Israel’s Banking System - More Luck Than Brains

The unflattering truth about how we avoided the great financial crisis of 2008.

Eytan Avriel
Eytan Avriel
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In this Sept. 29, 2008 file photo, a trader rubs his eyes as he works on the floor of the New York Stock Exchange
In this Sept. 29, 2008 file photo, a trader rubs his eyes as he works on the floor of the New York Stock ExchangeCredit: AP
Eytan Avriel
Eytan Avriel

“In 2006, I did not realize what they were doing. I did not realize why the banks abroad were giving credit customers such unreasonably easy conditions,” a very senior source in the Israeli banking system told us. “So I went to America to ask them. I sat with the people of one of the important banks, and after a few uncomfortable looks, they told me the truth. They did not hold the long-term loans that they gave – they almost always resold them. That was when I realized that the financial system was in trouble.”

That was how the senior bank manager revealed one of the causes of the great financial crisis of 2008, from which the world has not emerged yet: the fact that the banks created loans – the term they adopted for the trick was “origination” – and resold them right away to the public, to pension funds and to institutional investors. They did this in a variety of ways: directly, or after packaging the loans into portfolios of hundreds and thousands of various kinds of loans, which were cut into various types of bonds according to risk levels and sold to various kinds of investors.

So before 2008, it was a situation of “anything goes.” They introduced the world of “securitization” – mortgage customers, leasing contracts for cars, business loans, cash flow from credit cards, and actually everything they could think of, put it into a special company that was created for the purpose, and then issued a series of the new company’s bonds to institutional investors – in other words, to the public. The variety of tools in the financial jungle is huge: There are mortgage-backed securities, which are bonds of mortgage portfolios; credit-linked notes, which are bonds of loans provided to businesses; collateralized debt obligations, another variation that is comprised of several types of bonds – to name just a few. There is also CDO-Squared – bond portfolios of bond portfolios (it can go on ad infinitum), and there are also “synthetic” portfolios, which have nothing to do with real bonds, but only with insurance contracts against the bond’s going bankrupt.

The principle is always the same: If there is something – a business, a contract or a bond, that pays interest or creates any cash flow – an investment banker will always be found who will package it, tell everybody how good the investment is, and sell it to the public who is saving for their pension. There, the game is creativity and presenting a statistical formula that supposedly shows low risk and high yield. That is a kind of financial-mathematical alchemy in which one takes a lot of metal, mixes it well, and turns it into gold.

If you think that nobody is going to buy bonds of tycoons’ debts, think again. We will invite representatives of the institutions for a particularly lovely breakfast (in a five-star hotel in Eilat, with their families. Anyone who wants to can stay for the weekend; the flight and the hotel are on us), and we will tell them why these securities are excellent. It is true that the loans are problematic, but what is the chance that all the tycoons are going to go under at the same time? Some will fall, but some will certainly survive, right? The courts move slowly, right? Our mathematical model shows, according to past experience, that only one tycoon falls once every three years, so on average a portfolio of diversified assets will not collapse – and on the other hand it will bring in a high yield that will allow the institutions to show a nice yield in comparison with their competitors.

Financial tools of this kind, and ones that are even more bizarre, are just what the sophisticated capital market in New York and London invented in the years preceding the financial crisis – and to a large extent, they are the ones that crashed the whole system. Every bubble bursts in the end, and when housing prices began to drop, it seemed the statistical formulas held no water. What happened was that the “diversification principle” collapsed, and the correlation between the various securities, which had been low in the past (because there was no crisis in the past), coincided. Many of those bonds lost all their value almost overnight – and we should bear in mind that the credit ranking companies gave these products a grade of triple A.

‘Israel wasn’t affected by crisis’

The finance ministers, bankers and officials of the Bank of Israel like to state proudly, to the public and also to visitors from abroad, that unlike the United States and Europe, the banks and the financial system in Israel did not fall, and were almost unaffected by the financial crisis. While that is true, it would be a lie to hint that the reason for that was sophistication, planning or better predictive ability than that of the banks overseas.

The real reason that the local financial system was saved from the financial crisis is that the banks and the institutional investors simply did not manage to join the party before everything came crashing down. If the crash had taken place two years later, our banks would have fallen as well, and Israel would have crashed together with everybody else. And then the government, like in the other countries, would have had to take tens of billions of dollars of taxpayers’ money and invested it in “saving the banks” at the expense of health care, education and social welfare (because defense must never be touched, after all).

It is true that we were saved (people in the capital market like to say: “We did not get to a wedding, but we did not go to a funeral either”). But the real reason for that was a lag and of course a market without competition. Since our banks are as antiquated as a horse and buggy, but can create high profits with no risk and without sophistication with regard to the individual consumer and small business sectors, they had no motivation to hurry and upgrade the horse and buggy to a racing car. Overseas, because of the greed for profit and harsh competition, the banks transformed themselves into sophisticated racing cars, and then they roared off into the abyss the moment it started to rain and the road became slippery. So the next time you hear a senior official saying that Israel was not affected by the crisis, at least you will be able to smile because you know why.

Israel wants to securitize too

But suckers never die; they are just replaced. Several years have gone by since the sub-prime crisis, and our banks already want to go back into the securitization market, and in order to do that they are demanding that a local securitization market be developed. They want to take mortgages, package them, and sell them to people who are saving for retirement. They want to take tycoons’ credit and sell it to pensions. Practically speaking, they are already doing that. A “consortium” that includes Israel Discount Bank, Harel and HSBC Bank is currently trying to sell the public a package of bonds of Clal Industries that includes the loan it received from investor Len Blavatnik to acquire a controlling share of the company. Banks sold, or are trying to sell, the credit of profitable real-estate companies, the credit of diamond merchants and the credit issued for establishing energy companies to institutional investors. Everyone wants to sell “collections” of mortgages to the institutional investors, and are only waiting for the regulations to allow it. Whenever there is an increase in interest and unemployment and a decrease in prices, the mortgage problem will become the public’s problem.

An official committee is currently looking at setting new rules of the game. The regulatory agencies must assure that new regulations not permit the next crash. After all, that kind of luck never strikes twice.

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