Many of the world's central bankers saw signs of a credit crisis five years ago, said former Bank of Canada governor David Dodge, but no one foresaw the “period of great financial danger and unrest” that followed the meltdown in credit markets last summer.
“We've known for a long time, going back to 2003 and 2004, that we were building up to a global problem that needed to be resolved,” Mr. Dodge said during an interview to mark his new career as an Ottawa-based senior adviser to one of Canada's largest law firms, Bennett Jones LLP.
The biggest danger, he said was the overheated U.S. housing market and proliferation of mortgage-linked securities, which left global investors and major financial institutions exposed to billions of dollars of losses. Some powerful critics such as former U.S. Federal Reserve Board chairman Alan Greenspan privately warned for years “that a disaster was waiting to happen” in a real estate sector fed by historically easy access to mortgages, he said. But Wall Street and other regulators turned a deaf ear.
“It was very hard to get reform because there was the perception that if you make mortgages more accessible, you are helping homeowners, but what you're really doing is driving up home prices.”
In a wide-ranging interview during which he discussed monetary policy for the first time since retiring from the bank in January, the 65-year-old bureaucrat and academic was uncharacteristically blunt about “ridiculous” mortgage investment innovations.
Mr. Dodge pointed to the soon-to-be ended private sector life of U.S. mortgage backers Freddie Mac and Fannie Mae as “stupid” and the U.S. Treasury's intervention into the sale of hobbled Wall Street giant Bear Stearns Cos. Inc. as “brilliant.”
Mr. Dodge's sharp language is a departure from the careful central-bank-speak that defined his seven years at the helm of the Bank of Canada. Market watchers who devoted careers to parsing his language for nuances that could reshape currency and interest rate outlooks will now have to recalibrate their Dodgemeters for much franker economic assessments.
Even seven months after leaving the central bank, he occasionally catches himself when he loses that well-rehearsed central banker reserve and openly shares his unease over market dangers. For example, when applauding the Washington-managed takeover of Bear Stearns, he said: “This was a huge systemic problem and if any of the major counterparties would have gone, the whole house of cards – no, I should say, the whole system – would have frozen.”
Part of the appeal of joining a law firm, Mr. Dodge said, is the freedom he will have to speak out about economic issues. Unlike most retiring central bankers who move on to lucrative posts at investment banks or hedge funds, Mr. Dodge said he believed “I wouldn't have the freedom to talk about issues” if he worked for a financial institution “engaged in selling certain kinds of products.”
Unleashed from his central bank duties, he is planning major speeches in the next few months at the C.D. Howe Institute and the University of Western Ontario's Ivey School of Business to give his take on the roots and remedies for a global credit crunch that is choking economies and toppling once untouchable financial institutions.
While he declined to discuss his planned speeches in detail, it is clear a major focus will be the financial system's failures in recent years and the need for more co-ordinated regulation.
Much of the blame for the current credit crisis, he said, is the evolution of mortgage-backed securities that allowed banks to shift increasingly risky U.S. mortgage loans off their balance sheets into poorly understood securities sold around the world.
The “ridiculous” motivation behind the mortgage-backed securities, he said, was for banks to avoid the cost of setting aside capital reserves as required by bank regulators to cushion against potential losses. Once the mortgages morphed into securities, he said traditional caution about credit risk was abandoned and regulators learned too late that the innovations would trigger billions of dollars of losses.
“All of us didn't recognize the extent to which it would come back to hurt financial institutions,” he said.
The solution, he said, will be a more centralized and interventionist approach. Financial innovation has shifted billions of dollars of one-time bank products such as mortgage loans into virtually unregulated markets that need more transparency and tougher accounting standards.
One answer, he said, would be to regulate investment firms with the kind of credit and capital rules that govern retail banks. Investment houses such as Bear Stearns and Lehman Brothers Inc. were heavily exposed to the real estate crisis through the sale of and investment in mortgage-linked securities, but unlike banks they were not required to set aside capital reserves to cushion against losses.
Changing the regulatory regime, he concedes, will trigger “an enormous fight” from investment bankers and pose a “very difficult challenge” for rule makers who have to write laws for a constantly innovating market.
Maybe that's why, he says with large grin, “working for a law firm is such a good fit.”
VERBATIM
On the roots of the global credit crunch:
What we had was a financial system where leverage increased quite substantially while credit controls declined. Financial instruments were introduced and nobody had any idea about the risks.
On the need for greater government intervention in financial markets:
We have moved so much into the market in rather complex ways that it is hard to see how we can avoid systemic crises without bringing all of the big system financial players into some sort of collective regulatory oversight.
On the failure of wiser heads to restrain Wall Street:
So much of this originated from trading books and traders don't come at things from the point of view of credit risk. Alan Greenspan spent the last decade saying this is a disaster waiting to happen. It was very hard to get reform because there was this perception that if you make mortgages more accessible, you are helping homeowners.
On why Canada didn't need a Freddie Mac/Fannie Mae style intervention:
We didn't get ourselves in the stupid position that the Americans did with Freddie and Fannie. … To pretend that these [players] can operate according to private sector principles is just lunacy.
On the writedowns by banks on mortgage-linked securities:
All of us didn't recognize the extent to which these off-balance-sheet products would come back to hurt financial institutions. There was a sense that if they were off balance sheet, they couldn't be hurt. These products were designed to avoid capital reserves. It was ridiculous.
