Saving New Bank From Failure

By TAN Kee Wee
(MediaCorp 938LIVE’s Money Talks on Thursday, 16 August 2007, 7.45 am and 7.20 pm)

Most of us put our hard-earned money in a bank for the convenience and to earn interest. We do this also because we are confident that the bank will lend our money wisely.

This confidence is heightened by the fact that the Monetary Authority of Singapore, or any central bank for that matter, will conduct regular checks on these banks.

Because of this, bank failures are a thing of the past. Today, when we think of a bank, we think of a physical building, with safety and reliability thrown in.

However, in the past decade, a new kind of bank has emerged. Let’s call it “NewBank”. It also takes in deposits and gives out loans. At the heart of NewBank is an elegant arrangement, whereby loans are financed directly by rich investors, rather than indirectly by traditional bank depositors.

NewBank employs no one directly and is nothing but a collection of securities or bonds backed by loans and assets. In year 2005, NewBank issued about US 3,000 billion dollars worth of securities.

Unlike traditional banks, there are no checks and controls by central banks over NewBank. Investors, ranging from hedge funds to wealthy individuals, have, or rather had, confidence in NewBank because its securities were blessed by the rating agencies, such as Moody’s and Standard & Poor’s.

All went well till a few years ago. That was when NewBank started to issue more securities backed by US subprime loans. These are housing loans to people who should not be given such loans. The size of these securities has shot up five times to some US 800 billion dollars today.

When US house prices rose, it was not an issue. But with US house prices falling, and mortgage rates rising, these subprime loans are defaulting and registering capital losses.

Investors who had deposited money with NewBank now want their money back. This has created a 21st-century version of a bank run.

The massive falls in the global financial markets recently is due to investors selling other assets to make good on their losses. Even those who were not exposed to NewBank took fright.

The world’s central banks can’t do much to help, like they normally do when traditional banks fail. Besides having no control over NewBank, they don’t even know how much of these securities are leveraged and who owns them. Central banks can only try to calm investors by keeping down interest rates in the money markets.

Currently, there is a stalemate in the US 800 billion dollar market for the securities backed by these subprime loans. No one dares to buy them. And no one wants to sell them because it would mean massive losses. In many cases, they have borrowed heavily against them.

But this stalemate must be resolved soon. Otherwise, the financial house of cards could collapse. Then the only parties who could benefit would be those with lots of money and unaffected by the subprime crisis. These parties could be the Asian central banks.

To try and prevent such a collapse, the US Fed may have no choice but to cut interest rates. This could make mortgage payments easier. And it could revive NewBank from coma. Certainly, lower rates are what the weaker US economy needs right now.

Of course, there is the danger that cutting rates could lead to more reckless lending in the future. But if nothing is done soon, the collapse could take its course. In the end, besides Barclays Bank, Asian central banks might be the new owners of major US investment banks.