figures in the account books. We now should pay attention to the question of how to convert the growth into a higher living standard. Since the ancient times, any strong and powerful country must be the ones that were the most successful in preserving its previous development achievements during tumultuous and chaotic periods.

 

LI Fu’an believed that the central bank of China now has a very good opportunity to have a clear mind and make a set of sound policies. On the one hand, the central bank should ensure that no large-scale and partially uncontrollable crisis like the sub-prime lending crisis of the United States should happen in the Chinese market, and on the other, it should take into consideration the current economic status of China and formulate a long-term and steady strategic plan for “winning”. Relevantly, the strategic plan of Japan has turned out a failure. To integrate itself into global economy, China must make sure that when its economic influence reaches the impressive magnitude of Japanese economy, the country can avoid the financial tragedy suffered by Japan. For the rest regulatory bodies, the urgent task is to set up a clear system of rules and a sound technical framework. LI Fu’an compared this task to building an “expressway system” and a “system of traffic lights” across the country, which ensures that the “vehicles” will not cause any destructive blockade to the market whatever their speed is. The significance of such a financial operation system cannot be more evident.

Analysis of the Mortgage Crisis: Greed and Fear

Apr 18-2013   



 

     By CUI Aibo

The American sub-prime crisis that has been lasting for more than one year with no expected end date in sight has finally become the greatest threat to the global economy now. Numerous disappointing messages have been coming out of transnational financial magnates' quarterly reports and yearly reports, startling prophesies have been spread out of the news reports and comments of the mass media one after another. In the great terror, have we really understood this crisis? Can China keep sound alone in this crisis? What on earth can people learn from this crisis?

 

In the face of these questions, Beijing International MBA at Peking University (BiMBA) has built up a platform for its students and alumni, to get the most genuine information and enlightenment from the personal experience of senior bankers of both China and the USA.

 

The Crisis in Progress

 

In February 2007, Hong Kong and Shanghai Banking Corporation declared that, owing to the deterioration of the mortgage loan business in the USA, it had withdrawn a higher-than-anticipated reserve for dead loan to cope with the possible loss. The announcement has aroused a great shock. Hong Kong and Shanghai Banking Corporation's domain in the USA has mostly originated from Household it bought in 2003, the earliest independent consumer finance institution in America doing sub-prime loan business. Its business chiefly covered two aspects: the traditional terminal operations closely linked to clients, and the newly established business, namely, repacking the mortgage loans bought by brokers into financial products, such as mortgage backing securities (MBS), asset backing securities (ABS), claim deposit obligation (CDO) and so on. The problem now just centers around the latter. Hong Kong and Shanghai Banking Corporation has already handled this part of problematic assets, and did an all-round personnel replacement and strategic reform to Household at the beginning of 2007. Although the target client group of the subordinate loan has remained unchanged, different approaches and channels may lead to different results.

 

Soon after that, in April 2007, the largest sub-prime lending operator in the United States, New Century Financial, applied for bankruptcy protection. In June 2007, two hedge funds managed by Bears Stern, one of the top five investors on the Wall Street, went into trouble and suffered severe losses, and finally went through bankruptcy liquidation.

 

Till July and August 2007, these events had developed into an overall crisis. In July, the three major credit rating institutions lowered the credit ratings of hundreds of CDO’s, with the most drastic degradation plunging from the highest credit rating to the that of junk bond. In August, the whole credit market almost came to a close, and both the Fed and European central banks took emergent measures to save the market.

 

After August, the situation became worse. In September 2007, Northern Rock Bank of Britain experienced a bank run and managed to survive the crisis only with British governmental assurance of the safety of the loans plus capital injection by British central bank. Afterwards, the Fed took a succession of steps to lower interest rate. In October and November of the year, many more CDO’s were rated down. Influenced by these tumultuous events, Stan O’Neal, CEO of Merrill Lynch, the largest investment bank on the Wall Street, took responsibility and quit his job and, similarly, Charles Prince, CEO of Citibank Group, had to resign ahead of schedule.

 

In January 2008, American Bank invested 4 billion dollars to acquire Countrywild, the largest mortgage lender in the United States, which was once worth up to five times the current value.

 

The crisis currently has two names in China, respectively sub-prime lending crisis and sub-prime mortgage crisis, of which neither is accurate. In fact, as early as last November, the crisis was no longer limited to the sub-prime loan market. Therefore, the U.S. media now call it the “Mortgage Crisis”.

 

Excess Fluidity: Soil of Crisis  

               

Dr. LUO Ning, Senior Credit Analyst, former Vice President of Office of Risk Management, Citi Cards, Citibank North America, is now Senior Banking Comptroller of Department of Bank Regulation of the Federal Reserve Bank in New York and Overseas Consultant and a columnist for the credit card columns of Digital Wealth. He has been working on financial risk management at Wall Street, and is a member with NYSSA, PRMIA, GARP and IAFE.

 

“The crisis, before its explosion in last year, actually had lurked quite a long time since 2005,” said Dr. LUO in his lecture for BiMBA students. The house price had been soaring by 2005, he analyzed, and when the price hike slowed a bit in 2005 some regions already began to have trouble. Then in 2007, the crisis fully exploded.

 

Sub-prime lending means lending of a sub-prime class. The standards for defining sub-prime class lending are different for different varieties of loans. For instance, for credit card operation, a loan of a FICO less than 620 is defined as sub-prime, while the standards for sub-prime housing loans range between 600 and 660 with regards to the specific loan type. The type of sub-prime lending that triggered off the current crisis was the sub-prime housing loans in the United States. Therefore, one needs to know the development of U.S. housing loan market to understand the sub-prime lending crisis.

 

The development of the housing loan market of the United States went through several major stages. The first stage was the New Deal era under the Roosevelt Administration, when FHA and VA were established to provide lending services to low-income groups and military veterans. In 1933, FDIC was established, whereby the deposits of the public became safer. The second stage happened after the Second World War, when the return of a large number of military veterans together with the “baby boom” and the wave of “suburban development” greatly boosted the housing market in the United States. After 1968, housing lending experienced large-scale mortgage-backed securitization and the current FNMA was halved with part of its function going to the newly established GNMA. Afterwards, the FHLMC was established. These three organizations, directly led or sponsored by the federal government, acted as the intermediary on the secondary housing loan market and greatly facilitated the growth and maturity of this market in the United States, liberating the capital of banks for circulation. Of the current total of 8.5 trillion dollars of housing mortgage loans, sub-prime loans account for 40%.

The formation of bubbles took many factors. The first is the low interest rates in a long run. After the collapse of the stock market for shares of technology companies, especially after the 911 event, Greenspan adopted low interest rates in a long time to save U.S. economy, for which he is now blamed. Japan and Europe encountered the same problem. The second is the pursuit of investment returns. The third is slight fluctuation. In a period, hedge funds maintained a high margin level. The fourth is the depressed risk premium. The fifth is the tax reduction policy introduced by the Bush Administration, including lower capital appreciation tax and dividend tax. The sixth is excess fluidity. There are all kinds of interpretation of the reasons for this, such as high capital returns, lower interest rates resulting from large-scale Asian purchase of U.S. treasury bonds, greater fluidity caused by financial derivatives as a “massive destruction weapon” for the financial market, and greater fluidity on the capital market resulting from prevalent re-mortgage loans due to rising house prices. In reality, most houses were not on the market but were evaluated according to the prices of the small number of houses on the market, so when they actually entered the market for sale, the house prices would accordingly change, making it impossible to realize the originally held high prices.

 

In the course, the corporate culture of banks was confronted with great challenges. Drawing on his experience of working at the office of Citibank Group for risk management of credit card business, Dr. Luo described the changes of corporate culture that he personally felt. Though a succession of acquisitions swiftly pushed up the market capitalization value of Citibank Group, the acquired banks were not integrated in the real sense judging from the internal perspective. He especially emphasized that banks, especially their credit officers, need to have experiences accumulated during time of economic recession, which was exactly what Citibank lacked. Recovery of Citibank is far more complex than dealing with the resulting problems on its accounting books, for its corporate culture has almost been ruined. When Citibank is confronted with restrictions such as the prohibition by the Fed, limitation by the anti-monopoly laws, and reputation risks in its practice of successive acquisitions, its performance will inevitably experience quick downturns.

 

Rules Cannot Check Temptation: Origin of Crisis

 

Then, how did the neglected sub-prime housing lending evolved into a time bomb of global economy?

 

LI Fu’an, Director of Department of Business Innovation, Regulation and Coordination of China Banking Regulatory Commission, pointedly questioned why the multinational banks, which are known for their prudence and have numerous professionals, failed to recognize, and prevent, the serious consequence which the indiscreet behavior of certain people on the financial market might cause.

 

One viewpoint holds that commercial banks were not familiar enough with the capital market and their regulation was therefore not fully enforced. Dr. Luo regarded this idea reasonable, but not a satisfactory explanation of the problem. In terms of this familiarity alone, the top five investment banks can be said to have thorough knowledge of the capital market. However, except Goldman Sachs, which withdrew unharmed three months in advance, none of the other four escaped the disaster. Hence, this viewpoint is not convincing enough.

 

FICO is only an index based on statistics about repayment behavior, asset-liability ratio and “hunger” for loans, and cannot properly rate the credit level of housing loans. For the risk of housing loans is not purely credit risk, but more depends on the risks of the real estate market. At the same time, insufficiency of data about sub-prime loans made it hard to obtain reliable results using the models based on statistics. The banks released sub-prime loans at a large scale, without even giving comprehensive consideration to factors like loan ratio and income status. Accordingly, the borrowers could obtain large sums of loans without even having to repay the principal, thus maximizing the levering effect of housing mortgage. When house price was in the rising channel, all participants in the chain benefited and the whole nation lived in exhilaration, while the few sober minds were neglected. Besides, having not experienced any period of “economic winter” for over a decade, people accustomed to the warm weather had gradually loosened their guard and lost their ability to resist cold, becoming “frogs in warm water” and allowing the insidious accumulation of the crisis.

 

Why did the institutions fail to take proper reaction after some people had already perceived risks? Each company had its own special condition. Take Citibank, the biggest loser in this respect by now. Why did it happen? The bank had long failed to make any breakthrough in the consumer credit operation, which provided the bulk of its profit. The bank had previously depended on continuous acquisitions to expand its market capitalization, but as the market became fully competitive, the bank could not sustain its acquisition progression and suffered declining performance. Naturally, when it discovered sub-prime lending as a new growth point of profit, it grabbed it as if it had been a life-saving straw. In addition, Dr. Luo discussed another factor that influences the relationship between an institution and its personnel, namely, salary. In fact, all the personnel, from CEO, CFO to the mid-level staffs, are all being driven by this factor. During the hottest economic boom, there was a saying like this: “it is better do the wrong thing with others than do the right thing on your own.” For testing of any practice takes a long time, but by then the current superintendent will have resigned from the post, together with the duties therein. Till now this reward system has been an established institution, and it is hard to find its substitute in a short or medium term. 

 

LI Fu’an believed that confronted with social instability caused by the adventurous deeds of enterprises, the government will have to give priority to recovery of social stability regardless of the social costs, so the irresponsible “adventurous drivers” and “mad wall-hitters” will be the real beneficiaries while others will only get the benefit of having a smaller loss. To this opinion Dr. Luo expressed his full agreement. The development is too fast and all discreet considerations will be forgotten, so the bubble keeps expanding. Against such a background, it is the cautious people who will suffer. The temptation can overpower any systematic precaution, and the trend of pursuing high reward cannot be checked, for after all, mechanisms have to depend on people for their enforcement.

 

“Rules cannot check temptation,” commented Dr. Luo.

 

Regulation Late for Half a Beat

 

LI Fu’an pointed out that the United States, compared with other countries, has a rather sound regulatory system and a very mature market. Was it simply due to negligence that the United States failed to perceive such serious bugs?

 

Dr. Luo thought that at a time of inflating bubbles, though still useful, the regulatory system has very limited effect. He introduced that the Fed is divided into two layers in structure. The upper layer is the Board of Governors of the Federal Reserve System consisting of 7 members nominated by the President and approved by the Senate. The members have a tenure of 14 years so that their duty can last beyond two presidential terms, so as to avoid partisan manipulation. However, near the expiry of the governors’ tenure, politics would still impose its influence. The lower layer consists of 12 districts. In each district, there is a federal reserve bank responsible for implementing the macro currency policy, regulating local banks, and exercising the right of the national payment system. The district partitioning has much to do with the environmental and political factors in history. 

 

The Fed was established according to the “Federal Reserve Act” of 1913. The First World War broke out in 1914. Then Secretary of Treasury Eugene Meyer actively advocated the establishment of the Federal Reserve System to protect U.S. financial market from the shock, and became its first chairman. For many years after that, Secretary of Treasury always held the post of Fed Chairman. This situation only began to change in late 1950’s when the Congress laid down strict restriction to such arrangement through legislation with a view to increase the Fed’s independence.

 

Dr. Luo made a brief introduction of the organizational characteristics of the Fed. Firstly, in terms of personnel, though a Federal Reserve Bank is a non-governmental organization, 3 of the 9 members on its Board of Directors, including the chairman and the vice chairmen, are decided by the Federal Reserve Board, so the power of its Board of Directors is actually controlled by the central bank. The other 6 members, of whom 3 come from the banking industry and the other 3 from other industries, are divided into 3 groups, each consisting of a banker and a non-banker. Secondly, in terms of funds, the Fed obtains its income mainly from the interest of treasury bonds on its account, of which it spends less than 10% and submits the rest to the Department of the Treasury. Thanks to its independent fiscal incomes, the Fed enjoys a high level of independence in not only personnel but also finance. Finally, in terms of decision-making process, the decision of the Fed is influenced by the districts instead of the chairman alone, which is also one of its important features.

 

Since the occurrence of the crisis, the regulating bodies, especially the Fed, have been receiving criticism from the Congress. Though endowed with sufficient regulatory power, much of the power was not used in reality. For this reason, the Congress once talked about transferring the regulating power to the Federal Deposit Insurance Corporation (FDIC). Under the pressure from the Congress, the Fed put forward a set of new stipulations and measures for regulation of housing loans. However, the punitive measures of the Fed were largely meant for correction after the event, while the prevention relied more on the supervision over non-bank institutions by the states. Nevertheless, out of their considerations to tax income and other factors, the states did not attach sufficient importance to their regulating function in this concern. The financial regulation of the United States was once meticulous and rigorous, but was somewhat relaxed since the deregulation in the 1980’s and 1990’s. Particularly, since the United States entered the new era of “mixed operation” in 1999, new products have emerged in large numbers.

 

Besides, after a new product was introduced, it would take a period for the financial institutions, including the rating companies and the regulatory bodies, to get to know and understand the product. Of the two, the latter has a weaker ability for quantitative analysis. The teams of the federal regulatory bodies for quantitative analysis and model analysis only got established 3 or 4 years ago. Added by reasons concerning financial input, they have quite limited strength compared to the companies active on the market. All these factors have contributed to the “half-a-beat-late” reaction of the regulatory bodies.

 

Impact of the Sub-prime Lending Crisis on and Its Lesson for China

 

The main action that the Fed currently takes is to lend money to the selected banks to keep the fluidity on the market. However, some banks not only have the fluidity problem but also face insolvency and credit risks. The Fed wants to but cannot help them out. Judging from this, Dr. Luo stated, from a pure economic perspective and leaving out political considerations, recession is actually not dreadful and in a certain sense is a healthy cleaning-up process. 

 

This crisis also has serious international impacts. The financial markets of many countries, including France and Australia, have suffered severe setbacks. How to minimize the loss? In Dr. Luo’s opinion, though different countries gradually reached consensus in policy, tone and public opinion during the previous period of common prosperity, they can no longer adopt identical policies because they encounter the problems at different points of time. He proposed three steps: Firstly, each country should take care of its own interests; secondly, notwithstanding lack of consensus, coordination among countries should be enhanced; finally, it must be realized that the greatest challenge today is the lurking threat of global stagnation resulting from capital bubble and rise of labor price.

 

Can China de-link itself from the U.S. market and remain affected by this crisis? Dr. Luo’s answer was negative. Chinese economy, no matter judging from the export (its direct drive) or from the expansion of domestic demands (its indirect drive), will definitely be affected when recession occurs outside the country. As the country most susceptible to blame, plus the influence of political factors, China will very probably become the victim of another wave of global protectionism similar to the one occurring in 1929.  

 

Dr. Luo emphasized that China currently should not place its priority exclusively on economic growth. Whether the economic and social progresses achieved in the past 20 to 30 years can be preserved should be put on the agenda as a very important issue. A large part of Chinese economic growth still means no more than the figures in the account books. We now should pay attention to the question of how to convert the growth into a higher living standard. Since the ancient times, any strong and powerful country must be the ones that were the most successful in preserving its previous development achievements during tumultuous and chaotic periods.

 

LI Fu’an believed that the central bank of China now has a very good opportunity to have a clear mind and make a set of sound policies. On the one hand, the central bank should ensure that no large-scale and partially uncontrollable crisis like the sub-prime lending crisis of the United States should happen in the Chinese market, and on the other, it should take into consideration the current economic status of China and formulate a long-term and steady strategic plan for “winning”. Relevantly, the strategic plan of Japan has turned out a failure. To integrate itself into global economy, China must make sure that when its economic influence reaches the impressive magnitude of Japanese economy, the country can avoid the financial tragedy suffered by Japan. For the rest regulatory bodies, the urgent task is to set up a clear system of rules and a sound technical framework. LI Fu’an compared this task to building an “expressway system” and a “system of traffic lights” across the country, which ensures that the “vehicles” will not cause any destructive blockade to the market whatever their speed is. The significance of such a financial operation system cannot be more evident.