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The money train
by Prea Peter

Will the current crisis in the global financial markets adversely affect Australia? Will a sick passenger on a Chatswood train disrupt the Bankstown service?

The answer to both these seemingly unrelated questions is something along the lines of “we don’t know for sure. Even if we did, there is probably not much we can do”. Complex networks of tracks or markets definitely have a downside.

There were two distinctly opposite reactions in Australia to the global financial crisis. On the one hand, the Rudd government declared that Australian financial institutions are in “sound shape”. On the other, the financial markets swam in fear about the fallout of the crisis. Share prices for major banks fell to record lows, inter-bank lending rates increased, and investors scrambled to buy insurance for their investments.

The two different reactions clearly show that no one really knows what the implication of the financial crisis is likely to be for Australia. Even if anyone did, complex interdependencies in the financial system may leave little room for anything to be done.

In the US, banks were lending money to home buyers, relying on their ability to pay back the mortgage, or if that fell through, on the option of repossessing and selling off the houses against which the loans were secured. According to Dr. Alex Eapen, lecturer at the Faculty of Economics and Business at the University of Sydney, “This arrangement collapsed for two reasons. First, lending was not responsibly done and many mortgagees ended up defaulting. Second, lenders were unable to recoup the loans in a housing market in a trough”. In the meantime, lenders had sold off their mortgage-repayment cash flows to other financial institutions such as Fannie Mae and Freddie Mac for cash to finance yet new mortgages. Mae and Mac then repackaged the debts into complex financial products and resold them to other institutions like Lehman brothers and Merrill Lynch. A lot of cash rich Chinese, Japanese and other investment banks also bought into these mortgage-based securities and passed the risks on to yet other investors around the world. And all along, investors were trying to pass on their risk to insurance companies like AIG by buying insurance. All it took for this complexly intertwined chain of investments to collapse was the crunch in the housing market. Without mortgages being repaid and low returns from repossessions, financial institutions with substantial exposure to the mortgage-based securities found themselves short of liquid cash and in line for bankruptcy. With huge claims to meet, insurance companies also felt the pressure.

Many are already calling for better regulation of the financial markets. But I think the crisis also points to need for investors and institutions to better monitor their risk exposure and posture in complexly intertwined financial networks. To stem the contagion of the crisis, institutions need to be able to quickly decouple from the network. Just like city rail is doing with its $1.8 billion ‘rail clearways’ plan to ensure that a problem on the Chatswood line does not disrupt traffic on the Bankstown route.

Links:

Australian Financial Review, Friday 19 Sept 2008, p.34 (online access at http://www.afr.com/)

 http://www.cityrail.info/news/clearways.jsp