BT: Crises of '97 and '08: lessons to be learned (23 Sep 2008)

Crises of '97 and '08: lessons to be learned

Interestingly in both cases, there are fire sales that make some smile

By BERNARD YEUNG

THE world seems to have a major financial storm once every decade. In 1997, I was in the US, saddened by the Asian financial crisis. Fast forward, today, I am in Singapore, saddened and hurt by the US financial crisis that started with the sub-prime mortgage lending and the bursting of the US housing bubble in 2007.

We can take turns to mock each other for the exposed weaknesses in the financial markets and institutions. But, that should not be the point. The two storms have a lot of similarities and we can learn from them.

First, investors were blindfolded. Distant investors relied on rating agents which failed them. In the current US crisis, rating agents gave credit ratings based on the investment bank's past records but did not adequately reflect the risks in the bank's new activities, such as the peddling of sub-prime mortgage payments.

In the Asian crisis in 1997, credit ratings were built on gross macroeconomics information and did not adequately reflect the actual risks of underlying activities.

Moreover, the blindfoldedness stemmed partly from the lack of transparency. Investors, and rating agents, would not make systematic mistakes if they knew what they were getting into.

Many blamed the Asian financial crisis on the lack of corporate transparency. The inadequate public knowledge of what is really on the book in some investment banks serves the same purpose.

It is interesting why the rating agents keep failing us. Is it a matter of lack of competition amongst them? Or, is it an innate problem that new things are too challenging for old monitors?

Second, poor corporate governance is an issue. Investors are aware that smart investment is guided by more than just public information. That is why expert intermediaries are needed. Pension fund managers, investment bankers, insurance companies, private wealth managers, etc, are supposed to serve. In both crises, many of them failed in carrying out their fiduciary duties.

These intermediaries have not done their jobs, so ordinary investors lost. I suspect corporate governance is the key reason why some banks stay strong and cash- rich while others are at the brink of failing.

There is an additional level of breakdown in corporate governance. In the Asian financial crisis, a breakdown in corporate governance at some Asian family pyramids and conglomerates is well known. In the current crisis, there is an obvious breakdown in the corporate governance of some investment banks.

They over-sold securitised sub-prime mortgage payments at an inflated price, which failed to reflect the underlying default risks. They pocketed the fees but did not attend to the banks' actual risk exposures. Clearly, both reflect the 'other people's money' mentality.

Third, both crises were preceded by a period of excitement, which led to bubble- ish excess investment. Asians are familiar with the excessive construction in Bangkok, Jakarta, Seoul, etc and the overrated economic performance of various countries back in the 1990s. But, the key is that earlier economic development in the region is genuinely exciting. The early birds claimed the early profits. Later, investors got over-excited by the observed successes and then over-invested.

The concept of diminishing returns dimmed in their minds. In the US, housing construction, home ownership, and house prices surged before the crisis too. But the fact that the US had a long, sustained period of stable growth excited investors, the dot.com bubble notwithstanding.

Like the Asian situation at the beginning, the growth was justified - there was the new information technology that created many innovations. Getting too used to good returns, investors over-invested, forgot about diminishing returns, and then over-traded on what was not there.

Both the Asian and the US crises therefore illustrate the formulae of a financial crisis. Justified early excitement based on real economic fundamentals attracts blindfolded investors who then over-trade and fall victim to poor corporate governance. A bubble is generated, it bursts, investment is wasted, and the aftermath takes years to digest.

Calming the jitters

Interestingly in both cases, there are fire sales that make some smile. It is well known that some Asian production facilities were sold at bargain basement prices. We currently see fire sales of US brandname financial institutions, some to non-US firms. In both cases, there are people who prey on ailing companies. In New York, there is now a serious investigation on strange short-selling. The over-excitement leads to the over-trading that eventually bursts into a ball of destructive fire. Then raiders of the ruins come.

Inevitably, investors herd after exciting news and may make mistakes. We cannot easily contain that, maybe we don't even want that. But, we can reduce the chance of them falling victim to greedy people. The same old advice applies - we need better transparency and better corporate governance. Yet, these are longer-term strategies. What should we do in the interim?

The Asian financial crisis did not cause the US much grief; as the Asian economies were then relatively small. The current US financial crisis, however, is much bigger because the US is much bigger. The US crisis could be a global economic nightmare.

The expected slowdown in US consumption will negatively affect us. But, that is not likely to be huge. Take China as an example, it exports about 10 per cent of its GDP to the US. A 10 per cent slowdown in the US will only hurt China by one per cent, not counting the multiplier effect. Indeed, there will be substitute locations and markets for goods originally intended for the US.

The more severe concern is the global credit crunch following the crisis. Locations like Singapore appear to be all right. But, some other locations appear to be significantly affected. We ought to be cautious and take steps to avoid a prolonged credit crunch so that our investments are not choked. Credit crunches are based on fears that financial institutions are not reliable. Savers do not give them money and so they have no money to lend.

The key is to alleviate the fear. Financial institutions should volunteer to make clear what they have suffered and recognise the losses.

The Japanese financial firms' coming out action in this regard is the right move. Indeed, in recent days, messages from various banks are clearly aiming for transparent revelation.

Asian economies should seize this chance to strengthen their inter-reliance on one another's consumer and credit market. It could, at the end, strengthen Asian development and her global economic presence.

The writer is dean and Stephen Riady Distinguished Professor of Finance, NUS Business School


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