Queen's University

Frank Milne

[Frank Milne]

Swinging between Euphoria and Despair

The 2008 global financial crisis was the worst economic and financial calamity since the Great Depression, and countries and financial institutions everywhere are still struggling with its consequences. Meanwhile, academics, analysts and pundits are studying the roots of the crisis in the hopes of averting another meltdown in the future.

Dr. Frank Milne is one of Canada’s leading experts in this regard. As the BMO Professor of Economics and Finance in Queen’sDepartment of Economics, Milne was one of the financial professionals around the world who warned that some of the financial and regulatory practices of the 1990s and early 2000s would lead to catastrophe. His research and graduate training on risk management and financial stability is influencing banking policy in Canada and in his native Australia.

In a 2008 analysis of the international debt crisis for the C.D. Howe Institute, for example, Milne argued that the crisis was caused by two different types of debt funding and risk management systems operating simultaneously within the banking and financial world. One model assumed that securitization – the packaging of mortgages, credit-card debt, auto loans and other interest-bearing debt into bonds and various other asset-backed securities that could be bought and sold on the market – was a market-based system that reduced the need for standard risk-management approaches regarding the transparency of information available to buyers and sellers, uncertainty and market liquidity.The second model was the traditional one, which assumed that securitization merited the same rigorous risk-management strategies as any other investment.

Between the early 2000s and 2008, the former model, now re ferred to as a “shadow banking system,” operated outside of standard bank regulations and supervision. It was successful while it lasted: the housing market, fuelled by millions of home buyers lured by low-interest mortgages and tax-deductible mortgage payments, boomed. Across the U.S., new housing subdivisions expanded rapidly. Traders, banks, insurers and investors enjoyed huge returns from the real-estate backed securities. The stock market soared.

But the bonanza was founded on an illusion. Asset-backed securities earn long-run returns only if the debt they are built around is relatively sound. Unfortunately, millions of sub-prime mortgages had been sold to people who could not pay them back because of subsequent job losses, or because they should not have been approved in the first place. Inevitably, defaults and foreclosures began to mount by the hundreds of thousands, rendering the once-valuable bond securities worthless: the institutional investors who had sunk money into them collectively lost trillions of dollars. Major investment banks and mortgage companies, such as Lehman Brothers and Countrywide Financial, went bankrupt, were sold to other banks at fire-sale prices or were taken over by government. Worst of all, millions of American investors, whose savings had been used by the banks to purchase the junk securities, lost everything while the banks that caused the crisis received large bailouts from the U.S. government.

As we now know, and as Milne observed, inadequate risk management within banks, lax regulatory oversight, widespread corruption and conflict of interest were root causes of the crisis in the U.S. and in a number of European Union (E.U.) countries. In too many cases banks and mortgage companies facilitated, or even promoted, the reckless lending to people who were obvious credit risks. Credit rating agencies gave AAA ratings to bonds they knew to be junk. Traders knew they were junk, too, but sold them to net massive profits and bonuses. People everywhere are outraged that none of the banking executives and traders who caused the crisis have gone to jail.

While the financial crisis affected Canada, tighter regula tion of its banking system helped it avoid the sort of meltdowns that occurred elsewhere. But Milne says Canadians should not be complacent. The dramatic increases in sovereign debt in the U.S. and the E.U. caused by huge fiscal stimuli, combined with looming fiscal challenges posed by the aging baby boom generation, pose a serious threat to national economies everywhere.

At the same time, Milne says a long view of economic history suggests that while things may get rough, there is cause for hope.

“The road to the future is never smooth: it is littered with booms, busts, surprises, disappointments and failures,” he says. “We should adapt, looking for opportunities and encouraging our fellow citizens through thoughtful policy implementation. It is foolish to be myopic, swinging between euphoria and despair.”

Profile by Alec Ross
(e)Affect Issue 3, Spring 2013