Monday, 4 July 2011

Sausage factories

I'm aware that most of my posts so far have talked mainly about the way the UK retail banking system works and its role in the financial crisis of 2008. It has not escaped my notice that the US retail banking system is very different, but I must admit that until a recent twitter conversation with Cate Long I hadn't realised just HOW different it is. In particular, the US mortgage market operates in a fundamentally different way from the mortgage market in any other country - and that very different model was at the heart of the financial crisis not only in the US but throughout the Western world.

I'm also aware that some of my blogs get quite technical and they aren't always jargon-free. And the way the US mortgage market works is complex and hard to get your head round without illustration. So I thought I would describe it in terms of something much more familiar. I'm going to talk about sausages.

Imagine there are a hundred small farms all producing various varieties of meat - chicken, lamb, beef, pork.  They sell some of their meat locally, but most of it is bought up by two huge processing plants.  These processing plants dump all the meat, irrespective of its type, into huge vats, where it is boned, skinned and minced.  It is then processed into sausages, which are packed up and sold on to domestic supermarkets and exporters.  The exporters repackage the sausages under their own labels, taking some of them apart and creating new sausage-based products such as tins of baked beans with sausages in, tinned sausage stews and frozen sausage pies.  Many of these repackaged sausages are exported, particularly to the UK and European countries where sausages and sausage-based products are popular because they are cheap and tasty.

Sounds like a really good, sound international industry, doesn't it? What could go wrong? 

The meat that is produced is of course inspected by meat inspectors to make sure it is fit for human consumption before it is sold.  And in the past the standards were high and quite a lot of meat didn't pass the test.  This annoyed the farmers, because they couldn't get rich from farming, and it annoyed the factories, because they couldn't get enough meat to satisfy their international customers.

One day an enterprising farmer had a moan at the meat inspector about the meat standards and the fact that so much of his meat was only fit for pet food. To his surprise he discovered that the meat inspector agreed with him. So between them they came up with a scheme whereby some of the meat that should be condemned would actually be marked as "fit for human consumption" and sold at the higher price.  Not all of it, of course - too much and questions would be asked.  But enough to give a nice little boost to farm profits. The meat inspector got a cut of the proceeds, of course. 

The farmer told his (equally frustrated) farmer friends about his friendly meat inspector. And the meat inspector told those of his colleagues he knew held similar views to him on the stupidity of meat standards. And before long, several farms were working with helpful meat inspectors to pass on some meat as "fit for human consumption" when it should have been condemned. 

Well, the inevitable happened, of course. There was a massive outbreak of E Coli, initially in the UK and then in the US and various European countries. Hundreds died, and thousands more were very ill. Hospitals were unable to cope with the influx of sick people, and nurses and doctors worked around the clock but were still unable to treat everyone. Stocks of medicines ran out.  Businesses lost money and many went bankrupt because so many of the workforce were ill. Governments declared national emergencies and asked unaffected countries for financial and medical assistance. It was a major global disasater. But no-one could work out where it had come from.

The obvious culprits initially seemed to be the export firms.  After all, they were doing major repackaging and reprocessing operations: maybe some of their practices were a bit dodgy. And investigations discovered that that was indeed the case.  Some of the export firms were adding potentially lethal substances to their products to make them look more attractive to housewives. And consumer watchdogs, noticing the pretty packaging, attractive colour and pleasant smell, were giving them top-notch approval ratings, which encouraged more consumers to buy the products.  But if that was the only cause, how come people in the US were dropping like flies when all they had bought was sausages?

All the way down the line, companies involved in meat reprocessing were going bust. People just weren't buying sausages and sausage-related products any more. The export market collapsed. It was a major disaster for the industry. So the government stepped in to provide financial support to these companies so that they could find alternative suppliers and rebuild their shattered reputations. The largest amount of support went to the two giant factories.

Government investigators soon realised that although the export companies were making matters worse by their use of toxic substances in reprocessed products, they weren't the source of the E Coli outbreak. So they looked at the two sausage factories. Everything looked alright there - the factories were clean and hygiene standards were good. So they started to look at the farms themselves. And it soon became apparent that all was not well. Some of these farms had poor hygiene and animal welfare standards, others had untreated TB in cattle and there was an outbreak of swine fever in one area.  All of these should have reduced or stopped the sales of meat from those farms - but it hadn't. Eventually, after much snooping and undercover work, the investigators started to expose the collusion of some farmers and meat inspectors. Prosecutions followed, of course.  Interestingly, in the course of one of those prosecutions it emerged that both the factories had known about the public health risk and turned a blind eye.....they were only too happy to have the additional meat so they could produce more sausages.

The underlying problem was, of course, fraud.  But had the meat that should have been condemned only been sold in local markets and not passed on to the factories, there would have been small local outbreaks of E Coli which would have been easily contained and the culprits identified and prosecuted quickly.  Because it was sold on to the factories, which mixed it up with good quality meat and repackaged it, it went EVERYWHERE. Every sausage produced by the sausage factories was potentially a public health risk. And there were millions of them, and they were sold all round the world. So what started as a small-scale scam by a few disgruntled farmers and unscrupulous meat inspectors became a global public health disaster. It took years for the economies of the countries affected to recover. And the people who lost loved ones, or who were scarred by their illness, will never recover.

It's a horrible story, isn't it? Fortunately it has not happened. Or has it? Try substituting "mortgage" for "meat", "RMBS" for "sausage" and "financial" for "public health" in the above tale and see what happens.....

9 comments:

  1. It's a nice analogy. But it's left out the tranches of the RBMS.

    Yes, securitisation, pooling etc. Then the slicing and dicing. One trance, the "equity" tranche, would take the first losses from the pool. These were sold at a low price. Then all the way up to the AAA tranches. These only started to lose money when all the lower tranches were wiped out.

    The differentiation into dog food and filet steak happens, in these pools, after the mixing, not before. What killed the banking system was two things.

    1) They weren't supposed to hold the AAA tranches themselves. They were supposed to sell the filet on to the restaurants, the insurance and pension funds. Yes, there would still have been losses there, but not systemic collapse, because those ins and pension companies are not leveraged, unlike the banks.

    2) There never had been a general decline in US house prices. Regional, yes, but never a nationwide one. So no one thought that national house prices could be so correlated.

    However, they were.

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  2. Interesting comments, Tim.

    I'm aware of the RBMS tranching but didn't want to add complexity to a blog that was only discussing the role of the US mortgage system in distributing toxic debt around the world.
    Yes, the actions of investment banking made matters much worse. But dog food should never have got to the factories in the first place. Because it did, "prime US beef sausages" sold in Fortnums and Tescos value sausages were equally poisonous. So although the reprocessing of toxic debt allowed banks and investors to believe that Fortnums sausages were completely safe and Tescos sausages very dodgy, in fact the whole lot were only fit for rendering down for glue.

    The proximate cause of the banking crisis is indeed the behaviour of investment banking and the general failure of financial institutions to manage risk. But the ultimate cause in my view is the extensive mortgage lending fraud in the US that is now coming to light. And the US mortgage system itself disguised that fraud and exported the ensuing toxic debt to the global investment banking industry.

    I have promised various people a blog or two on the failures in investment banking though!

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  3. Frances,

    As one who has no financial acumen - who, in fact has great difficulty managing his own in/out transactions - may I say I find your 'simple' explanations of matters financial - viz-a-viz our country's woes - extremely helpful!

    Keep up your good work. Of late you have provided a 'Cuppola' good posts!

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  4. Oh dear - buggered that pun up! Shud have read 'Coppola' good posts!

    Hey ho.........

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  5. "But dog food should never have got to the factories in the first place. "

    Ah, no. The tranches are a way of dealing with the dog food.

    Leave aside mortgages and fraud etc for a moment and think only of loans. To whatever: small companies, houses, property developers, credit cards, student loans, absolutely whatever.

    So, we know that some of these loans are going to go wrong. Doesn't matter how tight our underwriting standards are, some people are not going to, not going to be able to, pay these loans back.

    However, we don't know which ones.

    We could insist that those who make the loans hold them to maturity. OK, this has good effects (no dog food entering the system) and bad effects (anyone who might even just, maybe, default, ain't gonna get a loan).

    OK, *shrug*, there are no answers in economics, only trade offs. Maybe that's the trade off we want to make.

    Or, we can securitise and tranche these loans. We know that some will default. Not which ones, but some will. So, we bundle them all together and then parcel them out in tranches. Here's the dog food one: we still don't know which loans will go bad but you buyers of this "equity tranche" are going to take the loss of those who do default.

    You AAA people over here, you're the last in line to take the losses. You've got the filet. We don't know which loans are the filet, just that some of them are and you're the people who have those.

    This also has good effects (those who might default are more likely to get loans, we've placed the risk of default with the speculators who buy the equity tranches.....and yes, those sections really were bought by risk loving speculators) and it also has some bad effects (if we get the risk measurement wrong then those AAA tranches are also going to crater).

    Again, it's a trade off. There are no answers, only trade offs.

    Now, did they get this wrong on housing? Yup, they surely did. But the basic idea of securitisation and tranches, has this been disproved?

    Well, no, not really, for we still use it for student loans, credit card receivables, auto loans. A pension fund is exactly this in theory, diversifying across assets, knowing that some will go wrong but that in diversification there is safety. Heck, having a diversified portfolio is the same thing: we're all advised to have a little bit of risky stuff, a little bit of entirely safe and a spread of other assets in between those two extremes.

    There's nothing at all wrong with the principle of securitisation and tranching: it's exactly what we want to be able to do. By slicing and dicing risk we get to place the high risk stuff with people who are looking for risk and the low risk stuff with people who want low risk stuff. In the process we've reallocated risk (this is good) and we've also increased the mobilisation of society's savings: also good.

    That it all fell over in the mortgage market is true: but then so did the internet boom all fall over. And yet out of the internet boom we got Amazon, Google, etc.

    It really isn't securitisation as securitisation which was the problem. For we use it elsewhere without problems.

    It was this specific example of it that went wrong, not the basic idea itself.

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  6. All very true, Tim.

    I'm not arguing that securitisation was wrong, just pointing out that when there is excessive risk-taking and fraud in the lending system that provides "meat" to the securitisation process the effect is to distribute the consequences around the world, rather than containing it in one place.

    Securitisation is a perfectly reasonable way of distributing risk when your risks are normal. But when they aren't, because retail lending is taking huge risks and managing them poorly - or there is extensive fraudulent lending, as is evident in the US - the securitisation and tranching process creates a global disaster. That's not the fault of the securitisation process, but people talk as if it is. We hear a lot about needing to "protect safer retail banking from risky investment banking". In my opinion this is the wrong way round. The global investment banking system was nearly brought down by excessive risk-taking and fraud in retail lending on both sides of the Atlantic. Yes, the effects were inflated by investment banking practices. But the underlying cause was failures in retail lending.

    If we are to continue with a securitised lending model then the lending activity ITSELF needs to be better managed in order to protect the worldwide financial system. Tinkering with investment banking won't solve the problem. And nor will separating retail and investment banking.

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  7. The global investment banking system was nearly brought down by excessive risk-taking and fraud in retail lending on both sides of the Atlantic.

    Now that is very true and bears repeating. In fact, I'm sure I'll end up using that line myself somewhere or thrice.

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  8. So how many retail bankers have been prosecuted for fraud?

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  9. In the UK the CPS is currently considering prosecution of former (and possibly current) HBOS (Lloyds TSB) employees in relation to corporate lending fraud (ref. Ian Fraser). So far there have been no prosecutions for mortgage fraud.

    In the US a number of mortgage fraud cases of varying sizes are proceeding at the moment and well over a thousand people have been individually charged with fraud. Many of the companies charged are relatively small mortgage lenders but there are a few large ones - notably Deutsche Bank and Countrywide (now part of Bank of America), both of which settled out of court. The longest sentence handed down so far is 30 years for the ex-CEO of bankrupt mortgage lender Taylor, Bean & Whitaker. The Taylor, Bean & Whitaker case also implicates Fannie Mae and Freddie Mac, which appear to have known about the fraud but failed to report it to the authorities.

    Fraud appears to be endemic throughout the US mortgage market and there has been further fraudulent lending since the financial crisis. I think the American mortgage fraud scandal may well turn out to be the largest corporate fraud in history.

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