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John Quiggin

Guilty must bear the cost

John Quiggin Australian Financial Review

25 September 2008

The pace of events in financial markets has been so rapid that any projection of events in the short term seems likely to be obsolete soon after it is printed. So, rather than try to predict the immediate future, it may be useful to look back at the relatively recent past. The stockmarket boom and bust of the late 1990s, focusing on Internet-based ‘dotcom’ enterprises has important similarities with the current crisis.

The NINJA (‘no income, no job, assets’) subprime mortgages that form the starting point of the chain of securitisation and financial engineering that has produced the current disaster are identical, in all important respects, to the hot startup companies of the late 1990s, valued at billions of dollars despite having no profits, minimal revenues and, in some cases, not even any products.

In both cases, the claim was made that old-fashioned concerns about income and cash flows were no longer relevant. In the 1990s, the Internet was supposed to wipe out the difficulties involved in turning a (supposedly) good idea into a massively profitable business. In the early 2000s, financial engineering turned mortgages with no serious prospect of repayment into AAA-rated assets.

There is nothing new about such new-era speculative bubbles. As Robert Shiller has pointed out, every speculative boom in history has come with its own new era theory, promising that this time, everything is different.

What is remarkable is to observe two such bubbles in immediate succession. Normally, the bursting of a bubble is followed by a period of caution and conservatism, lasting until those burned the first time around have died or retired, to be replaced by a new generation eager to find new ways of getting rich quickly.

The obvious explanation is that no one who really mattered paid a price for the dotcom bubble. Many individual investors lost their life savings, but the financial sector as a whole barely missed a beat.

The Wall Street investment banks that had pumped and dumped Internet stocks had a bad year in 2001, but were soon back, bigger than ever, selling products like collateralized debt obligations (CDOs) to naïve or greedy investors. From 2002 to 2006, these firms reported record profits time and again.

The ratings agencies that had failed to detect Enron’s misuse of off-balance sheet special purpose entities (SPEs) promised to reform. But within a few years they were giving AAA ratings to CDOs and other assets held in ‘structured investment vehicles’ that were little more than rebadged SPEs.

Commercial banks and S&Ls, largely left on the sidelines during the dotcom boom made up for lost time with innovative products like “Pick-a-pay” mortgages in which cash-constrained borrowers chose how much to repay. The assumption was that however fast their debts might grow, the value of their houses would grow even faster.

And, of course, the CEOs and senior managers of these enterprises abandoned any remaining restraint on their pay and perks. Bonuses went from millions to tens of millions, and with share options, hundreds of millions. By 2007, billionaire status seemed guaranteed for the top brass, and anyone with an ounce of ambition expected to be a multimillionaire.

Most strikingly of all, the limited restraints introduced in response to the bubble, such as the Sarbanes-Oxley Act, were derided as unnecessary over-reactions, holding up innovation. Financial firms in particular, found it easy to evade the controls that were supposed to prevent another Enron.

This was supported by a policy of easy money, implemented by Alan Greenspan and continued by his successor, Ben Bernanke. The existence of the ‘Greenspan put’ (the idea that if asset prices ever fell really sharply, the Fed would rescue investors) has been confirmed in spectacular fashion by the trillion-dollar bailout now being proposed.

At this point the risk of full-scale collapse is such that a rescue seems inevitable. But unless all those who are rescued are made to bear large losses, the whole cycle is likely to be repeated on an even larger scale within a few years.

Memories are short, but regulations endure. Only if regulation is greatly tightened will the lessons of the current crisis endure beyond the current cohort of financial system players. The stringent regulations introduced after the Depression kept the financial system stable for decades. The cost was a restrictive regime in which financial innovation was severely constrained. But now that uncontrolled financial innovation has led the system to the brink of disaster, this is a trade-off that must be reconsidered.

John Quiggin is an ARC Federation Fellow in Economics and Political Science at the University of Queensland.

John Quiggin is an Australian Research Council Federation Fellow in Economics and Political Science at the University of Queensland.

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