First World Financial Tsunami

First World Financial Tsunami - a lesson

Do we ever apply anything we learn from history each time we are faced with a “new” situation?

Didn’t know what hit them…a recent painful history
On the morning after Christmas in 2004, a Tsunami was triggered by an earthquake in Indonesia. The waves traveled around the world, systematically crashing onto shores as far away as Africa. The catastrophe took all by surprise - affected countries didn’t know what had hit them when the waves suddenly crashed against the shore and the streets turned into raging rivers.

On hindsight there are 2 things we learnt from this disaster:
• There was no early warning system despite Indonesia straddling one of the most active earthquake zones. Perhaps it is simply because Indonesia is also one of the poorest countries in the world.
• The full extend of the impact was not known until weeks later, which also meant that the initial response was grossly inadequate. What started off from a developing country eventually affected half the world.

If this had happened in the pacific however, the outcome would be different. The US and other pacific-rim countries like Japan have a sophisticated earthquake and Tsunami early warning system. This also ensures a response that commensurate with the scale of the anticipated problem. We expect nothing less from the First World countries, with their wealth and advance technology.

Still didn’t know what hit them…an unfolding tragedy
Similarly, we also expect these First World countries to take the lead in financial development. With that, perhaps they should also have “financial tsunami” early warning. Indeed, the US and the Swiss is known for financial innovation and risk management. But just because they were perceived to be world best, it doesn’t mean that they know where to look for potential trouble.

This current financial crisis can be traced to as early as Aug 07, and we have not seen the end yet. On top of this, we are also experiencing higher inflation rate and slowing economy. This First World Financial Tsunami is still unfolding one year after it started. On reflection during the 1st anniversary,
• The US had no earning warning about the potential dangers of subprime debt, and neither did the Swiss when their risk controls went wary. A picture came to mind, that of Charles Prince (Ex-CEO of Citigroup) in Jul 07 as he “was still dancing” to the music of leveraged buy-out. Clearly there was a lack of early warning just before the Tsunami hit.
• The impact remains far-reaching, and no one is sure of its full extend yet. Financial institutions are still reporting new damages done reflecting the ripple effects of this Tsunami. From the US, it has spread to the rest of the world. From the Sub-Prime sector, it seems to be spreading to other sectors and into the real economy. The initial response to this crisis is not sufficient to pro-actively limit further damages.

Were there danger signs prior to this financial tsunami? Of course! At the root of this financial problem – how can granting loans to people with no means to repay be a financial innovation that will be a success story? Historians will eventually document how it happened in detail when the full damage is done. But for now, we shall learn 3 simple lessons:

First - The Lack of Equity At Stake. In the core of banking, it is about taking risks for a commensurate reward. For any loans business, there will be credit losses when loans turned bad. There must be check and balance to avoid excessive credit losses arising. When there are suitable equities at stake, there will be balance (平衡). If nothing seems at risk, it is simple to just walk away. So with regards to the sub-prime problem:
• The mortgage brokers didn’t have anything at stake. They are the risk-free middle men who cared about volume done and nothing about quality of loans.
• The commercial banks didn’t have anything at stake when the loans they grant can be sold off through investments banks in the form of structured financial investments. The risks were offloaded to investors, so they too had little reasons to care about quality, and therefore they also had nothing at stake.

Second - The Lack of Identifiable “Risks”. Once risks are identified, bankers are very good in mitigating them. But when there is the perception of no problem that is where the problem lies.
• Sub prime borrowers cannot afford the loan but they probably thought that banks and mortgage brokers know best, so if they can grant the loan, then it must be fine. These borrowers don’t see the problem even as their home is at stake.
• Banks cannot always sell all of the structured investments, so for the residual they bought insurance, put them into special purpose vehicles and had a sophisticated model that concluded the risks were no problem. After all, even independent rating agencies confirmed that quality of the residual. While bank’s financial health is at stake, they failed themselves thinking that the risks are fully controlled.
• Investors who bought the structures may not fully understand the risks, but trusted the advisors and reputed brand-names they represent, and the independent ratings. They don’t see the problem even when their wealth is at stake.

Third - The Lack of Long Term Orientation. This inflicts investors, bankers and shareholders alike. Investors want quick performance, bankers demand quick results, shareholders mandate quarterly improvements. When short term achievements do not add to long term value, things will fall apart.
• Bankers must strike the balance as short term performance lays the foundation (both good and bad) for long term prospects. Perhaps the shifts towards individual performance and short-term rewards have been excessive. There may be a need to balance with more emphasis on long-term goals and benefits.
• Shareholders must view things in relation to the industry development as well different strategies and direction taken. Shareholders always put pressure on share price and they naturally compare performance between different banks. Such short term comparison and pressure can be counter-productive. 赛翁失马，延知非福。
• Clients and investors must appreciate that some times when things are too good to be true, they just might be. Long term goals are achieved through long term strategy where short term punts may lead to dead-end and not a short cut.
• At the root of it all, how can we avoid situation where short-term gains significantly outweigh long-term obligations or when motivation of the counterparty is not aligned with yours.

And history will repeat itself…for better and worse
The US, the Swiss and the whole world would probably suffer a little longer in this First-World Financial Tsunami, but we will eventually recover. Just as history has taught us - Asian economies recovered from the financial crisis 10 years ago and Indonesia has since recovered from the 2004 Tsunami.

And in 10 years time, maybe I can also look back and wonder how people have forgotten the pain from this First World Financial Tsunami. After all, the recovery that follows may be as spectacular as the fall.

History has and will repeat itself, but the time, the place and the people will be different. I will bet my last dollar that there will be a strong recovery and I will also bet my last cent that there will be another Tsunami to follow that recovery! Why? Because people are resilient but we also forgetful.