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UFO: Unidentified Financial Obligations.

  • Written by Syndicated Publisher 50 Comments50 Comments Comments
    October 13, 2011

    That is Unidentified Financial Obligations. According to Hernando de Soto, a Peruvian economist (I wrote about him earlier this year) and the author of The Mystery of Capital, the root of the current financial crisis was the inability of financial institutions to trace back loans and other financial obligations to their proper owners. As the tranching, slicing, dicing, pooling and reselling of complex financial obligations (created through the use of derivatives and special purpose vehicles) grew, the complexity of the “ownership” question grew likewise.

    Not only these securities were most often owned by multiple owners, but what they owned and what their obligations were, was also totally unclear. Moreover, untangling the web of transactions to trace these back to the original borrowers and, from there, reconstructing the ownership structure and the obligations of each party in the strings of transactions that followed, was both a useless and an impossible task. Without clear ownership and obligations in case of default who would want to buy these securities, even at a discount?

    It is this reality (basically the total absence of formal financial instrument property rights) which slowly sank into the heads of market participants in 2007 and 2008. As early as the Spring of 2007, some insiders saw the writing on the wall. The system held its breath until it blew up in October 2008 when it became obvious to enough people that there would not be a short-term solution to the problem. This interim period allowed a few to make a fortune and many to run for cover.

    De Soto’s thesis is that establishing clear property rights is a necessary condition for economic development to occur. It is a view that the economist has held for decades. Hernando de Soto burst onto the scene with another book, The Other Path, written in 1986 in Spanish; the path breaking piece was published in English in 1989. In that book, de Soto explained how the lack of property rights was inhibiting economic development in many emerging countries. The prescription he offered was therefore to properly structure property rights in order for financial insitutions to be able to lend against “formalized” assets and thus enable them to play their crucial role of providing entrepreneurs with access to capital.

    The book helped him lunch a very successful consulting career with governments in Africa, Asia, Latin America and the Middle East; at least with government leaders who understood the need to create properly functioning markets for their economies to develop.

    Basically, we are back to the same issue today. But the lack of property rights has now become a problem in the developed world. Without being able to correctly attribute the property of financial obligations to their proper owners, we ended up in a huge liquidity crisis as no one was ready to buy assets for which owners and obligations were unknown. The situation created such a profound crisis that it almost brought down our financial system. In fact, it would have collapsed had the authorities not intervened to plug the hole created by the knowledge (i.e. property rights) gap.

    By playing the role of universal lender of last resort, the central banks of the world temporarily removed the need to know precisely the information about the ownership of the financial assets; they basically took the risk of owning these “fuzzy” securities. However, as the central banks tried to pull away from providing life support to the financial system, the patients proved to be too weak to survive on their own.

    This is mainly why all the liquidity injected into the system has not been sufficient to ignite the engine and convince banks to return to the business of creating credit by making loans to private businesses. Until we untangle the property rights mess, we are likely to remain with an ineffective financial system. Banks might appear stable today but they are likely to be unable to play their expected role as financial intermediaries as long as this issue is not resolved.

    Securitisation was a breakthrough innovation and it proved very good at distributing risks into the global system. It was supposed to prevent the concentration of risks into a few hands and make the whole system less risky. However, its biggest drawback was probably that it removed incentives to trace back loans and financial obligations to their proper owners at each step of the transactions that took place as these loans were repackaged and sold many times over.

    In retrospect, given the magnitude of the financial crisis, this was a huge mistake on the part of banks and regulators. But as market participants thought that they could sell their risky assets to someone else relatively quickly in a liquid market, their incentives to keep track of the information on ownership and obligation were indeed very small. The game of musical chair continued, unsupervised, until the system collapsed when liquidity dried up. Regulators and rating agencies really failed here.

    Here is the piece, The Cost of Financial Ignorance, published in the Washington Post last week:

    Federal Reserve Chairman Ben Bernanke said recently that, given the ongoing credit contraction, “advanced economies like the U.S. would do well to re-learn some of the lessons” that have led to success among emerging market economies. Ironically, those economies in the 1990s accepted 10 points for promoting economic growth that were known as the “Washington Consensus.”

    Advanced nations seem to have forgotten Point 10 of that consensus: how important documenting assets and transactions is to the creation of credit. Consider that most private credit is made up not of bills and coins, anchored in bank reserves, but in papers that establish rights over the assets, equity and liabilities that guarantee loans. Over the past 15 years, however, as they package, bundle and resell securities, Americans and Europeans have gradually undermined the reliability of the records that guarantee or make credit trustworthy — the deeds, titles, liens and other documentation that establish who owns what and how much, and who holds the risks.

    Not having reliable information reduces confidence, which in turn leads to credit contractions, fewer or smaller transactions, and declines in demand. And these cause employment and the value of assets to fall.

    The majority of us in emerging markets know this firsthand, having lived in a chronic credit contraction. To understand why there is no credit without truth, you need only walk down certain streets — the businesses that cannot get significant credit are those in the informal economy, where assets and transactions are not legally recorded and are therefore unknowable.

    When property is poorly documented, markets don’t get the information needed to connect assets to finance, and governments don’t obtain the data required to detect which connections have gone awry and how to fix them. This became obvious in 2008, when a relatively small number of subprime homeowners’ inability to meet their mortgage payments ultimately triggered a global financial crisis. The world was surprised, and terrified, because no one seemed to see the connection.

    The initial reaction three years ago was swift: The U.S. Treasury secretary created the Troubled Assets Relief Program to prevent a run on banks by purchasing the derivatives that financed the subprime mortgages. But officials realized within days that they couldn’t locate the assets or find criteria for pricing, buying and then removing them from the market. Given the lack of hard information, they improvised, using the TARP money to bail out the owners of the assets.

    But finance wasn’t always this way. The connection between knowledge and credit was valued in the United States as far back as Thomas Jefferson’s day. During the Panic of 1819, the former president wrote in a letter to Richard Rush of his “despair” that finding the truth about how to stop credit from expanding and suddenly contracting would require “more knowledge of political economy than we possess.” He warned that U.S. citizens “had suffered themselves to contract . . . in debt,” that the nation was awash with “fictitious capital,” and that all this new credit and capital exceeded “the measure of our own wants and surplus productions.” Jefferson understood the dangers of overleveraging — and the “toxic assets” of his time — and that the way to get the information he needed was to connect finance and investment to “real capital and the holders of real property.”

    For hundreds of years, the United States and Europe gathered and classified all that paper in publicly accessible records, from deeds and registries to balance sheets. Originally created for recording ownership, these data systems were gradually adapted to serve all legal interests and relationships linked to property. Credit and debt could be measured, risk and potential inferred. Matching capital and finance to property made it easier for liquidity to move in step with the general interest. This knowledge served the West phenomenally well: Since World War II, Western economies not only avoided major contractions but also grew more than in the previous 2,000 years.

    Until 2008 — when we found that those systems had stopped telling the truth.

    TARP authorities couldn’t locate knowledge about toxic assets fast enough because so many non-standardized types of records were scattered around the world. U.S. property and mortgage transactions records became obscured when companies were permitted to raise large amounts of financing by “bundling” mortgage loans into marketable liquid securities and recording these “derivatives” not with the traditional public registries but with the Mortgage Electronic Registration Systems, a private company whose registry reportedly holds about half the mortgages in the United States.

    These derivatives had a notional value of $600 trillion to $700 trillion — 10 times the amount of global annual production. They are still outside any property memory system.

    After hundreds of years of clear, reliable information on balance sheets, newer policies allowed companies to engage in off-balance-sheet accounting, effectively permitting them to appear more profitable than they really are. Information on debts is passed to the ledgers of “special-purpose entities” (SPEs) – think Enron, which had more than 3,000 SPEs — or swept into illegible footnotes. More broadly, national balance-of-payments accounts were supposed to signal facts regarding financial capital and transfers and debt. Yet no one saw the Greek or Italian sovereign debt crises coming because governments made their fiscal status look rosy by using new financial devices to swap their debts in one currency for another. An old debt looked like an inflow of new money.

    We reformers in emerging economies have struggled for the past two decades, as Bernanke noted, to get our people and their assets onto the books, searching for and — whenever possible — incinerating fictitious capital to bring swarms of citizens living in economic anarchy under the rule of law.

    We learned this from you, that the main source of credit is not money but the “moneyness” of property documentation. All financial activity must be documented if trust is to be regained in paper and, ultimately, in markets.

    From The Sceptical Market Observer: De Soto on UFOs.

    Images: Flickr (licence attribution)

    About The Author – Luc Vallée

    Currently President of The Independent Market Observer. Chief Economist and Vice-President at the Caisse de dépôt from 2001 to 2008. Chief Financial Officer and Vice-President, Corporate Strategy for Mediagrif Interactive Technologies from 1999 to 2001 – MDF.TO. Deputy Treasurer at Canadian National Railways, 1997-1999. Associate Professor of Applied Economics at l’École des Hautes Études Commerciales (HEC) in Montréal, 1989-96. Consultant for the World Bank, the Canadian government, the Quebec government and the City of Montreal. Deputy director of the Center for International Studies, 1993-1996. Adviser to the investment banking division of Société Générale in Canada, 1996. President of ASDEQ in 2005-06. Member of the National Statistics Council of Statistics Canada, 2008-now. Ph.D. (1989) in economics from the Massachusetts Institute of Technology.


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