4 The Global Financial Crisis of
4.6.3 Bank Behaviour and Risk Transfer through Securitised Credit
In a speech in January 2009, Adair Turner provided an insightful assessment of the effective- ness of risk transfer through securitised credit (Turner 2009). His perspective is as follows.
Securitised credit began to take off in the 1980s. A significant argument put forward in its favour was that securitisation would reduce risks for individual banks by passing credit risk to end investors, reducing the need for unnecessary and expensive bank capital. Rather than a regional bank in the US, for instance, holding a dangerously undiversified holding of credit ex- posures in that particular region, which created the danger of a self-reinforcing cycle between the decline in a regional economy and the decline in the capital capacity of regional banks, it was much better to package up the loans and sell them through to a diversified group of end investors. Securitised credit intermediation could reduce risks for the whole banking system, since while some of the credit risk would be held by the originating bank and some by other banks acting as investors, much would be passed through to end non-bank investors. Credit losses would therefore be less likely to produce banking system failure. However, that is not what happened. When the crisis struck, and as figures from the IMF Global Financial Stability Report of April 2008 made clear, the majority of the holdings of securitised credit, and the vast majority of the losses which arose, did not lie in the books of end investors intending to hold the assets to maturity, but on the books of highly leveraged banks and bank-like institutions.
17The risk-free interest rate is the theoretical rate of return of an investment with zero risk, including default risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a given period of time.
Table 4.1 Predatory lending
Forms Explanation
Excessive fees Frequently charging fees totalling more than 5% of the loan (on competitive loans fees of 1% were typical).
Abusive prepayment penalty A prepayment penalty, a fee for paying the loan off early which was typically effective for more than 3 years and/or cost 6 months’ interest (80% of subprime mortgages carried a prepayment penalty, in the prime market only about 2% carried a prepayment penalty).
Higher interest rates Selling mortgages with an inflated interest rate (i.e., higher than the rate acceptable to the lender). Some lenders incentivised brokers to sell this type of loan by paying them a “yield spread premium” as a reward for making the loan more costly to the borrower.
Loan flipping Refinancing a loan to generate a fee income without providing any net tangible benefit to the borrower. This practice is called
“flipping” a borrower.
Steering and targeting Steering borrowers into subprime mortgages even when the borrowers could qualify for a mainstream loan (i.e. one with more favourable terms).
Mandatory arbitration Not permitting borrowers to seek legal remedies in a court if they find their home is threatened by loans with illegal or abusive terms (i.e., increasing the likelihood that the borrowers would not receive fair and appropriate remedies in case of
wrongdoing).
Targeting vulnerable borrowers Deliberately targeting senior citizens and low-income borrowers with low levels of education and little experience of mortgages to deliberately place them in unnecessarily expensive loans. In 2005, 40% of mortgage loans taken out in Latino communities and 50% in African American communities were subprime.
Costs Making mortgage payments seem artificially low by omitting to declare that quoted mortgage payments exclude property taxes and insurance.
Adjustable-rate loans Not explaining to ARM subprime borrowers that loan payments would rise significantly when they reset.
Sources:US National Association of Consumer Advocates and US Centre for Responsible Lending.
4.6.4 “Group Think” and Herd Behaviour
When the credit crisis unfolded there was a desperate search for the causes. Naturally board performance came in for close scrutiny. Shareholders of failed or failing companies wanted to hold responsible director’s “feet to the fire” and understand why corporate leadership had failed so spectacularly. From the findings of the numerous reviews of the crisis, it is abundantly apparent that board decision making was poor – and in the case of Northern Rock “reckless” (House of Commons 2009). While numerous recommendations have been made about the appointment, experience, induction, availability and evaluation of board mem- bers, the process that boards should adopt for decision making has received scant attention.
However, what brings boards and companies down is dysfunction within their social system (Cairnes 2003).
The Global Financial Crisis of 2007–2009: A US Perspective 73 Boards are fraught with extensive interpersonal dynamics, like any other group of people (Carver 2006). Optimal board performance occurs when chairmen understand group dynamics and foster openness and debate to reach informed decisions. People differ in their comfort in confrontation, their ability to express their point of view and the personal agendas they bring to a meeting. The human social dynamic within a group of individuals sees individuals agreeing to, or failing to oppose, a group decision even though they are not satisfied with it (Cairnes, 2003). Such dysfunctional boards can fall into “group think” where members reach a consensus without critically testing, analysing and evaluating ideas. This is a form of herd behaviour that tends to be more problematical within institutions. The term “group think” was coined by psychologist Janis Irving in the 1970s. It was adopted to describe the process in which a group can make irrational or bad decisions as a result of each member of the group attempting to conform their opinion to what they believed to be the consensus of the group. It can be argued that “group think” can occur on two levels: members of a group (a board), and a group within multiple groups (boards within a specific industry, sector or market).
Atboard level, when this group dynamic is present, independent thinking is sacrificed in pursuit of group cohesiveness. Members of the group impose self-censorship, succumbing to direct pressure to conform to avoid being considered disloyal. Irving discovered this behaviour during a study of military disasters and found that there were people in decision-making groups who believed that the group was making the wrong decision and had the information to support that belief (Irving 1971). The information was not tabled or, when it was tabled, was put to one side. Individuals did not fight for their point of view of even press their evidence for that view. He discovered that when this group behaviour was present there was an “us-and-them”
mentality, a view that meant that each group member was either “with us or against us”
(see Box 4.2). During the financial crisis, full-time board members or NEDs may have been reluctant to act according to their own information and beliefs, fearing that any contrarian view may damage their standing and relationship with fellow board directors. Hence, directors will
“follow the herd” if they are concerned about how others will assess their ability to make sound judgements. Human social relationships are a key determinant in decision-making processes.
The prevalence of emotional factors in corporate success and failure means that they should be recognised as being at the heart of boardroom leadership and effectiveness (Lees 2010).
Lessons should be learnt from the corporate crisis in which such behaviour played such a decisive role.
Box 4.2 Group dynamic behaviour Lehman Brothers
An example of group dynamic and emotional boardroom behaviour was exhibited by one of the most prominent banking personalities, Dick Fuld, CEO of Lehman Brothers. In forming his executive committee in 1996, “Fuld quickly instituted an ‘on-the-team-or-off’ mentality at Lehman” (Fishman 2008). This behaviour had striking similarities with Irving’s findings (see above). A colourful description of Fuld’s behaviour is provided by Andrew Gowers, a former editor of the London Financial Times, who in 2006 joined Lehman Brothers in London as head of corporate communications. Gower described him as a “textbook example of the command-and-control CEO” who “inspired great loyalty and on occasion
great fear” (Gowers 2008). Describing Lehman being “at war” in the market, Gowers said
“his ferocity could be intimidating, his eyebrows beetling over his hard eyes, his brutally angular brow appearing to contort in rage. Even when in a relatively upbeat mood he seemed to take pleasure in violent imagery.” The most revealing aspect of Gowers’s article is his assessment of the operation of the board. “Here was a corporate governance structure almost pre-programmed to fail: an overwhelming CEO, a top lieutenant (Joe Gregory) eager to please and hungry for risk, an executive team not noted for healthy debate and a power struggle between two key players. Furthermore, the board of directors was packed with non-executives of a certain age and woefully lacking in banking expertise. It is small wonder that Lehman was so ill-equipped to recognise and adjust to the changes in the environment that were dramatically signalled by the collapse of Bear Stearns in March this year.”
Atcorporate level, when this group dynamic is present, participants in the same market are seen to be exhibiting identical behaviour. As the scale and widespread nature of the financial crisis became apparent, particularly the common acute problems of illiquidity and capital inadequacy of banks investing in the same markets, it has been suspected that forces were present which had led to both excessive and identical “group thinking”. While it was initially assumed that investment decisions had reflected rational behaviour based on an assessment of all available information in an intelligent efficient manner, a contrasting view evolved. It is believed that at times investment was driven by group psychology which weakened the link between the rigorous assessments of data and informed rational decision making. Board decisions were not made in a vacuum. They will have been keenly aware of the investments of their competitors, and the profits being realised as a result of those investments. It will have been impossible for them not to be influenced by banks in the same market. If the first investors in a new class of assets profit from rising asset values, as other investors learn about the innovation, more may follow their example, driving the price even higher as they rush to buy, in hopes of similar profits. If such “herd behaviour” causes prices to spiral up far above the true value of the assets, a crash may become inevitable. If for any reason the price briefly falls, so that investors realise that further gains are not assured, then the spiral may go into reverse, with price decreases causing a rush of sales, reinforcing the decrease in prices.