Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 12 - Evidence, October 29, 2009
OTTAWA, Thursday, October 29, 2009
The Standing Senate Committee on Banking, Trade and Commerce met this day at 10:38 a.m. to examine the present state of the domestic and international financial system (topic: global economic crisis).
Senator Michael A. Meighen (Chair) in the chair.
[English]
The Chair: This morning we are meeting to discuss in some depth the causes and consequences of the current global economic and financial crisis, as well as what actions have been taken to assist in the recovery. This is the first opportunity we have had to take a macro view of the situation before deciding the nature and extent of the in-depth study we would like to begin as soon as possible.
Our colleague Senator Oliver unfortunately had to go to Boston today. He is responsible for today's witness being here, in that he told me that he had heard Mr. Rodgers make a presentation and was blown away by his skill and the interest he aroused in the audience.
Mr. Rodgers, who is Special Advisor to the Director General, Economic Policy Bureau the Department of Foreign Affairs and International Trade, comes with considerable favourable publicity.
We are very grateful to you for taking the time and look forward very much to our discussion. We are particularly honoured that you should do so today, which is a very significant birthday, I understand, for you. Thank you so much. We hope that the day will begin well here and end even better tonight wherever you will be celebrating.
Mr. Rodgers indicated to me that he has worked a bit on the statement that Senator Oliver, has already heard. He will review that with us and, at my request, after analyzing what went on and what the causes of the economic crisis were, he will throw out some possible ideas for us to consider in due course with respect to an in-depth study.
Without further ado, I want to welcome you again, Mr. Rodgers. Thank you for being here and I turn the floor over to you.
David J. Rodgers, Special Advisor to the Director General, Economic Policy Bureau, Foreign Affairs and International Trade Canada: Thank you very much, Mr. Chair. Thank you to the committee for inviting me here today.
I intend to follow the same sort of outline as I did to the International Parliamentary Union Group. I will begin by looking at the underlying causes of the financial crisis and then at the crisis itself and how it unfolded. I will look at the emergency and short-term policy responses and what this has meant in terms of the real economic impact and the economic outlook. Then I will finish off by looking at the long-term policy responses in the G20 framework that is guiding our response.
Senator Hervieux-Payette: Maybe for the people who are listening to us, we could hear about what you are doing at the department and your background. Do you come as an economist or as someone with a financial background? That would clarify what you are going to say.
Mr. Rodgers: Thank you for that. Yes, I have been an economist for approximately 23 years; most of those years working in the government. I worked 14 years for the Department of Finance and five years for the Treasury Board. I worked for PCO for six months. I have worked almost the last three years at the Department of Foreign Affairs. My role is in the Economic Bureau. I am the main person who writes the briefing notes on economic and financial matters for the ministers, including the Prime Minister.
I report directly to the director general as his special adviser, but I have been running a speaker series once every two weeks, on important economic financial issues. Therefore I have heard from many key witnesses on this issue.
You are getting the benefit of my synthesis of many presentations from over the last couple of years. One of my responsibilities was to coordinate the activities of our economic and finance counsellors abroad for the benefit of our Government-of-Canada clients. Once a year we would fly them home for a week-long conference to bring them up to speed with government thinking on issues and policies. I was responsible for that conference.
All of these different opportunities have helped me learn about this crisis, although I have to confess I am not writing research papers or probing things in-depth. Nor am I a player as I might be with the Department of Finance or the Bank of Canada. I take a more macro viewpoint, if you will. That is my background.
I will first discuss the underlying causes of the financial crisis, which I group into four major causes. The first one is macro-economic. It is in two parts. The first part had to do with very low U.S. interest rates that were in place for an extended period, and then their sharp reversal. Here what can guide us is the work done by John Taylor, famous for his ``Taylor rule,'' that in effect assesses the appropriateness of monetary policy. He determined that U.S. monetary policy was far too loose from mid-2001 to mid-2006, and this fuelled the housing bubble. When that policy began to be unwound and tightening occurred from June 2004 to June 2006, without loosening taking place until September 2008, this caused the housing bubble to deflate.
The second macro-economic item is the large inflow of foreign funds into the U.S. owing to global imbalances. Here we are about a large savings glut that developed because of to the rise of petro-states as oil exporters, and the development of Asia as a significant exporter.
Standing out was the Middle East, notably Saudi Arabia, which went from an average savings rate in the latter part of the 1990s of 26 per cent, up to 38 per cent from 2003 to 2006. Developing Asia, which includes China, went from 33 per cent to 40 per cent, China being the world's largest saver. It is noteworthy that both Saudi Arabia and China have inflexible exchange rates, which did not allow for the currency appreciation commensurate with their growing current account surpluses.
At the same time you had the U.S. become the largest net borrower in international capital markets, owing to the fact that its savings rate had fallen from 17 per cent in the late 1990s to about 15 per cent in the 2003-06 period. This was mainly due to the rise of their fiscal deficit, which grew from 1.4 per cent of GDP in 2001 to 5.5 per cent in 2003 and remained over 4 per cent through 2006. As well, its current account deficit increased from 3.9 per cent of GDP in 2001 to 6 per cent in 2006, owing to such factors as a decline in its terms of trade, being a net oil importer, and competition from developing Asia. The large and growing amount of foreign funds flowing into the U.S. ended up raising the price of financial assets, lowered long-term interest rates and stoked the housing bubble.
The second major cause of the financial crisis is regulatory loosening in the United States, and there are four different items I will be pointing to there.
The first I will group under the heading of the 1977 Community Reinvestment Act, which is an act that promotes housing ownership in the U.S. for lower income people. The problem was not so much with the act, because it had been around for a very long time, but with policies that interacted with that act. Specifically, in 1999 the U.S. administration put pressure on its mortgage corporations, Fannie Mae and Freddie Mac, to devote a greater share of their lending to low and middle income people in distressed areas designated by the act.
For financial institutions, you do not have to abide by the act, but it is to your detriment if you do not. These financial institutions successfully asked Fannie and Freddie to ease their credit requirements in order to purchase their sub-prime mortgages. Fannie and Freddie work in the secondary market, purchasing mortgages from these originators and then securitizing them and selling them off in the secondary market.
The shift here, however, was curtailed until 2004 because the U.S. Department of Housing and Urban Development, HUD, dropped predatory lending rules that disallowed risky high-cost loans from being credited toward affordable housing goals. The move was significant because Fannie and Freddie significantly ratcheted up their purchase of sub-prime loans to $175 billion, which was 44 per cent of the market in 2004; to $169 billion, which was 33 per cent of the market in 2005; and to $90 billion, which was 20 per cent of the market in 2006.
When the housing market reversed, this created large losses for Fannie and Freddie. Their stock value fell in the year leading up to September 2008 by 90 per cent, and they were put into conservatorship by the government just one week before the Lehman Brothers failure.
The second item is the 1999 partial repeal of the 1933 Glass-Steagall Act. That was brought in during the Great Depression to help bring stability to the financial sector by separating out the safer commercial banking from the riskier investment banking. This was undone in 1999 by the Financial Services Modernization Act, which allowed for single ownership now in the various pillars of the financial sector — banking, insurance and securities.
The change caused normally conservative banks and insurance companies to move into the riskier investment banking business. They could now underwrite and trade mortgage-backed securities, collateralized debt obligations and establish so-called structural investment vehicles that bought these securities, causing a proliferation of these activities.
The next piece of legislation was the 2000 Commodity Futures Modernization Act. This act allowed for the self- regulation of over-the-counter derivatives such as credit default swaps, which were used to hedge or speculate against credit risk, such as that associated with mortgage-backed securities. As a result, the volume of credit default swaps increased 100-fold from 1998 to 2008, with debt covered in CDS contracts totalling as much as $47 trillion by November 2008, which is roughly the size of the world's GDP.
The problem with CDSs was that financial institutions writing the contracts did not set aside resources to support their commitments. They were taking a one-way bet that housing prices would keep going up, but they did not. When the housing boom went bust, holders of credit default swaps started cashing in and the losses of the issuing financial institutions mounted quickly. Financier Warren Buffet labelled such contracts as ``financial weapons of mass destruction,'' as far back as 2002.
I should mention that the TV show ``60 Minutes'' did a very good report on this in about a 12-minute spot. You can download this by visiting their website and searching ``credit default swaps.''
The final rule change occurred in 2004. This was the relaxation of the net capital rule by the Securities and Exchange Commission, SEC. The SEC brought forward a new program. They were being pressed by the industry, trying to play catch-up in response to what was going on in Europe at that time.
The program would effectively allow the five major investment banks to self-regulate, subject to SEC oversight, instead of being bound by the net capital rule, which had been in effect since 1975. Unfortunately, the SEC made supervision of the new program a low priority. Not a single inspection had been made by the time Lehman Brothers collapsed in September 2008. Large investment banks felt free to take on considerably more debt as a result. Hence, leverage ratios, which were once fixed at a conservative 12 per cent, rose as high as 40 per cent.
Shortly after the Lehman collapse, SEC chair Christopher Cox, previously a champion of deregulation, told the Senate Banking Committee that the oversight program, which he had already moved to shut down, was ``fundamentally flawed from the beginning'' and that ``voluntary regulation does not work.'' Furthermore, its failures contributed to the global financial crisis.
The third major cause of the financial crisis has to do with financial innovation, specifically securitization and risk management. As part of technical innovation, that is more sophisticated computer programs and whatnot, the large investment houses were hiring mathematicians to try to come up with risk management models. They ended up parcelling up things like mortgages, car loans and other forms of debt into complex financial instruments that lacked transparency. These were things like mortgage-backed securities and collateralized debt obligations.
The problem here is that it led to a principal agent problem, where you have asymmetric information. Primary lenders were encouraged to make loans to customers who were poor credit risks because they could quickly securitize these loans and sell them off to investors.
The key in all of this was that to make it work, required good credit rating grades by the credit rating agencies. These agencies were giving out AAA ratings to products that had a sub-prime component to them, even though sub- prime is the absolute highest risk end of the mortgage market. It lulled investors into a false sense of security. Meanwhile, the credit rating agencies had severely underestimated the risk.
The mistakes of the credit rating agencies were the subject of a 10-month SEC investigation that ended in December 2008. This indicated that the failures had much to do with conflicts of interest. Specifically, credit rating agencies were paid by the very firms issuing the mortgage-backed securities and collateralized debt obligations, firms that had an interest in seeing the highest ratings applied. The agencies received triple the fee on these sorts of products compared to other products, which provided them with an incentive to maintain this business and lower their standards.
I should point out there was a downward adjustment in ratings made by the credit rating agencies of $1.9 trillion on mortgage-backed securities from the third quarter of 2007 to the second quarter of 2008, which just shows how wrong they got it.
The fourth major cause of the crisis was the failure of U.S. policy-makers to fully understand the growing importance and functioning of the shadow banking system. By that, I am talking about nonbanks, things like investment banks, mortgage market funds, hedge funds, structured investment vehicles and insurance mono-lines. They were rapidly increasing their participation in banking functions and yet they were evading normal banking regulations.
The nonbanks developed predatory lending habits that were going unpunished. For example, they would introduce teaser rate mortgages, where you could have an introductory rate as low as zero per cent, with the rate climbing a few months later to a normal rate or above normal rate. All of this was being extended to a borrower who may be classified as a ``ninja'': No Income, No Job or Assets.
The lenders were not concerned with defaults during the boom. They were quite prepared to foreclose, comfortable in the knowledge that the property was likely worth more than when the mortgage was originated.
Banks increasingly shifted assets and liabilities to off balance sheet entities, such as structured investment vehicles, SIVs, which masked the actual capital base of the firm and the degree of leverage or risk taken. These SIVs dealt entirely in securities. They would issue short-term securities that paid low interest and buy long-term securities which paid high interest, which made them potentially subject to both solvency and liquidity risk.
When the sub-prime crisis caused a liquidity crunch in August 2007, the U.S. government tried to coordinate a bailout fund of the major banks. Instead, the major banks ended up taking these SIVs back on balance sheet — SIVs that were once worth about $1 trillion. This resulted in huge losses for the major banks and dealt severe blows to the valuation of their stocks.
Senator Hervieux-Payette: What are SIVs?
Mr. Rodgers: Those are structured investment vehicles. It is an off balance sheet item that deals entirely in securities, unlike an on-balance sheet banking situation where a bank might, through the process of intermediation, lend money directly to a consumer and then follow that to its completion and ensure that payments are being made on time and so forth.
The structured investment vehicle is a disintermediation process, dealing entirely in securities. Therefore, you have a breakdown in that sort of ``originate to distribute'' model.
The final aspect here was that regulators were taking a micro-prudential approach, which resulted in an underestimation of systemic risk. This was certainly shown in the decision to let Lehman Brothers fail in September 2008.
Financial regulation is highly fragmented in the U.S., and it is fairly fragmented in Canada. Regulation is at both federal and state levels, for banks, for insurance and for securities. A single corporation may be subject to a whole panoply of regulators. The problem here is to try to coordinate their actions and to understand what the implications for the whole industry will be of letting an institution fail. There were serious mistakes in that respect.
Turning to the terms of the financial crisis and how it unfolded: Sometimes, reading the paper, you think that the crisis all started in September 2008. It really started long before that. It escalated at that time. It really began in the sub- prime mortgage market. A crisis developed there. Early evidence was appearing in the latter part of 2006 and building throughout 2007.
When we look at all of the causes, it was the combination of low interest rates; regulatory loosening; financial innovation creating non-transparent products that were incorrectly rated; and a growing importance of the risky shadow banking system, resulting in financial institutions taking unprecedented risks, allowing sub-prime and Alt-A mortgages to become a significant portion of all mortgage originations. Alt-A mortgages are a little less risky than sub- prime but certainly not prime
In the outline I provided you, there is a table which just shows the dramatic increase. I mentioned the rule changes in 2004 which really stoked the sub-prime market. You can see that sub-prime and Alt-A taken together up through 2003 never exceeded 10 per cent of all mortgage originations. Yet by 2004, they had reached 25 per cent all of a sudden, and went to about one-third of the market in 2005-06.
Overall, this was a threefold increase in a very short period of time. The risk was managed by the securitization of these mortgages, which were sold off throughout the U.S. and globally.
This activity fuelled the housing bubble. The price of the average home increased 85 per cent, adjusted for inflation, from 1997 to 2006, which makes it the largest housing boom in U.S. history. The median home price rose from three times median household income in 2001, where it had been for the previous two decades, to 4.6 times in 2006 — a 50 per cent rise. You can see the sheer amount of debt the U.S. consumer was taking on at that time.
Housing starts rose continuously from 1.57 million in 2000 to 2.07 million in 2005, which was a record high.
The Federal Reserve unwound its monetary stimulus over the 2004-07 period, which gradually brought the housing bubble to an end. The rise in interest rates was soon felt by sub-prime borrowers since 80 per cent of their mortgages were adjustable-rate mortgages, which eventually prompted some sub-prime borrowers to seek refinancing.
Almost immediately, you see in the data that homes were taking longer to sell. This was followed by a sales decline, then a residential construction slump that started at the beginning of 2006. Home prices started to fall towards the end of 2006, so refinancing became very difficult, especially for the low end of the market, and many sub-prime borrowers began to default.
The U.S., at that point, started to go into a vicious circle of rising delinquency rates leading to foreclosures. An increase in the supply of homes for sale would result, dampening housing prices further, making refinancing even more difficult, leading to further delinquencies and foreclosures. It is been going like that ever since.
The slump in the U.S. market has been nothing short of staggering since 2005. I will lay out some facts that show how it has been approaching 1930s Great Depression levels. Housing starts have plummeted 77 per cent, which approaches the 90 per cent figure of the Great Depression. Existing home prices have slipped 24 per cent, which approaches the 30 per cent decline of the Great Depression. While delinquency rates have risen dramatically from 1.5 per cent in the second quarter of 2006 to 8.2 per cent in the second quarter of 2009, this is well below Great Depression levels, which were estimated at about 50 per cent, although that did not necessarily mean you were foreclosed upon. There were allowances made to keep people in their homes despite the defaults.
The Chair: Can you speculate, Mr. Rodgers, as to why it is so different this time? Is it an encouraging sign?
Mr. Rodgers: We are still early on. I think this trend will worsen. I do not think we will get up as high as we used to, but there have been some programs put in place, as well, in the U.S., to help mitigate the situation. I should say that on the sub-prime mortgage segment, the default rates are 41 per cent. If you look at that segment alone, it is very much like a Depression-era scenario for these people.
Senator Moore: Is that since 2005?
Mr. Rodgers: Yes.
The second segment of this financial crisis was a credit crisis that erupted in July and August 2007. The unfolding of the sub-prime mortgage crisis led to heavy losses for financial corporations that held mortgage-backed securities. They had to take write-downs and so forth. It was particularly felt in the unregulated non-bank segment that did not have a sufficient capital cushion against such loan defaults. The non-banks also could not rely upon deposit taking to improve their capital base. Nor could they go to the central bank discount window to receive an injection of liquidity.
The challenges facing financial institutions were made even greater by the rising delinquency rates of other loans and leases. The commercial real estate market was going through almost as bad of downturn. Consumer and car loans were also going through a bad decline, although not on par with the real estate market.
On July 24, 2007, Countrywide Financial Corporation, the largest U.S. mortgage lender, spooked investors when it badly missed expectations, saying that credit quality had deteriorated and defaults had risen in all product categories.
Stock market declines accelerated as merger and acquisition activity, which had previously been fuelled by leveraged buyouts, began to be called off and hedge funds began to deleverage themselves. In August, 2007, evidence showed that the sub-prime mortgage market was global in nature as international financial institutions began to report losses from sub-prime exposure.
For Canada, the impact of the credit crisis owed much to an external shock emanating from the U.S. as opposed to problems in its own housing market. Canada's sub-prime mortgage market was estimated to be five per cent of total originations. All of these were secured by mortgage insurance. Canada did have home grown problems, however, notably its non-bank asset-backed commercial paper market that failed.
The third segment was when the credit crisis escalated dramatically in September 2008 with the failure of investment bank Lehman Brothers. This was the largest bankruptcy in history. The firm had assets of $600 billion. The U.S. government refusal to bail out Lehman Brothers, as it had done for Bear Stearns the previous March, and the inability of the private sector to find a solution like it had done with Countrywide Financial the previous year, defied investor's expectations and created a crisis of confidence. Compounding the problem were the dire problems revealed by Fannie Mae and Freddie Mac the previous week, and AIG, Merrill Lynch and other financial institutions the very same day or the next day.
The revealed large exposure of the reserve primary fund, which was the oldest money market fund in the U.S. and one of the largest, created a run on all money market funds that week. By the end of the week, the Federal Reserve had to inject liquidity of up to $230 billion to protect this market. The U.S. treasury had to provide temporary insurance. These actions showed how the U.S. government had severely underestimated the systemic risk of allowing Lehman Brothers to fail.
The major concern at this time was that money market funds were dumping commercial paper to cash out fleeing investors. This prevented companies from rolling over short-term debt. Owing to the heavy reliance of corporations on using commercial paper to fund their short-term debt, U.S. policy-makers were staring at a potential liquidity crisis causing extensive corporate bankruptcies, much like the 1930s Great Depression.
This was the scenario they faced at the time they really began to respond.
I will go through the emergency and short-term policy responses. They are broken into several categories.
First is monetary stimulus. Central banks have undertaken the largest injection of monetary stimulus in world history and have pledged to maintain such policies as long as needed. They moved to aggressively cut interest rates, which reached record lows by the second quarter of 2009.
The Bank of Canada lowered its overnight lending rate by an accumulative 425 basis points from November 2007 to April 2009 when it reached a record low of 0.25 per cent. They pledged to keep it there until the end of the second quarter of 2010.
Second is support for the financial sector. To restore domestic lending and international capital flows, central banks and governments have supported their banking systems by providing liquidity, recapitalizing financial institutions and decisively addressing the problem of impaired assets. In October 2008, G7 finance ministers introduced their five-point action plan that contained an important pledge not to allow any systemically important financial institutions to fail.
The United States went on to commit as much as $9.8 trillion, of which $2.3 trillion has been invested in supports for their financial sector. This is up to around September of this year and excludes fiscal stimulus. The European Union has also introduced its own guarantees and recapitalizations that totalled 2.8 trillion to March of this year.
Canada has been fortunate in that it has not had to be involved in any recapitalization of its banks. They have held up quite well under the circumstances. The focus for Canada has been on improving access to financing. This ultimately culminated in the $200 billion extraordinary financing network announced in the budget in January of this year.
Third is fiscal stimulus. Governments undertook unprecedented fiscal expansion. G20 concerted action will amount to $5 trillion, which is four per cent of GDP over two years. Canada's fiscal stimulus was laid out in the Economic Action Plan in the budget. Looking at the updated figures from September, the combined federal and provincial fiscal stimulus is estimated at over $60 billion. This will be 4.2 per cent of GDP over two years. This ties it with Japan among G7 countries as offering the most fiscal stimulus among the G7 countries relative to the size of their economy, as a share of GDP.
The Chair: Canada and Japan are tied in the top position?
Mr. Rodgers: Yes. It has much to do with the fact that we have the fiscal wherewithal to do this. We went into the crisis in very good fiscal shape, having among the lowest debt to GDP ratios and running a surplus at the outset.
Looking at international financial assistance, at the April 2009 summit in London, G20 leaders agreed to provide $1.1 trillion to international financial institutions. This included new and substantial resources for the IMF, additional capital for the multilateral development banks and support for trade finance. Canada has been contributing its fair share in respect of this commitment.
What has these policy responses done for us in terms of the real economic impact? We heard earlier this month from the IMF that economic growth has now turned positive again after going through the first synchronized world recession we have seen since the Great Depression. The world economy will be contracting 1.1 per cent, going by the forecast of the IMF. Essentially, the world went into recession somewhere in the middle of last year and is coming out of it in the middle of this year. The IMF takes pains to point out, though, that this global positive turnaround owes very much to the emergency and short-term policy responses that I have just outlined.
Canada, for its part, suffered a three-quarter recession. Its peak-to-trough contraction is estimated at 3.3 per cent, placing it the lowest among G7 nations, and its growth in 2010 is expected to be the fastest among the G7.
Going forward, recovery will be slow because financial systems remain impaired. Support for public policies will have to be gradually withdrawn, and households that have suffered significant asset-priced collapses will have to rebuild savings and struggle with high unemployment. The key policy requirements going forward, and I am still talking about the short-term here, are to restore financial sector health while maintaining support of macroeconomic policies until the recovery is on a firm footing.
The Chair: Mr. Rodgers, I thought savings rates in Canada were at high levels right now.
Mr. Rodgers: I would say our savings rates put us in the middle of the pack. Some economies are saving a lot more than we are, but we save more than the U.S. We have been helped by the fact that we have been running surpluses. When you look at IMF savings rates, you are really talking about private sector savings, both individuals and corporations in the form of retained earnings. In addition there is the impact of government on that: Are governments running surpluses or deficits?
Canada has been in the enviable position where governments, until recently, had not been a drag on the savings rate. They were a positive contributor. Our savings rate had been growing because of the positive fiscal developments over the last decade, whereas the U.S. was going down. The U.S. had among the lowest savings rates in the developed world.
The Chair: In our discussion with the governor of the Bank of Canada yesterday, there was some talk about the possible impact if those piggy banks are broken open and the money is poured into consumer purchases.
Mr. Rodgers: That can always be a desirable short-term strategy. In the long-term, it is healthy for investment to have decent savings rates, because investment is drawn from savings. If you have insufficient savings to obtain those investable funds, you have to look offshore to obtain them. That is what the U.S. did and why it got into a lot of trouble.
Turning to the longer-term policy responses, the longer-term policy responses are being guided by the G20 leaders' process. Responses promulgated by G20 leaders at their summits in April and September are very comprehensive indeed, and they address all the causes of the crisis that I laid out.
At this time, I would just like to go through what really needs to be done following from the causes that I laid out earlier with the steps outlined by the G20 to date.
First, we need to ensure against inappropriately loose monetary policy for lengthy periods. On that, the G20 has said they will be undertaking cooperative and coordinated exit strategies that will be implemented when the recovery becomes secured. Monetary policies are to be collectively consistent with more sustainable and balanced trajectories for the global economy, and there will be a new cooperative process of mutual assessment of each member's policy frameworks.
The second item is to reduce global imbalances. G20 members with sustained significant external deficits pledged to boost savings, consolidate fiscally and strengthen their export sector. G20 members with sustained, significant external surpluses pledged to boost investment, loosen fiscally by taking measures such as improving social safety nets, and strengthen the domestic economy. Monetary policies are to be consistent with price stability in the context of market- oriented exchange rates that reflect underlying economic fundamentals. G20 members are to refrain from competitive devaluation of their currencies.
The third item is the need to tighten financial regulations and strengthen supervision. Finance ministers and central bank governors are being asked to reach an agreement on stronger capital standards, building in countercyclical capital buffers, and to address cross-border resolutions in event of failures in systemically important financial institutions. These two measures conform to the recent agreement by the oversight body of the Basel committee on banking supervision.
G20 members are committed to the consistent implementation of global standards in order to avoid regulatory arbitrage, and by that I mean financial institutions shifting activities to other jurisdictions with looser regulations.
The fourth item is the need to improve securitization practices and risk management. Here, G20 leaders say that securitization sponsors or originators should retain a part of the risk of the underlying assets, thus encouraging them to act prudently. They have expanded the perimeter of regulation and oversight to include credit rating agencies. Specifically, finance ministers and central bank governors have been asked to reach an agreement on reforming compensation practices to support financial stability and improve the over-the-counter derivatives market.
Finally, to regulate the shadow banking system, the perimeter for regulatory oversight was extended to all systemically important financial institutions, instruments and markets. For the first time, this includes systematically important hedge funds, with supervision to be done on a consolidated basis. As well, regulatory systems are to be shaped to take account of macroprudential risks in addition to their microprudential risks.
That is the end of my presentation.
The Chair: Thank you very much. That was extremely well carried out. I think you had also prepared, had you not, at my suggestion, perhaps, some ideas for us going forward?
Mr. Rodgers: Yes. I can launch into that right now, if you would like.
The Chair: If you do not mind.
Mr. Rodgers: Again, my suggestions flow from the causes of the financial crisis, so I will first focus on monetary policy. Here I have a section entitled monetary policy in the face of asset-priced bubbles. This is something being talked about quite a lot in central banking circles right now, and I will just give a little preamble here.
Many central bankers contend that monetary policy would not be effective in leaning against the upswing of a credit cycle but that lower interest rates would be effective in cleaning it up afterwards. This is called the ``leaning cleaning'' scenario.
Canadian economist Bill White was a manager in the Bank of Canada for many years and held significant positions at the Bank for International Settlements. He forecast the global financial crisis long before it happened. He says that monetary policy should be focused on pre-emptive tightening to moderate these credit bubbles instead of pre-emptive easing to deal with their effects. He would like to see a new macro financial stability framework, which would use both regulatory and monetary instruments to resist these credit bubbles and promote sustainable growth. He was supported on this by Joseph Stiglitz, the 2001 Nobel Laureate, who believes that monetary policy should focus on financial stability and long-term growth, not just inflation.
The Bank of Canada's monetary policy targets inflation using interest rates as its instrument. Should it be considering the use of other targets and/or instruments to avoid excessive credit growth and asset price booms? My suggestion is that the committee may wish to hear from Bill White on this matter, as well as the Bank of Canada, to learn more about the challenges facing monetary policy in the context of low inflation but emerging housing price bubbles.
The second item has to do with global imbalances and the need for currency realignment. Global imbalances are one of the macro economic factors underlying the crisis. They remain a problem, and there is need for much better currency realignment to help deal with them.
Paul Krugman, who is the 2008 Nobel Laureate in economics, wrote about this in the New York Times on October 22. He singled out China as being a particular problem. He wrote that China's managed exchange rate is posing ``a greater threat to the rest of the world economy.''
The currency has been undervalued since China's current account surplus began growing at a tremendous rate after 2001. Had it been running a flexible currency like the other large economies in the world, its currency would have appreciated considerably. Instead it kept its currency fixed to the U.S. dollar until the middle of 2005 and has managed it thereafter, letting it appreciate a modest 17 per cent since then. In order to keep its value restrained, it has had to purchase vast quantities of foreign assets, mostly denominated in U.S. dollars, with its currency. These assets currently total $2.3 trillion.
Mr. Krugman and many other economists believe this asset-buying spree helped fuel the U.S. asset bubble, setting the stage for the global financial crisis. China has the world's largest current account surplus, $426 billion in 2008 compared with $17 billion in 2001. Given that, continuing to keep its currency fixed to the U.S. dollar at this particularly bad time in the world's economy is particularly egregious. The policy is literally stealing jobs from other countries; particularly the ones with flexible exchange rates like Canada. Those other economies within the G20 that have fixed or managed exchange rates are Argentina, India, Indonesia, Russia and Saudi Arabia.
A country like China accounts for a far larger share of the U.S. trade deficit but is largely avoiding the burden of the adjustment of U.S. dollar depreciation. This means that Canada, with its flexible exchange rate, has had to bear a disproportionate burden of adjustment. This has given impetus to China's recovery and put a drag on Canada's.
The G20 has pledged to refrain from competitive devaluation of its currencies and to maintain market-oriented exchange rates that reflect fundamentals. The criticism is that this may be rather toothless and not achieve a whole lot. Perhaps more needs to be done. The committee may therefore wish to study this issue, obtaining the thinking of, I would suggest, academics on this issue.
The next item is capital requirements and counter-cyclical capital buffers. This is the cornerstone of the G20's regulatory reforms. They even want to introduce a leverage requirement. Canadian financial institutions, unlike some of their international peers, entered the financial crisis well capitalized, yet this will impose new burden on them, particularly this counter-cyclical aspect. All of this needs to be worked out. Therefore, the committee may wish to hear from representatives from representatives of Canadian financial institutions in terms of the practicalities and challenges of implementing such an approach.
The next item is the originate to distribute model, avoiding another failure of asset-backed commercial paper, ABCP, and the role of credit agencies. As mentioned earlier, the ABCP market failure was a home-grown one for Canada. The market grew considerably in the years leading up to its failure in 2007. Canadian rules in respect of this product, being not as strict as they were in other countries, were part of the problem. Favourable grades that were provided by one credit agency in particular were also a problem. The committee may wish to hear from public and private sector financial experts on how originators of securities should have the incentive to monitor underlying loans and ensure that another ABCP type failure is avoided in the future.
The committee may also wish to hear from credit agencies and learn more about their modus operandi as well as hear from government regulators on how credit rating agencies should be subject to greater oversight.
The next item is regulation of mortgage markets. The committee may wish to examine if it would be more prudent for Canada Mortgage and Housing Corporation, CMHC, to return to a minimum down payment requirement of 25 per cent for conventional mortgages and 10 per cent for high leveraged mortgages compared to the current 20 and 5 per cent respectively. It may wish to hear from financial and housing experts as well as government and central bank representatives on this.
I mention this because just prior to the crisis, Canada had made a move to allow those with good credit ratings to put zero per cent down. It was actually even more than that; it could extend up to 103 or 104 per cent of the value of the loan if the banks factored in their transactional fees. We had a practice that was not too unlike the U.S. situation. This all happened around the end of 2006. I believe Scotiabank started it in October, but the government took action to prevent it in the latter part of 2008.
I should say that from talking to people in the financial industry and so forth, I have heard that Canada was lucky that financial crisis hit when it did, because up until then, our financial industry had been under some competitive pressure, mainly from the U.S., to extend more mortgages to the subprime component and so forth.
We cannot forget that these kinds of pressures exist. They are bound to come up again some day, in which case we cannot just be sanguine in the fact that we have come through this pretty well. We have to be forward looking and think about the prudent regulatory regime we should have in place for the long term.
The next item is macro prudential regulation. The G20 leaders' process is committed to overlaying macro prudential regulation onto micro prudential regulation. This could pose a difficult challenge for Canada, considering that we have a fairly complex regulatory system which is split between federal and provincial levels for the three pillars, not to mention credit unions. The committee may want to invite appropriate officials from federal and provincial finance departments, as well as officials from regulatory bodies, to discuss how Canada may best adopt a macro prudential approach in addition to a micro prudential one.
We benefit in Canada from coordinating committees, so some of this work is being done, but we will see more evolution taking place, and the committee may want to learn more about how this should be done. It is important; it is one of the key long-term policy responses, that our regulators take a macro prudential approach.
The next item is moral hazard. I mentioned that G7 finance ministers in their five-point plan of action in October 2008 made an important pledge to support systemically important financial institutions and prevent their failure. While this pledge was extremely important to give confidence during a time of market turmoil and recession, what will the impact be once we recover? Is this a licence to financial institutions to take on more risk than they otherwise would? I heard the governor of the Bank of Canada speak on this just the other day. It is indeed something we need to think about.
George Soros, the international financier, spoke on this, and he thinks the system is fraught with moral hazard right now and that the only thing that can be done is to have strict regulations rein in the industry so that they do not take advantage here.
Perhaps the committee would want to hear from Finance Canada officials in terms of what they intend it do to address the moral hazard implications of this pledge.
The next item is lessons learned by the Canadian financial industry from the crisis. The committee might focus on how Canadian financial institutions are changing their business models in response to the crisis, protecting themselves from future instability and what key lessons they are taking from the crisis, what the competitive challenges are for them in the new environment and how they see their peers in other countries changing and adapting. The committee might invite presenters from the Canadian financial industry and from the government.
The next item is the government policy responses, what worked well and what might have worked better. In particular, I would think the committee should focus on the extraordinary financing network and obtain the perspective of the financial industry on this government policy response.
Finally, something came to me while I was preparing these materials for you. That is, the difficulty in obtaining good housing financial information in Canada. I find it more difficult to obtain Canadian data than U.S. data, specifically data dealing with the subprime mortgage market and data on foreclosures. As well, one must go to a variety of sources. It might be more desirable to collect the data under one statistical agency and have that agency tasked with turning out regular reports on the housing market conditions.
That is from the point of view of transparency, so that we can obtain this data readily and so it will cast a greater spotlight on our housing industry, alerting policy makers in the wider public to emerging problems. The committee may wish to look into this issue, and I would suggest inviting CMHC as a start.
The Chair: Thank you very much, Mr. Rodgers. You have given us much food for thought. It has been very helpful indeed. Would it be possible to get a copy of your notes on your final portion?
Mr. Rodgers: Yes, certainly.
The Chair: We will distribute those to members of the committee when they are translated.
Senator Greene: Your presentation and the paper I read last night were among the best I have ever read on these issues. I have read parts of the story before in other articles and so on, but never before has it all been part of a synthesis that I could readily understand. It is quite wonderful.
Many people blame the United States for the problems that we are in, and, certainly, that is the place where the problems originated. They have a tendency, I think, to blame the U.S. and say that they did not know what they were doing or that they took a break from reality or whatever.
I tend to think that we are in the trouble we are in as part of the natural tension in a free market and a democratic society between the regulators and the anti-regulators. The anti-regulators win a couple of victories, and then the regulators come in to save the day and they might overdo it, and then the anti-regulators come back in and ease up.
I have a tendency to think what we have experienced, we will experience again, because it is a natural part of both a free market and the democratic system under which we live.
Could you comment on that?
Mr. Rodgers: There is no question that the epicentre of the crisis was the U.S., and a lot of what happened there was their own failings, but it was not just their failings. It was an internationally induced crisis as well, as I mentioned, in terms of the global imbalances.
In the famous speech given by Ben Bernanke in 2005 where he coined the term ``global glut of savings,'' he said much was made of U.S. fiscal deficits leading to their large requirement to borrow and so forth. He said that if they were running balanced budgets instead, it would not have made a very big difference. Their current account deficit might have been 20 per cent lower, or something like that, but they still would have been a heavy borrower, and a lot of those conditions that created the crisis would have been in place.
Therefore, one had to really look externally as to what was happening. There is no question that in this day and age of large and growing economies with inflexible exchange rates it presents a problem. China ascended to the World Trade Organization in 2001. Their trade just took off after that but, combined with a fixed exchange rate, they have been running the biggest beggar-thy-neighbour competitive devaluation policy that the world has ever seen. This cannot be ignored. I agree with your first statement that it is not just a U.S. problem.
You also mentioned that there are always tensions between regulators and business, with business pushing regulators to the hilt. Indeed, you did get regulatory arbitrage. I mentioned earlier about the relaxation of the net capital rules by the Securities Exchange Commission, which was prompted by the Europeans introducing a directive along these lines. The U.S. industry said that they needed the same thing. Hopefully through greater coordination at the regulatory level, we will be able to stifle this kind of activity.
As the world becomes more and more globalized, it needs to respond in terms of international policies to which everyone will adhere. Certainly, some countries will not play along. Currently, the G20 has banded together to represent 87 per cent of the world's economy. Outlier nations continue to act a certain way but the G20 is putting more and more pressure on them. They are trying to take the lid off tax havens and countries with banking secrecy by pressuring them to change. Going forward, we will see more penalties or sanctions or other such action applied to these countries with deemed non-responsive governments. If they are not responsive to the G20 request, actions of some sort will be taken against them, so it is at their own economic peril to ignore this. The whole process being unleashed is one of trying to obtain greater cooperation in terms of coordinating international policies.
That being said, there will always be pressure due to sheer competition, whereby industry will tell the regulators that they are stifling them and so they are falling behind. That will continue no matter what happens. Some economies in the world are more productive than we are in certain sectors due to the low wage rates and an abundant source of labour, such as in China. China creates 1 million jobs per month. They put infrastructure in place that is equivalent to the city of Vancouver every month. That is how fast they are growing.
Canada has an aging population, and that holds true for many advanced western countries. We will find it difficult to compete in the future so those tensions will remain. The Department of Finance will always have to look at everything in a balanced way — what is right for industry and what is right for consumers — and try to follow the right course. There is no doubt that in the regulatory world there is a variety of tensions that govern how policy is set.
Senator Frum: You mentioned that the world will be able to pressure China if it does not change the fixed exchanges rates. What kinds of levers exist to take action?
Mr. Rodgers: We have been seeing it for a long time. When our central bankers go to that part of the world, they try to use their moral suasion in their speeches. Basically, they say what the right thing would be for them to do, but it has been largely ignored. There is a mindset among the Chinese that this is absolutely anathema. They cannot even fathom it. They have to work on changing the mindset of the Chinese and instil upon them the idea of understanding their international responsibilities, in particular in light of the fact that we allowed them to accede to the World Trade Organization. While it is fine to have a currency board for Hong Kong or even for Argentina or other, when you are talking about one of the leading economies of the world in terms of its sheer size, it is too destabilizing for them to maintain these old policies. As a starting point, more needs to be done to educate them. To date, the odd central bank speech has not been sufficient. In the previous U.S. Congress a number of bills were put forward to deal with this, but they were private member bills that never went too far. More recently, the U.S. has been talking tougher, and perhaps something will be done in the end. This is the concern. If things get too bad, we could very well see some more force majeure action taken against the Chinese. Before we ever get there, it will be a slow step-wise incremental process of trying to bring them along. They can keep a fixed exchange rate as long as they revalue it every so often to reflect underlying fundamentals. The key is to try to keep the exchange rate in sync with the fundamentals.
Senator Harb: We would be wrong to blame China, in a sense, because as you just said, China brings about $2.3 trillion in assets to the U.S. that prop up the U.S. economy. One would think that China must have taken a big hit when the markets went down thanks to the lack of regulation in the U.S. and the fact that they cannot enforce something that does not exist. I am interested in your comments on this.
As well, perhaps you could comment on the vast majority of products shipped to the U.S. from China that are made by American corporations with plants in China. They take advantage of the cheap labour in China to bring goods to the U.S. for sale to consumers and the government increases their revenues through the related taxation. That plays a very important role. Ask Wal-Mart; they will tell you.
This committee travelled to New York two or three years ago where we met with some investment bankers. We were told that there is what they call a ``herd mentality'' among investors of the big pension funds. Curiously, they all place their bets the same way. No one thinks to be contrary to the trends. One might conclude that there was not much competition with everyone betting the same way. All of the sovereign funds from Saudi Arabia and other places around the world will be invested in the same way because they all follow the herd because that is what the herd tells them do. To a large extent, that played a role in creating the bubble. When it burst, it really burst big because there were not a lot of people on the other side to take advantage of the shortfall. That is part of why we had the crisis.
Many people seem to go back to this sub-prime bubble, which frustrates me a bit. I will tell you why, and your statistic proves it. In 2004 through 2006 we had the maximum amount of money that was lent to sub-prime. You said, in your own statistic, that the delinquency rate for this was at 41 per cent. If I want to do the math, I will say 41 out of 20, so that is about 10 per cent of the overall housing market. That could not be one of the reasons why this whole situation became such a mess. I agree with you that the situation became a mess because there are no regulations in the U.S. market and because there is no enforcement of those regulations. What frustrates me is the fact that no one is being punished. There is no deterrent.
In 2005 we started to feel there was a problem, and what did we do? According to your notes, and I agree with them, we started to tighten up. We increased the interest rate, and therefore, I submit, we caused a crisis. In 2008 what did we do? We decreased the interest rate because we wanted to loosen it up again.
In one way we tell people they are buying too much, they have to stop, we have to increase the interest rate, and so on; and then, when the recession hit, and hit big, we turned around and told people they need to spend more, go out and buy goods.
Obviously, the tool in question, the interest rate and the way it is used, plays an important role in the problem. Personally, what I found missing from this presentation is the fact that the key element to this whole crisis is the fact that there is no international standard when it comes to investment. When you lack that standard, you see funds jumping all over the place, creating bubbles in different parts of the world, and causing crises. If you add that to the fact that you do not have proper rules in place, then you have a mess.
The Chair: I think there might be more than one question in there, senator. I saw the witness writing furiously. We will see how he kept up.
Mr. Rodgers: Yes, there is no question that those who are holding U.S. assets right now may be taking a downturn. However, in the case of China, they keep their currency pretty well fixed to the U.S. dollar, so they are not depreciating, or appreciating for that matter. They are obtaining lower returns right now, but that is a worldwide phenomenon.
Yes, there were good aspects to what went on with China, and that may be why the situation was excused, in a way, for as long as it has been. I think social stability is the major policy directive of the Chinese. They have all these millions of people coming from rural areas into cities each year. They estimate the migration is 20 million, and there are only 12 million jobs. It is a considerable challenge for the policy-makers there to deal with this.
Our policy-makers are sympathetic to that too. We understand what they are working with and their challenges. That is not lost on us. We understand their need to be highly successful in export markets in order to be able to provide these jobs and maintain social stability, because there is not enough domestic market there.
However, we have evolved to a situation now where this country has $2.3 trillion of exchange-rate reserves. By maintaining a fixed currency, they have to invest those in foreign assets, when they could be turning around and investing more in themselves, and building up their domestic economy.
I represent Canada on the APEC Economic Committee, and this is an issue we talk about there. They will have to do this more and more. It is not just China. There are other Asian economies whose whole economic policy has a hyper focus on export promotion, to the detriment of their domestic economy. Then they become huge savers because there is a lack of social safety nets. We call these precautionary savings. They save far beyond what they should. If the governments started to modernize, there would be less need for that, and all of this would start to rebalance the world economy again.
I guess you could say it is growing pains for China to gradually make their way more fully as an international player. This is a process under way right now, but we have to keep encouraging this to take place so that the world is operating in a better balance. If not, the potential problem is that you will have a backlash among policy-makers. If we start to go through a lost decade, like Japan did in the 1990s, and if we are connecting that heavily to practices elsewhere, and, despite the G20 process, say, some nations within that process are not acting cooperatively, then you could see the whole system start to break down, and this would be unfortunate.
It comes back to conveying the information that it is in their best interest to do this. We cannot be seduced by the fact that all this Chinese investment in our assets allows us to run big deficits, and this is great. Nor can we be misled by the fact that it keeps their currency down so much that their products are dirt cheap and I can walk into Rona and pick up a Chinese product that costs one third of something produced in North America with, perhaps, the same quality.
That is living in a fool's paradise. That cannot continue forever. You have probably heard the hollowing-out argument. As long as we are continuing this way, our industry cannot compete and it is being devastated. You just have to look over the last decade at all the small, one-industry towns that have been wiped out in Canada and the U.S. This is a reality. Part of this will happen anyway due to sheer competition, but we do not need unfair competition due to artificial means like fixed-currency regimes and beggar-thy-neighbour policies.
You also mentioned the herd mentality. Yes, this is a bit of a concern now. In terms of the global economy, we have all gone into recession at the same time, and now we are all coordinating ourselves at the same time to undertake policies. I think we will see more of this. In the past, because we were not so coordinated, it always appeared that we had some economic sectors of the world growing at times when others did not, and somehow the world economy kept growing overall. You just have to look at the last major crisis, which was the Asia crisis in the late 1990s. It had a severe impact on that part of the world but look at the impact elsewhere. Look how it affected Canada. Canada was affected in an asymmetric manner. B.C, which traded so heavily with Asia, went into recession. The rest of the country was okay and Canada continued on fairly well.
This time it is truly shocking seeing that we have all gone down at the same time. One really has to think, as we coordinate ourselves better going forward and forming more and more economic blocs, that we will see more synchronization in the business cycle. That poses big challenges when we are all down at the same time, or even all up at the same time. I think that is a legitimate concern.
Have I answered all your questions?
Senator Harb: Yes, pretty well. Thank you.
[Translation]
Senator Hervieux-Payette: I want to thank you for this succinct but very complete summary of the events. There is one issue you have not dealt with as much as the others, the issue of compensation, which has been the root of the development of toxic products.
Unless I am mistaken, in our own regulating organizations, such as our financial institutions inspector, people are not paid $4 or $5 million per year. They are compensated like you are, like all bureaucrats are, and so they have no personal interest in not reporting things as they are.
This morning, I learned that credit rating agencies receive triple compensation for their assessment of toxic products or commercial paper. I had always thought that the fees were the same for all types of products but it would seem that assessing toxic products was much more rewarding financially.
Also, you did not talk very much about insurance companies. In the U.S., when you get a loan, it is backed by an insurance company. Two big corporations, Freddie Mac and Fannie Mae, provide insurance for all those transactions, and there are others such as AIG. All those people have received truly humongous amounts of compensation yet did produce anything tangible for the economy. They just took money from pension funds, generally for workers, from Canada, the U.S. and elsewhere.
We have seen this kind of commercial paper in Quebec. Corporations such as Jean Coutu have bought this type of paper. They have been paid back by the banks but what strikes me is that nobody in the regulating agencies, such as the Securities and Exchange Commission, blew the whistle and exposed this type of product.
I want to come back also to the mathematical model. To create such sophisticated financial products, originators used algorithms that can only be understood by mathematicians. It is with this type of financial model that the Caisse de dépôt in Quebec managed to lose $40 billion. All that was hidden behind a scientific cover.
Now, we are assessing our portfolios and we find — as you said — that we had mortgages with about 5 per cent rates of interest but that those who bought them after they had been packaged got rates of return of 15 per cent or 20 per cent. How do you explain that? One does not have to be a lawyer, an economist, a financier or an accountant to understand that this equation is impossible, even with the best leverage imaginable. In some cases, they added to the packages credit card balances and automobile loans which were not necessarily very lucrative. It seems that everyone kept their eyes shut.
My colleague referred earlier to the herd mentality but I believe it was worse than that: people wanted to be well compensated, whether they were in our institutions — and here I refer to the Caisse de dépôt — or whether they were the people manipulating the funds and receiving bonuses for their performance.
I wonder if those famous bonuses tied to performance and profits that were paid by the financial institutions should not be clawed back?
And the same thing is true for credit rating agencies and financial institutions. In New York City, billions of dollars are still being paid for bonuses this year by financial institutions. In Canada, some experts I know in the industry are telling me that, in 2009, even though our pension funds are in jeopardy, Canadian financial institutions will still pay significant bonuses. Indeed, thanks to higher bonuses than in 2008, people will receive even more compensation than last year.
How can we deal with that issue in order to protect the public interest? That money does not belong to them. The funds that they play with do not belong to them.
[English]
Mr. Rodgers: The question of remuneration is extremely important. It is important to Americans right now, and we have seen action from the President recently. He rolled back CEO salaries by 90 per cent. You asked how we can regulate this. The Americans are setting the example right now, showing just how far they are prepared to go.
This is unquestionably controversial. There are those who are asking how we will ensure good performance in financial institutions if this practice persists. They say we will see people shift away from major financial institutions and will not want to be bothered because they are not being compensated enough.
Some wonder where these will people go, and some say they will probably end up going to hedge funds or private equity funds. George Soros was asked recently what he thinks about this. He said that is good. This last crew has been a bunch of risk takers anyway and they are better off working for private equity funds and hedge funds and taking risks with investor money as opposed to depositors' money.
There is no question that the risk management problems can be tied to the way remuneration practices worked within financial institutions. Something has to be done here. There is already a process well under way. The Financial Stability Board has made some proposals in this regard that the G20 leaders have embraced. They want to have remuneration tied to long-term performance so a CEO cannot step in and take reckless decisions and make a killing in a year or two and get out the door, after which the place falls apart. Meanwhile he has enriched himself extraordinarily.
The thinking now is that it is better that performance bonuses be paid out over the long term or that there be clawbacks or such things to prevent that practice.
Look at the way we set up our own institutions. We have central bank governors with five- or seven-year terms. The whole idea is to ensure a long period of stability, so that they do not act recklessly and then leave. Normally over that period you will probably have some sort of business cycle take place, so they will be there, typically, in good times and bad. We do that at a government level. We should be seeing this more in the private sector too.
I alluded before to the Christopher Cox (SEC chair, 2005-09) argument about whether the private sector can be trusted to self-regulate. That was a philosophy that existed for a while. It really caught on. I think now that is a philosophy in utter retreat. We now know that does not work.
To go back to George Soros, this is a man who has made billions off of currency speculation and whatnot. He is considered a real oracle on these sorts of matters. The idea of economic orthodoxy is that markets will naturally head to equilibrium. Mr. Soros is not so sure about that: Markets can easily head to excess, so it is one of more boom and bust. The only way you can keep the scale of these fluctuations at more reasonable levels is through regulation. In this case it would be regulation of salaries of executives or people who are tied to risk taking within financial institutions, and this would be a desirable thing.
Senator Gerstein: May I start, Mr. Rodgers, by adding my comments to your outstanding presentation as has been indicated by my colleagues. Your excellent reputation which preceded you was well warranted.
Mr. Rodgers, history is dotted with financial bubbles and busts. It is almost 50 years since I graduated from school. Over the past 50 years there have been crises with conglomerates, several periods of crisis in the real estate business, junk bonds, savings and loans and of course the economic crisis we are facing today.
You have given us a framework of a number of things we might like to study here at the Banking Committee, which I am sure are very well accepted and will be very helpful. However, if I am not getting too personal, I would like to ask what keeps you up at night. What is in the back of your mind that could be the next crisis; or perhaps, for the younger members of this committee, what will they be able to look back at and say that on October 29, 2009, David Rodgers came to this committee and ``he told us so''?
Mr. Rodgers: I do like to think about long-term trends, and I think a backdrop facing all of us in the advance economiesd is the aging populations. We will see, over the next 20 years, our worker-to-retiree ratio in this country falling from five to one down to two and a half to one.
We really should, at this time, be undertaking public policies of saving; running government surpluses, ideally; saving up for the pension and health costs that will mount on us down the road. If we do not protect ourselves well enough in this regard, the social compact will be compromised. We will have to see less promise to people later on, and this is a worry of mine.
I thought we were going along very well in this country, and now the Minister of Finance said we have a $55 billion deficit in the works for this year. The Ontario deficit is $25 billion, and Quebec re-ratcheted theirs up to $5 billion. It is a total of $90 billion right now for Canada at the federal-provincial level. I think how sad it is that this is happening to us at this time and that really we will be in this situation for some years to come.
I am not crying Chicken Little here. I am not saying this is a devastating thing; it is just an unfortunate thing. However, if we do not start taking action to ensure that this is only a temporary thing until we will work our way out of it and restore normalcy, then we do run the risk of going down that slippery slope. Will we head into a situation where we run budget deficits for a 20-year period like we did from the mid 1970s to the mid 1990s? This would mean our economy will never reach its potential, that there will always be this large debt overhang. To me, debt is just deferred taxation. We will have to pay the piper at some point or see it in terms of reduced savings.
I am worried more for the burdens that will be placed on young workers starting into the workforce. What will be expected of them; the tax burdens; the differential between the goods and services they receive for their tax dollar and the taxes they are paying. At the time we were running huge structural deficits, the vast majority of people in this country were benefiting more from the government than they do in a situation when we are running surpluses. Yet the latter is the healthier framework for the government and for society. In a redistributive system, you have the minority who are really net beneficiaries under the tax transfer system. If you distort that, it is not a long-lived process.
I think the concern for me is one of re-establishing a more normal sustainable growth model again. Our policy- makers are committed to that. However, there are always risk elements associated with this that can dislodge you and make things more difficult to achieve as fast as you want. Targets get postponed and so forth. As I say, with the aging society backdrop, I do not think we can afford this.
There has been a tendency of policy-makers to jump in and fix hard every little thing that goes wrong. Maybe sometimes biting the bullet is necessary. I am not saying that should have happened this time around. As I outlined in my presentation, this was a particularly severe problem, and the policy-makers did just the right thing. Thank God for it. The fact that we are coming out of this downturn as fast as we are, is really a blessing.
Nevertheless, we need to be focused on the long-term reforms that will be key. They are the ones that will guide the long-term growth process.
We have to be thinking of sustainable growth, not this boom-bust type of model that we have been experiencing far too often. I agree that these boom-busts happen very frequently. On average in the past few decades we have seen that a crisis crops up every three years or so. The world should be learning more from its experiences.
Frankly, a lot of progress has been made. We have seen many of these problems like the tequila crisis in the 1990s and some of the South American crises and the Asia crisis. We can say a source of the problem was inflexible exchange rates and the balance of payments problems that resulted, leading to banking crises, liquidity crises and so forth. Yet, much more of the world now operates on a flexible exchange rate system, so many countries have learned.
I take satisfaction from seeing that the developing world entered into this financial crisis about a year after the advanced countries. Then there was thinking for a while, asking whether they are essentially delinked from us in terms of their economic growth models. We eventually found out that, no, in the end if the U.S. goes down far enough, the whole world will be affected by this.
Yet, the impact on them has been less and some of these economies have not slipped into recession. You look at China and India. Brazil has been doing reasonably well. Part of it has to do with better policies they have been pursuing. They are not building up big fiscal debt like they used to. They have been managing more open trading regimes. They have been doing many things that have helped them along the way. The progress, speaking globally, is all incremental. We are learning from each crisis, hopefully, that things will not be as bad as the last time.
This last particular crisis was unusual in its breadth and the number of factors that contributed to it. Some people think that it was not preventable, that this is just the way the world works, given human nature. They say people are greedy and regulators are always one step behind the savvy private sector and so forth. However, I do think there is much more that can be done to ensure that a crisis like this really does not erupt again. Crises will come and go, but hopefully not one like this.
The Chair: We are out of time. Obviously, there is a great appetite to discuss these matters and it would not be right to end without Senator Moore.
Senator Moore: I have such a list. On page 4, Mr. Rodgers, you mention that ``Canada did have home-grown problems, however — notably its non-bank asset-backed commercial paper market.''
Were those items that were being sold in Canada financial instruments created in the United States out of this sub- prime market down there, or were these tranches of Canadian mortgages?
Mr. Rodgers: The product originated here, but because it was a security, they took in various types of loans and packaged them together. They did actually have a sub-prime component.
Senator Moore: These were Canadian sub-primes?
Mr. Rodgers: I cannot answer that definitely. All I know is that that ended up being the big problem, that a sub- prime component entered into these trusts that were created. I do not know if they were U.S. sub-prime mortgages that were sold off in an international market or if they were strictly Canadian. My guess would be that there was probably a combination of the two, because the failure rates in the U.S. have been much greater and there indeed was a problem here. That whole episode has taken 17 months to resolve, and it was just resolved earlier this year, so the untangling was a tremendous exercise. I would think that there would have been a U.S. sub-prime element there that created the real problem.
There were other problems that were homegrown as well. For example, remember that the originator of this product can then turn around and sell it, and it can be resold and resold again, and the rules did not allow for a prospectus.
Senator Moore: You have to have them in these things. You have to have a prospectus for these derivatives.
Mr. Rodgers: Right. You get down to the sponsor later holding the trust. He is not entirely sure what is really there. He might see a listing, and it has got this.
Senator Moore: That is why they could not value it.
Mr. Rodgers: He did not know the toxicity factor. That is why the G20 is looking at ensuring that these sponsors- originators cannot sell it off holus-bolus; they must keep an element for themselves. That will be an incentive to ensure that this will be paid off properly, that good governance is being applied so that the investor at the other end, that you are selling the security to, will be paid off.
Senator Moore: I understand that a number of these companies that were basically U.S. companies, were primarily working out of offices in London, and that they had one tranche, a very far-out one, that was called the super seniors. They were holding a lot of that, and there was nothing behind them. It is one thing for them to hold some paper, but they have got to have the capital reserves to back it up. You can say, ``I have got some paper and I am taking some of the risk.'' Maybe this is the buffer you are talking about: they have to have something to back it up when it goes south. Someone has to pay.
I have one other quick question. China holds so much of the U.S. debt, and yet there are rumblings about maybe replacing the U.S. dollar as the currency of resort. They are talking about a kind of a super dollar based on the currency of five or six other countries or something. Yet China is causing this disruption to normalcy within the international economy and holding all this U.S. debt. At the same time they would want to have that debt repaid in U.S. dollars of a higher value than what they are causing. They want to get their money back. They do not want to get back 80 or 85 cents U.S.; they want 100 cents back.
Mr. Rodgers: Yes, but they are keeping their currency fixed to the U.S. dollar, as I say. They have negated the exchange rate risk. Where they are losing is on the interest being accrued, let us say, from treasuries that are yielding something extremely low. They are largely parked in something very safe like treasuries.
However, I should say that these countries with very large reserves are starting to look at how to diversify. We have seen China establish large sovereign wealth funds, for example, that could potentially take a more risky approach to investing and look more broadly.
There are a variety of sovereign wealth funds operating in the world right now and many of them stay quite safe. They invest in things like government bonds and treasury bills. Because of the decline in yield in recent years, there is some rethink as to whether they need to take on higher risk.
We went through all of this with the reform of the Canada Pension Plan back in the 1990s. We used to finance that plan by giving less than market rate loans to the provinces and then that was considered to be unaffordable when the plan was not in great shape. Then we started up an arm's length organization that began to take on more risk, so there is an equity component, real estate and whatnot.
I believe this will be more the strategy you will see out of China and other countries with large reserves. They are not going to just automatically park their money in things like treasuries. They will look to take on a little more risk there.
As to the idea of a global currency, yes, that has been floated by the Chinese this year. They wanted to see the IMF special drawing rates become the new global reserve currency. It certainly plays a small role at this time. It is nowhere near what the U.S. dollar is. It could be a very long-term solution, but because it is a dwarf compared to the U.S. dollar in terms of reserve assets, I do not see it happening any time soon.
The Chair: I am afraid this must bring to a close our very interesting session this morning and, as I said earlier, you have given us much food for thought as we go forward. We are interested in the macro implications of the financial crisis and where we go from here. You have pointed the way for us, I think, in several ways that we will have an opportunity to review.
Thanks to my colleagues and particularly to you, Mr. Rodgers. I am sorry we went overtime but that is an indication of the interest the subject holds.
(The committee adjourned.)