Kohler on the Crisis | BTalk Australia

(21min 39) On today’s BTalk Australia Phil Dobbie talks to Alan Kohler, Editor-in-Chief of Business Spectator, about the credit crisis. How did it happen? What part did Freddie Mac and Fannie Mae play? Why was the collapse of Lehman Brothers so significant? What will happen next and what, if anything, have we learnt? It’s a step by step explanation for anyone a little confused by what happened this year!

Add your comments in the Talkback section at the end of this post.

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• Today’s Transcript

Phil Dobbie: Hello, I’m Phil Dobbie and welcome to BTalk Australia. Today: the lowdown on the credit crisis, what happened and why. It’s been a confusing year all up. In the middle of the year the Reserve Bank worried about inflation. We were pushing interest rates up, now they can’t bring them down fast enough. Employers were complaining that they couldn’t find enough people to grow their business and now it seems retrenchments are rife. And we’ve watched the all ordinaries fall throughout this year to a point where we’re pretty much back where we were five years ago. In fact, we’re worse off if we look at it in real terms. So how did it all happen? To give us the lowdown on the credit squeeze, I’m joined by Alan Kohler who’s the editor-in-chief from BusinessSpectator.com.au. Alan, we started talking about the sub-prime mortgage crisis in the US. What started it and what part did Freddie Mac and Fannie Mae play in it all?

Alan Kohler: Ok, I’m not an expert on Fannie Mae and Freddie Mac but I am inexpert on the outsider’s view that it really goes back a very long way. When Fannie Mae was set up in 1938, for the first 32 years of its existence, it was a government agency. It was set up to provide a wholesale conduit for mortgage securities to support the provision of mortgages after the Great Depression. The mortgage market was not functioning properly and people were finding it difficult to get home mortgages, so the government set up Fannie Mae, which was the federal home mortgage association to support the provision of mortgages. It was eventually privatised in 1970 and Freddie Mac was set up at the same time as a very similar organisation to provide some competition. And they were called government-sponsored entities or GSEs even though they were actually privatised, they were privately listed. Their boards were non-government individuals and they had ordinary management. But they continued to perform the same function, which is to buy mortgage securities from originators and then parcel them up, on a wholesale basis.

Dobbie: Now do you, do you think they played a part though in putting out unrealistic levels of risk and perhaps also pushing up house prices?

Kohler: Yeah, I do. I think the problem is that that part of the America economy was in a sense half-socialist. It’s the home of capitalism — capitalism is what it’s all about in America, except in that part of the business. Up until 1970 it was government sponsored and then after that time everyone thought it was still government sponsored. And so the money that ended up going into Fannie Mae and Freddie Mac to invest in the mortgages, the people who were investing, providing them with that money thought that they were investing in government entities. They thought that it was supported by the government’s triple-A rating. And, of course, that’s not strictly the case. The other thing was that they were hiring financiers from Wall Street to run the thing. And paying them huge salaries, and more importantly, big bonuses. So they were encouraged and incentivised to increase profitability, to get their bonuses and also to get the share price up, which is all part of the same thing. They were taking greater and greater risks. So there was this mismatch between what the investors in the thing thought they were getting, which was a fairly conservative of government-sponsored entity with a triple-A rating, while on the other hand it was actually behaving like a common garden-variety private financier with risk-taking and executives getting paid whacking great bonuses.

Dobbie: In fact, even worse possibly because they were able to take a bigger risk because they had that triple-A rating sitting behind them.

Kohler: Exactly, that’s right. And so, so over recent years, up until the peaking of the housing market in August 2006, they started to take greater and greater risks. They were investing in more and more sub-prime mortgages rather than the, the prime mortgages that they’re supposed to only invest in, that’s the charter.

Dobbie: Right.

Kohler: And the quality of the mortgages that they were investing in slipped and became more risky. So when the housing market began to fall, and defaults on the sub-prime mortgages rose, this was devastating for Fannie Mae and Freddie Mac and they essentially went broke, quite quickly.

Dobbie: That was the speed everything this year has shocked everyone, hasn’t it?  Including the collapse of Lehman Brothers. So was that simply an investment bank that was too heavily exposed to the subprime mortgage market? What happened there?

Kohler: Well, Lehman Brothers, after Bear Stearns went bust in March and was rescued by the Fed, which kind of sponsored the takeover of Bear Stearns by JP Morgan, Lehman Brothers was thought to be the next to go — the next domino to fall. That’s simply because they did invest — all these investment banks, Bear Stearns, Lehman Brothers, became gigantic hedge funds really. They became dominated by their proprietary trading desks. Whereas, traditionally, investment banks were brokers that were acting as intermediaries on behalf of clients, performing transactions and taking a clip. During the last 10 years they gradually became dominated by their own trading activities. And so Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, all of these outfits ended up having huge trading portfolios (of credit securities in particular) that they simply didn’t have enough capital to support. So when the value of these securities declined sharply following the fall in the housing market and then the sub-prime defaults, that caused a big fall in mortgage security values. All of a sudden their lack of capital was exposed. So Bear Stearns went first and it took a while for Lehman Brothers to fall over. What happened with Lehman Brothers is that, whereas Bear Stearns was kind of bought out or sold into JP Morgan so that it didn’t default on its debt, on the weekend that Lehman Brothers got into diabolic strife and ran out of money, as I understand it, the Treasury Secretary Hank Paulson and Ben Bernanke, the Chairman of the Federal Reserve Board, couldn’t decide between each other who was going to save it. Bernanke was saying to Paulson, you do it. Paulson was saying to Bernanke, no, no, you do it. And, and that went on all weekend until Sunday night basically Lehman Brothers fell between them like a ball in the outfield of a baseball match.

Dobbie: So do you think it would’ve been a very different story if they’d — I mean it was only a couple of weeks later that $700 billion miraculously appeared from somewhere. If they’d used that money, if Paulson had put that money in and provided the captial would Lehman Brothers have survived, do you think?

Kohler: They assessed the risk of Lehman Brothers going broke and they were basically looking at the credit default swaps market, which was very large and the issue of Lehman Brothers folding as a counterpart and what effect would that have. And they decided that Lehman Brothers was a risk worth taking, going broke was a risk worth taking and it wouldn’t cause a calamity in the credit default market. What they missed was that the world’s largest money market fund, the prime reserve fund announced on the Wednesday after Lehman Brothers went broke on the Sunday, that it held $800 billion worth of Lehman Brothers’ paper.

Dobbie: Right.

Kohler: And what happened was Prime Reserve Funds’ net asset value fell below a dollar, which really just never happens. That’s the event that sparked a run on the world’s banks, because that caused a collapse in the commercial paper market. The commercial paper market is supported by bank guarantees and all of a sudden it looked like the $5 trillion commercial paper market would fall over and cause a run on the world’s banks. That was the thing that everyone missed with Lehman Brothers. And it actually almost resulted in a complete meltdown of the global banking system.

Dobbie: People were just getting their money out of banks because banks were seen as being a risky place to keep it in other words.

Kohler: That’s right. So that’s what led to the bailout that Hank Paulson ended up introducing and in the second half of September and all of October there was this massive and frantic attempt by all the world’s central banks and governments to turn it around. Eventually they did, by doing what the British government did. The US bailout package of $700 billion was really just was really to buy mortgage securities fairly willy nilly, not with any kind of demands on the banks. The British government came out and said we will invest directly in the banks and in return for that we will take some sort of control — it was quite a different approach. The British one has now turned out to be the one that everyone’s followed around the world. And it’s been quite successful. That’s what really turned it around. But in the meantime it was too late for Iceland. Iceland has gone bung, the whole country. The whole event of Lehman Brothers and what happened after that has had a kind of dramatic effect on the global economy during October. There’s been almost an audible clunk in the whole global economy during October as a result of what happened in mid-September.

Dobbie: Some of the Aussie banks are out capital-raising right now, presumably trying to ensure that they’ve got the right ratio of equity against the debts that they hold. The fact that they’re able to actually go out there and do that must show that there’s a fair degree of confidence in the banks in Australia.

Kohler: Yes, they’re getting the money from institutional investors who made some pretty stupid decisions earlier on in the year. Those investors are being put under pressure by the investment banks who are working for the banks and raising the cash. So they ring up in the morning at 9 o’clock and say we’re raising money for X bank. You’ve got three hours to put in your bid. It’s at a discount of 10 percent. And the institutions feel like they’ve got to do it. As to whether it means everyone’s got confidence in the banks, maybe it does. I suppose it does, but …

Dobbie: The money has got to go somewhere as well.

Kohler: That’s right. And the money is going into those banks and they are getting their T1 capital above 8 percent which is good. But I think 2009 is going to be a very challenging year for the banking system because, particularly in Australia,  defaults are going to rise.

Dobbie: I think it’s going to be a difficult year for everyone, isn’t it? Do you think it’s almost inevitable? I mean not 0.1 percent growth in the last quarter. Is it almost inevitable that we’re going to find ourselves going into a recession?

Kohler: Personally, I can’t see how we’ll avoid a recession. I know that the official line is that we’ll come out of recession, or we won’t have recession or something. I don’t think that’s going to be possible. It was partly reinforced by news from China last night that their exports fell in November by 2.2 percent — which is the first time that’s happened for a decade. The news that China’s exports are falling are I think is a major concern.

Dobbie: I’m also wondering whether the impact of interest rates in terms of trying to encourage spending is going to have the impact because I think so many people are so heavily steeped in debt, are they going to spend or are they just going to try and reduce that debt?

Kohler: It has been said and it is true that Australia is in a relatively good position because interest rates here were high. And therefore they can be reduced a long way. Also petro prices have fallen a lot and also there’s the fiscal stimulus from the government, the $10 billion that’s been going into everyone’s pockets this week. Also the currency has fallen quite a long way. So there are four factors supporting Australian demand and therefore the Australian economy: the currency, fiscal stimulus, interest rates falling, and petro prices falling. Those four things are pretty good and will have an impact. But on the other hand, there is clearly already a global recession underway. And the notion that in some way China is decoupled from the developed world is proving to be incorrect. So China is being affected. The only question is to what extent is China slowing down and will it have a proper recession or just slow down to a relative recession?

Dobbie: What have you got to say to economists like Steve Keen who keeps on pointing to the rising level of debt in Australia and saying it’s skyrocketed since the war. Really the only way to get the economy back on its feet long term is to write off a lot of that debt. And I guess that particularly relates to house prices. All it takes is if asset prices, particularly property, starts to drop, we know so many people are highly leveraged, then the banks know that and investors aren’t, they will want to play it safe and remove the risk. And start our own spiralling of property prices here in Australia. 

Kohler: I find it difficult to disagree with Steve Keen in many ways. One of the big differences between this downturn and the previous recession in 1990 is that in 1990 household debt in Australia was 50 percent of average income. Now it’s 160 percent.

Dobbie: Yeah.

Kohler: Of average income. Interest rates are much lower now so you know the servicing burden is much lower. And we’re comparing, as an economist would say, we’re comparing a stop with a flow, that is to say the stop of debt with the flow of income. And that they’re not comparable. However, it is true that however you look at it, indebtedness is much greater now than it has been ever before. As to how that’s dealt with and to what extent it’s dealt with is hard to know. But my view is that it’s going to have to be dealt with. I don’t think there’s going to be massive debt writeoffs. Although you couldn’t rule that out. By that I mean household defaults and foreclosures and bankruptcies.

Dobbie: All the bad debt.

Kohler: I think there will be an increase in bad debts next year for the banks from individuals in the residential sector, but I can’t see that going to the same extent as the US. However, I do think that households will be looking to get their balance sheets in order, which will require a long period of reduced spending. And that’s really the main problem for the economy. We’ve had a long period (like seven years) of heightened spending, based on debt. Based on consumption based on using your house as an ATM. And using the mortgage to finance consumption. That is clearly over and it must go into reverse for a period of time. People need to reduce their spending in order to reduce their debts. And that is going to hold back the economy for quite a while. The exhorting by the prime minister and the treasurer for people to go and spend the $10 billion they’re sending out this week is merely a drop in the bucket, you know of what’s required and will not reverse the reduction in spending that’s going to have to occur in order to rebalance the balance sheet.

Dobbie: So a couple of quick questions to finish with. If we are going into recession, what needs to change to pull us out of it? And once we have come out the other side, what do you think we will have learned, particularly what do you think the banks will have learned? Apart from obviously spending less, what’s going to change in the way we handle the economy?

Kohler: We can guarantee that whatever we do learn will be forgotten again in 30 years’ time. Because it was learned before.

Dobbie: That’s true.

Kohler: You know it was learned in 1990 and then it was learned in ‘73, then it was learned in 1961. So, yes, it’s learned, but the learning of course has to do with leverage. And banks, the global banks, increase their leverage to 20 to 1; it’s going to have to be reduced to something less than that, perhaps 15, 17 to 1.

Dobbie: Maybe we’ll have to put a suit on and go and see the bank manager before we get a loan.

Kohler: Banks have certainly developed a habit of saying no — in the course of 12 months, we’ve gone from banks being run by marketers to banks being run by credit rationers as they used to be. As you say, you put the suit on, you have to go along and be interviewed and ask the bank if they would mind, pretty please, giving us the money.

Dobbie: So the other, the other part of the question was, what’s got to change?  When will we know that we’re really starting to turn around the economy? What couple of factors have we got to concentrate on to change the country?

Kohler: I think it is to a large extent to do with the level of debt. Australia is a lucky country because of its export focus and the strength of demand for commodities and the, you know the great amount of commodities that Australia has and to that extent, it’s really not up to us — it’s up to what happens in the rest of the world. And you know so much of the strength of the Australia economy in recent years has had to do with the resources business as the manufacturing business has declined. And so really it’s very difficult to control that. It’s a question of what’s going on in China, in India and in the developed world as well. So I think it’s encouraging that consumer sentiment jumped last month. It was reported yesterday by 7 and a half percent according to the West Pac Melbourne Institute Survey. That was really encouraging and due to the fall in interest rates and petrol prices. So it just shows, there is some resilience among consumers. They’re not entirely despondent and I think that they’re the seeds of a recovery, which is the resilience of Australian consumers and the strength of their spirit.

Dobbie: Alan, at least it’s summer as well, so you know we can take bad news while the sun is shining, I guess.

Kohler: That’s right.

Dobbie: Thanks so much for your time, Alan.

Kohler: Ok.