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©The Star (Used by permission)
by Tommy Thomas

In the second part of the article (the first appeared a week ago), the writer looks at how regulations may be key to sort out the global financial mess.

THE past 30 years saw the development and exponential growth of sophisticated financial instruments, designed and structured by the best and brightest minds from Harvard, Stanford, M.I.T, Chicago and Oxbridge who were rewarded with fabulous bonus payments, none of whom had to pay a personal price when the paper architecture that they had created crashed like Humpty Dumpty in September 2008.

The products included swaps, reverse swaps, swap options, caps, floors, collars, forward rate agreement (FRA), gilt and cash options, asset based securities, securitisation and derivatives.

In 1991, the House of Lords, the highest court in Britain, held in Hazell v Hommersmith Borough Council that a local authority had no power to enter into interest rate swap transactions because they were speculative in nature and would therefore result in huge losses to the local authority which were using public monies.

The court noted “the considerable risks involved in these transactions, and how serious wrong decisions can be”.

Despite the powerful sentiments expressed by senior judges well versed in commercial matters, no legislation was introduced to regulate such risky and speculative transactions insofar as the private sector was concerned.

Perhaps the most toxic of these products was securitisation: the process by which loans purported to be secured were bundled together and sold on to banks and other institutions as packages of secured debt.

In consequence, the original lender became indifferent to whether the loan could be repaid: it was somebody else’s problem.

These packages of debt were then resold in the form of horrendously complex financial instruments which ultimately led to the global collapse of capital markets.

The overlapping loans are so complicated that neither creditor nor debtor knows who owns what underlying debt; worse still, no one knows what these assets were really worth – it is ironic that if you own someone else’s debt, it is your asset in accounting terms!

The nail in the coffin is that the mechanism for assessing the value of these assets is the market: they are worth what someone is prepared to pay.

Because no one was buying in recent months, no one has a clue what they are worth, if anything.

Because of the accounting practice of “mark to market” requiring that assets be valued at their “current” values rather than at the time of their acquisition, balance sheets look disastrous in recent weeks.

What was totally disregarded was that the most complex econometric formula devised by a Nobel laureate is no substitute for an understanding of the human spirit and human nature, including the greed of the creditor and the stupidity of the borrower.

What strikes anyone with even an elementary knowledge of risk management and corporate governance was the total lack of inquiry by the designers and promoters of these new fangled financial products as to the consequences of default.

The obvious questions to ask were: what are the consequences of a breach by the borrower (on the assumption any creditor could identify its borrower), what are the chances of recovery in the event of insolvency on the part of the borrower, were they truly secured debts, and, if so, what is the worth of such security.

If the alarm bells had rung on such plain and obvious queries, the cancer of debt may not have been so widespread and so deep.

It is not as if derivatives and other similar products received universal acclaim. From the outset, cynics pointed out their flaws.

The most notable included savvy investors like Warren Buffet and George Soros.

In 2003, Buffet presciently observed that derivatives were “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal”.

According to him, they were easy to get into, but difficult to get out of. Soros was even more frank, stating that he avoided using derivatives “because I don’t really understand how they work”.

The scale of default has been impossible to predict, as demonstrated by AIG’s projection in early 2008 that in the worst case scenario, its exposure to its credit default swaps was US$2.5bil.

In September 2008, the US government had to inject US$85bil, which has recently been increased to US$150bil.

On the assumption that AIG was truthful in its projection, this illustration reveals that even AIG did not know the true worth of the collateral debt obligations (CDOs) and credit default swaps (CDSs) they held, and more significantly how much risk they were exposed to while carrying these “assets”.

The legal imperative

The London bobby came into being some 200 years ago to bring law and order into the streets of London, to protect the weak against the bully and to prevent anarchy.

Traffic lights are necessary because drivers cannot self-regulate on the roads. Most professionals are subject to regulatory authorities. War is too serious a matter to be left to the generals.

In nearly every sphere of human affairs, some degree of regulation occurs.

The modern nanny state regulates the life of an individual from cradle to grave. Yet, bankers in US and Britain have in the past 30 years persuaded politicians and informed opinion that they can regulate themselves because these bankers are immune to traits that characterise the rest of humankind; that they are naturally and inherently altruistic and not motivated by self-interest and greed.

The perils of such myths are glaring when they are in custody of billions of dollars collected from members of the public as bank deposits or insurance premiums. Yet bankers resist any form of accountability.

The 2008 crisis demolishes the fallacy of this argument. Banking is too critical a business to be left solely to the bankers.

One does not have to be a Marxist or a socialist to accept that bankers and others in the financial industry must be governed by law, and subject to supervision and oversight.

The Malaysian experience

Tun Ismail Ali, the legendary and first governor of Bank Negara, had an innate suspicion of bankers and businessmen.

He laid the foundations of a strict legal regime over banks, with the Banking and Financial Institutions Act, 1989 (Bafia), being the current Act of Parliament.

Foreign critics have often castigated the extensive legal powers given to Bank Negara under Bafia, but partly as a result of its overreaching statutory power, both Malaysian and foreign banks with branches here, have generally avoided the toxic products that have caused such havoc on Wall Street.

Whether it was inertia, caution, a sheer lack of understanding of these complex instruments or in part due to Bafia, there is no credit crunch in Malaysia; indeed, the system is today flushed with liquidity with some RM940bil worth of deposits.

In 2005, the Malaysia Deposit Insurance Corporation Act was enacted to provide for the establishment of PIDM to administer an insurance system for banking deposits.

Similar strict regulatory framework exists for the insurance industry.

The Insurance Act, 1996 regulates insurers and providers minimum protection to policy-holders. The governor of Bank Negara is also responsible for supervising the insurance industry.

The advantages of the Malaysian insurance statutory regime over its American counterpart is best illustrated by comparing what happened to AIG and AIA, its Malaysian subsidiary.

AIG became insolvent because it had total freedom to invest premiums collected from millions of individual policy holders (and no doubt from corporate clients) in wagering contracts like derivatives, CTOs and CTSs.

Even a US$150bil bailout has not stopped the haemorrhaging; no one can forecast when AIG’s insolvency will cease.

In the case of AIA, the strict manner of investments imposed and supervised by Bank Negara, ensures that all the premiums are prudently and conservatively invested, as befitting a life insurer. There is absolutely no question over AIA’s financial strength.

Malaysia’s capital market has been expertly supervised by the Securities Commission which has the benefit of extensive securities laws, now consolidated in the Capital Markets and Services Act 2007.

The Employees Provident Fund Act 1991 imposes a legal obligation on every employer and employee to deduct a specified sum from monthly wages to build-up savings for retirement.

The 1997 financial crisis that hit some Asian countries resulted in a holistic approach by Malaysia to solve the same problem of excessive debt, substantially by corporate borrowers.

A raft of measures was undertaken, including the capitalisation of banks by Danamodal, the enactment of the Pengurusan Danaharta Nasional Bhd Act 1998 and the establishment of Danaharta to remove non-performing loans from banks to enable the latter to resume their normal banking functions of lending and the setting up of the Corporate Debt Restructuring Committee (CDRC) to deal with major borrowers without allowing them to go under through liquidation.

The extra-ordinary legal powers conferred on Danaharta to deal with an extra-ordinary financial crisis was fundamental to its success in recovering 60 sen to the ringgit, which is a world record for a national asset management corporation.

The return of the state

A strong case can therefore be made for state intervention over the banking, insurance and financial sectors of a modern economy.

Whether such intervention should be by way of laws or otherwise is a matter for each nation to decide. The unacceptable face of capitalism has been unmasked in Wall Street in September 2008; lack of or lax supervision is no longer an option.

Neither the lender banker nor the borrower businessman can be trusted to carry on the critical business of credit and debt creation.

Malaysia’s laws are not only extensive and comprehensive, they are world class. The US, consistent with its superior attitude to everything, will not concede that in these vital areas of economic life, Malaysia’s regulatory regime is far superior, and the transfer of intellectual skills should be from Kuala Lumpur to New York, and not the other way.

·Thomas specialises in banking and insolvency law. He was involved in the Mosbert liquidation caused by Amos Dawe’s profligacy when he commenced practice in 1976. In the mid-80’s he acted against Lorrain Osman in the BMF scandal. He has handled insolvency problems during every economic downturn over the past 30 years. Thomas has in recent years represented Danaharta and Securities Commission in litigation matters.

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