02 October 2008

I'm telling you it's gonna get worse...

Went in to a great lecture in TCD last night on the origins and outcomes of the current international banking crisis, given by Professor Patrick Honohan, arguably the leading expert on financial crises in Ireland, and a man well able to explain the current troubles to an audience of non-economists in an engaging and quite humorous way.

He began by examining what has caused financial crises in the past, and what was different about this one. Basically the system of risk management in place in most major institutions was fundamentally flawed; the over-reliance by banks on an almost automated checklist of conditions that determined the level of acceptable risk in any situation allowed individuals familiar with those checklists to game the system to their own advantage, gaining approval for mortgages for those who could never afford to pay them back all, and making substantial amounts of money for themselves in the process through commissions and fees. This toxic debt was then hidden within bundles of less risky debt and sold as combined packages that financial institutions believed were solid financial investments. When people started to default on mortgage payments everything came crashing down.

He then took a look at who has been affected and why, and in what way, ranging from banks that took a huge hit but survived due to diverse portfolios, through to those that have neared collapse but were taken over, and then onto nationalised institutions and finally those that have just disintegrated with no government bail out.

Finally he looked at the various economic rescue plans that have been implemented or suggested here and in the US, and addressed some question about what the long term effects of these plans would be. Interestingly enough he touched on the need for increased regulation here in Ireland, or rather on the need for the financial regulator to have increased powers and take a more proactive role in the day-to-day running of the six Irish financial institutions being guaranteed by the government, rather than waiting for them to be visibly in danger of collapse.

The main message that I took away from the talk was that this is not over by a longshot. One slide that particularly struck me, and which I have deftly reproduced here through the miracle of I-can't-believe-its-not-MacPaint, was on the mortgage default rates in the US over the last few years.
This graph plots loan default rates over time of mortgages issued in a particular year. For mortgages issued before the introduction of the current wave of Risk Assessment Systems, a gradual curve emerges, for example at the time this snapshot was taken the default rates have levelled off for loans issued in 2003, 2004 etc; thus we have a very good understanding of what the likelihood of any given loan from 2003 defaulting. For loans issued during and contributing to the sub-prime crises, not only has the default rate been substantially higher, and occurring at a much earlier period in the lifetime of the repayment cycle (many borrowers could not even pay a single months instalment), the default rate is graphing exponentially, indicating that we don't really have any idea how high the rate is going to be, or when it will level off. This is the toxic debt that is the subject of the $700Bn bill passed by the Senate last night, unless it is dealt with now the crises is just going to snowball and more institutions will fold.

That does not mean that I agree with the bill in its current format; as Professor Honohan outlined last night the bill protects the shareholders of these institutions, but does almost nothing to shield the taxpayer, or look after those who have lost their homes and more. Though I doubt he would phrase it as such, I find the bill to be a very capitalist solution to a very capitalist problem, the banking class has once again looked after its own.

The lecture was recorded for podcast, and will be available soon (with much better graphs than mine) on the TCD section of iTunes. I'll come back and link to it here when it has been uploaded. It was great and I really haven't done it justice. Over two hundred people packed into the Thomas Davis Theatre, a heady mixture of businessfolk, students, academic staff, economists and, well, to be quite honest, a large number of pensioners with little else to do but worry about their pension fund, complain about the weather, and go to evening lectures they saw advertised in the back of the Irish Times.

Which would just about describe me at the moment, if I actually had a pension fund.

The podcast hasn't made it onto iTunes yet, but it is available for download with and without the slides here.


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