● The US mortgage market crisis of 2007 is continuing in 2008. Can you enlighten us?

Paul Samuelson?s best-selling A-level textbook, Economics, starts with the remark that every night ten million New-Yorkers go to sleep confident that the market economy will be there next morning. That confidence has been shattered time and again. Many CEOs, brokers and financial institutions had perished in market debacles over decades before he even thought of this telling statement. In the last 30 years, the US economy has been travelling the deregulation superhighway ? without rules or direction. Businesses have gone unfettered and good times have been rolling. But to where? The stop: the mortgage market collapse that has unleashed destabilizing forces threatening to plunge the developed world into a recession. The maze of international finance is so complex that it?s difficult to explain to even an educated guy that his mortgage repayments will increase because some indebted country has defaulted of its external debt obligations.

Let?s first take a retrospective look at the housing market to better understand the current mortgage market debacle. Until after the Bretton Woods System breakdown in 1971, if anyone obtained a mortgage from any financial institution, this lending institution would carry the loan in its balance sheet until fully repaid. With the revolutionary changes in financial technologies and engineering, this is no longer so in advanced financial markets. Financial institutions that give loans today often sell them to third-parties who repackage them and sell the payment rights to gullible and/or greedy investors.

«Many provided borrowers with ?teaser? mortgage rates - long-term housing loans at low interest rates for the first couple of years and rates jumping up afterwards. Such ?teaser? rates are common in Mauritius, too.»

● What does this loan repackaging mean?

Lenders have developed techniques of passing risk to other players in global financial markets. When banks extend loans for a house purchase, they don?t necessarily hold on to them. Financial engineers transform them into investment instruments for resale to investors seeking attractive returns in the same way as supermarkets buy meat in bulk from various sources, process and repackage it before selling to consumers. It is a business model based on trust. You trust the supermarket as the meat has a certified ?AAA? rating. As an investor seeking high yields, you trust the sellers in financial markets and the rating agencies that certify the securities as ?AAA? investment vehicles.

Wall Street guys cleverly bundled and rebundled the mortgage-backed security with higher-rated ?AAA? debt instruments and gave them colourful acronyms like CDOs (collateralized debt obligations), ABSCP (Asset Backed Security Commercial Paper) conduits, and SIVs (Structured Investment Vehicles), etc. The CDOs have been ?trompe-l?oeil?, like paintings to deceive the eye. Trillions of dollars of substandard but ?AAA? rated CDOs have been sold to unsuspecting buyers since 2003.

In this business model, the game is quicker and the ball goes faster ? to very distant markets. From a local business activity 30 years ago, it has turned into a global market for mortgage-related investments. Credit risks have travelled from knowledgeable lenders whose sole risk management strategy was to sell before prices fell to investors, in Europe and Asia, who ignored the creditworthiness of US borrowers.

The US economy was going through good times. And bad loans are made in good times. In brief, estate agents made fictitious appraisals of homes. Loans were made to insolvent people. Bankers invented instruments they were unable to value. High rate-of-return seekers bought those instruments they had no clue about ? thanks to mathematicians, engineers and lawyers in the business. If this was not an ideal recipe for a mortgage market crash with an almighty bang, a keen observer would wonder what else was.

«In January 2007, no central bank realised the gravity of the problem. It was considered a minor one that could be solved through usual market correction mechanism. Within weeks, what appeared as a small local problem had metastasized into a global one.»

● What would be the size of the mortgage loans at stake?

It is said to be in trillions. What is disturbing is the fact that the defaulting homeowners are mere pawns in the game. Loans were invented so that hedge funds could buy high yield debts. Credit rating agencies blessed the mathematical models suggesting they would seldom default. CDOs were used for more borrowings. When adding up layers over layers of borrowings, one single US dollar of real capital supported US$20 to US$30 of loans. This spiral of borrowings has generated derivatives outstanding at US$485 trillion. This represents eight times the global gross domestic product of US$60 trillion! One feature of this game is that players? gains amplify on the way up. On the way down, their losses cannot but amplify disastrously. In this game, banks have offered investment advice and loans ? one-stop shopping on the superhighway to disaster.

● What triggered the sub-prime mortgage crisis in the US?

After the 2001 September 11 attack, the Federal Reserve System (Fed), under Allan Greenspan, reduced interest rate to counter a slowdown of the US economy. This cheap money policy was pursued for almost three years. Demand for housing grew inordinately ? in most countries. Loans were made to both prime borrowers and sub-prime borrowers; a huge number of whom could not repay. Borrowers were not required to produce any evidence. Lenders demanded above-the-market rates to compensate for the risk. Many provided borrowers with ?teaser? mortgage rates - long-term housing loans at low interest rates for the first couple of years and rates jumping up afterwards. Such ?teaser? rates are common in Mauritius, too. Mortgage loans are sold between financial institutions ? a new development in our banking industry.

Borrowers in the sub-prime market were told not to worry about their debt. With real estate prices going up, the more they borrowed, the more money they could make. The truth was that, the more they borrowed, the more money banks and mortgage brokers made. Prices of real estate could not keep going up, especially with declining real income. Like professional spin-doctors, lenders tried to defy the laws of economics. The continuing low interest rates fed the bubble until the day of reckoning ? when the market collapsed. Once interest rates moved up, borrowers defaulted. This mortgage market segment was never regulated and supervised. Wall Street insiders probably knew the bulk of the loans could never be repaid. But lenders did not care as long as they could sell them and pass on the risk to someone else. The crisis was predictable and? predicted.

● When did the crack in the mortgage market appear?

Crises take much longer to come but blow out much faster than you would think. The CDO scheme was mounted in 2003 by investment bankers and lawyers. In 2006, they found the sub-prime mortgage market collapse was an accident waiting to happen. By the time the ?teaser? rate period expired, US interest rates had gone up. Mortgage rates also moved up. In December 2006, evidence of the collapse hit the attention of investment bankers and, from January 2007, capital started fleeing developed financial markets to emerging markets. The flight from US dollar by Wall Street insiders hit everybody?s attention.

None in global financial markets was prepared to lend to institutional investors suspected of holding huge amounts of infected mortgage securities in their investment portfolio until last September. Lenders in financial markets have been literally hoarding cash shunning needy financial institutions as if they were sub-prime lepers. The inter-bank markets in the US, UK and Eurozone were starved of liquidity. And a liquidity crunch affected most Western financial markets. In the wake of successive defaults, regulators and central banks have discovered in the past months, to their dismay, that respected financial emperors have no clothes.

● It is argued that central banks could avert the market turmoil by providing liquidity on a timely basis. The resulting credit crunch aggravated the crisis. Do you agree?

In good times, financial markets embrace Capitalism. In bad times, they rediscover Socialism. Central banks provide liquidity to banks. It is not their business to provide capital to banks. Central banks? money is taxpayers? money not meant to be thrown away to reckless players partying in good times. It is a tool like a Swiss army knife that can be used in many ways for many purposes. Good central bankers use this money for good purposes to meet good ends.

It is difficult for any outsider who has no access to the balance sheets of the financial institutions to get into a blame-game show. Various economists and players have given interpretations to the ongoing turmoil. Take the case of Northern Rock, the fifth biggest UK mortgage bank. It had relied heavily on the inter-bank market for short-term funds. One basic principle taught to bankers is that no bank should borrow short to lend long. Northern Rock ignored this tenet; once market players suspected it had infected assets in its balance sheet, no one was prepared to lend to that bank. Both in the US and in Europe, banks suspected each other of having loads of infected assets. Lending and borrowing on the inter-bank market virtually stopped. Banks, like Northern Rock, got choked.

The outside world does not know if the bank has incurred massive losses and may have eroded its capital. One would not expect the Bank of England (BoE) to provide capital to an ailing bank. There is a difference between liquidity and solvency. The BoE refused to extend a lifeline to the bank. I guess Mervyn King, the Governor of the BoE, must have had in mind that the BoE or any other central bank is not a lender of the first resort but a lender of the last resort. He put forward a solid argument concerning moral hazard : in a deregulated financial market since Margaret Thatcher, you have conducted your business recklessly. And you have to pay for it. The Governor?s stand was sound: he severely punished one reckless player to eliminate the problem posed by moral hazard.

With my own problems in regard to the BoM Bill in 2004, I?ll share the outcome of the Treasury Select Committee long-awaited report on Northern Rock. The recent proposal to grant the Financial Services Authority (FSA) greater regulatory powers and marginalize the BoE was rejected last week by an influential group of UK MPs. John McFall, the Committee Chairman, said, ?The FSA appears to have systematically failed in its duty?? Vincent Cable, Liberal Democrat spokesman, let loose: ?The FSA has failed in every test since it was set up.? Mervyn King?s stand was qualified as ?Victorian? in its severity. John McFall mentioned: ?Banks should be allowed to fail to ensure market discipline, but only in an orderly manner.? Good red meat ? at least for me.

● Why are central banks unable to assuage the crisis?

It is not a question of central banks?ability to tackle the debacle or not. In January 2007, no central bank realised the gravity of the problem. It was considered a minor one that could be solved through usual market correction mechanism. Within weeks, what appeared as a small local problem had metastasized into a global one. US financial markets clamoured for liquidity. The contention was that a liquidity crunch would lead to a credit crunch causing a drastic slowdown of the US economy growth rate. The Federal Reserve System provided the liquidity. The Fed, followed by the European Central Bank, including the BoE, have lent out billions of dollars.

The crisis is aggravating and part of it is uncertainty. No central bank knows its depth. The US$1-2 trillion of assets that banks had parked off-balance sheets are gradually coming back into their balance sheets. Banks must find the money for this and the capital to cover the losses. No one knows the number of casualties. Over the hundred significant crises in the last three decades, this one seems the most serious.

After all, central banks must consider the implications of massive refinancing. No central bank would keep injecting liquidity in a system already flushed with excess of it. Don?t forget that successive years of massive US trade deficit have flushed the international monetary system with amounts of dollar liquidity. The state of liquidity today resembles the Bretton Woods System breakdown in the late 60s. What we see today is a repetition of unpleasant events. Decades ago, Richard Nixon?s Treasury Secretary, John Connolly, told the Europeans that the dollar was ?our currency, but your problem?. That was in the days when the US had a positive trade balance. Now it needs US$3 billions in foreign money daily to finance its trade deficit. Its weakness is a problem for the rest of the world...

The collateral damage could be very serious. In market conditions already flushed with liquidity, the dangers of a liquidity boom in the world?s monetary system cannot be taken lightly. The chaotic ?butterfly effects?, in which tiny perturbations are amplified into financial cataclysms, have made monetary management very tricky...

● Do you mean that bankers have been doing bad banking?

Indeed, yes. This debacle should serve some good lessons to those implementing Basel II. The focus of banking regulation and supervision is too biased towards capital against liquidity. Before the debacle, a survey of the world?s 59 biggest banks revealed that liquidity risk has been given less importance than market risk, operational risk and credit risk.

The present turmoil has led to the demystification of excessive reliance on mathematical-statistical models. We are reminded of the famous theorem in IT ? ?garbage in, garbage out?. Perhaps Basel III, after the present crisis, will take care of liquidity, appropriately.

● How do you see the local housing market? Could we face a similar situation?

Mortgage loans by banks and insurance companies in Mauritius are mostly to prime borrowers. Banks are more than prudent with mortgage loans for residential buildings ever since the BoM created a reoriented regulatory and supervisory framework in 2000. We fixed the roof when the sun was shining. The sale by levy problem relates mostly to loans made before this framework.

The sub-prime borrowers are mostly with the National Housing Development Company - if I?m not mistaken - and with the Mauritius Housing Company. They are subsidized by Government ? under the Welfare State philosophy. From the standpoint of regulation, the authorities should have a good insight into the financing technique of Integrated Resorts Scheme (IRS) and risks, if any, associated with it. Whatever be the case, stress testing of the banking industry should be regularly carried out.

As regards possible market turmoil in this segment of our economy, I?d rather go along with the Chinese poet, Lao Tzu: ?Those who have knowledge don?t predict. Those who do predict don?t have the knowledge. We have excellent world financial market analysts, but very poor prophets.?

● In your opinion, will the crisis end soon?

The worst is yet to come. It will take a few years. Investment banks have issued US$500 billion in debt obligations linked to mortgages in 2006 and the first half of 2007. The bulk of mortgage securities has not yet recorded significant losses. They occur only when residential buildings are foreclosed and sold. Two years can pass between a borrower falling behind on payments and the property auction. It is only when the property is sold that a loss is recorded. So the crisis could continue for some time with unpleasant consequences for the US economy.

● What could be the size of total sub-prime losses?

I don?t think anybody in the world has even an approximate figure. Last July, the Fed Chairman had put the figure at $100 billion, private sector economists at $150 billion and a New York firm the range of $150 to $346 billion. The debts have been piling up faster than plastic garbage bags in landfills. Many streets in the US are blighted with houses for sale. There is no buyer. Prices will go down further. This means heavier losses than one would imagine. It is only when the tide goes down that financial markets will discover the players who have been swimming naked ? and how many corpses there still are in the financial markets.

● Do you think this crisis can harm our banking industry?

Billions of dollars are fleeing developed financial markets to emerging markets. I fear the eventual adverse impact of short-term speculative capital inflows resulting from the crisis. Otherwise, I don?t think our banking industry has anything to do with this crisis. Possibly high-rate-of-return-seeking Mauritians, who have invested in mortgage-related securities through their banks-agents, may have incurred losses. Those securities, like all investment instruments, have travelled far away from their place of origin to world financial markets. It is thus difficult to make an exact assessment.

The sub-prime mortgage debacle is a reminder of the ?lend now, collect later? mentality that pervades the highly competitive banking industry globally. You might recall how pervasive this mentality was in the late 1980s and 1990s in our banking industry. The regulatory and supervisory framework set up in 2000 gave a powerful wake-up call to our bankers. I believe J. P. Morgan?s dictum, ?first class business done in a first class way? is now the pervasive business method in our banking industry.

By the time I left the BoM, the financial soundness indicators of almost all our banks had improved to comfort zone since the end of 2000. I don?t have any idea of their state now. But we should keep a vigilant eye on short-term capital inflows. My worksheet gives an estimate of at least US$250 millions of such investment in Mauritius. It could be more. Moreover, IRS promoters seem to have contracted foreign currency borrowings. Such borrowings could impair our financial stability in the medium term. That?s why I believe we should keep our eyeballs focused on the short-term external liabilities of our economy.