Home .Finance The great American Financial crisis
The great American Financial crisis
Monday, 10 January 2011 05:11

As the OECD makes clear in its recent book on the causes, course and consequences of the Great Recession, the Great American Financial Crisis (otherwise known as the global financial crisis) is a product of easy money, financial innovation, greed, corruption and weak regulation.  Many, many people are to blame.  Are we doing enough to correct the regulatory deficiencies?  Sadly, no.

 

Let’s come back to the beginning of the crisis.  At the heart of most financial crises is a whole lot of bad debt in the financial system (financial crises can also be provoked by shortages in foreign exchange).  Such bad debt can threaten the functioning of the whole economy.  This is why governments should supervise and regulate the activities of financial institutions to ensure they do not provoke systemic risks for the whole economy.  The US had plenty of supervisors and regulators -- arguably too many -- as each one was watching his or her piece of the action.  But no-one was watching the overall financial system, and as discussed below, the enormous shadow banking system was not even supervised and regulated at all.   

 

When a crisis does occur, government should also intervene and save those financial institutions whose survival is necessary for the stability of the financial system, that is, financial institutions which were “too big to fail”, “too interconnected to fail” or “too complex to fail”.  But herein lies one of the great problems of the financial system, the problem of “moral hazard”.  Financial institutions who know that they might be saved when their viability is threatened, have a reduced incentive to behave prudently.          

 

If you want to have an idea of how bad debt is created, read this.  In the early 2000s, Clarence Nathan borrowed $540,000 against his house, even though he didn’t have a full time job.  Sure, he held down three part-time jobs.  But none of the jobs were very secure, and he earned just $45,000 a year.  He later told the US National Public Radio that if he were a bank, he would not have leant himself that money.  Indeed a decade earlier, the bank would not have loaned him that money.  In fact, there were lots of Clarences which fed into the global financial crisis.  They borrowed lots of money from banks who were not sufficiently well regulated and supervised for the risks involved.  They invested in real estate and stock markets contributing to housing and share price bubbles. 

 

So what changed so that Clarence could borrow so much money?

 

First, there was loads of money around, way too much we now realize.  Following the collapse of the dotcom bubble, the US Federal Reserve ran a policy of low interest rates and easy money.  As Japan was trying to recover from its lost decade, it also ran a policy of low interest rates to stimulate the economy.  But lots of Japanese money was then invested in the US since interest rates were still higher on US bonds (the “carry trade”).  Then China built up a large current account surplus much of which it invested in the US.  And with oil prices riding high, oil producers also invested lots of their surpluses in the US.

 

In short, the world economy was awash with easy credit, a lot of which ended up in the US.  Everything then seemed fine.  The economy was strong.  Housing and stock prices were driven high.  And home loans were made to all sorts of people including low-income people like Clarence.  (Loans to people with weak credit records, and therefore a higher risk of defaulting, are known as “subprime mortgages”.) 

 

Things seemed so good that in mid-2007, Citigroup CEO Chuck Prince said "When the music stops in terms of liquidity, things will be complicated.  But as long as the music is playing, you've got to get up and dance.  We're still dancing."  Alan Greenspan, the Chairman of the US Federal Reserve, did not follow the advice of former Fed Chairman William McChesney Martin "to take away the punch bowl just when the party starts getting interesting".   

 

But it was not just easy money that enabled people like Clarence to obtain a big housing loan.  He was also encouraged by George Bush’s 2004 “American Dream” home-owning policies which helped poorer Americans obtain zero equity mortgages.  As well-meaning as this policy was, it encouraged people like Clarence to take out a home loan even though they had little hope of repaying the loan.  It also meant that any fall in housing prices would result in negative equity for Clarence.

 

We should also remember that there is always a shark in every sea, and loan sharks are very plentiful in financial markets.  Many poor and innocent citizens were seduced into taking out loans that they could not avoid to repay.  Some loans were based on initial very low interst rates, which increased a couple of years later.  Paper work was often falsified and not checked.  Some people were even tricked into corrupt schemes.  These loan sharks were paid a commission on the number of loans they made, not on whether the borrowers actually repaid the loans.

 

Even though lending to subprime borrowers like Clarence seemed risky, banks believed that they could “manage” this risk by what is called “securitization”.  In short, banks would sell their loans on to an investment company who would then group together many loans into one investment instrument known as a mortgage-backed security (MBS).  These MBSs would then be sold onto investors including many investment banks.  The logic is that the risks of loan default were pooled together and spread out.  Everyone would not default together.  Regulatory and tax changes in 2004 provided a great incentive for securitisation which exploded after this time.

 

In this way, the bank now acts as a middleman between the home buyer like Clarence and the investment markets.  The bank no longer has to worry about whether the home buyer can repay his loan.  That is the problem of the ultimate holder of the MBSs.  Banks could earn quick fees on the operation and did not have to wait for the long term repayment of the loan and interest.  Bank staff were paid high bonuses for these transactions thereby encouraging risk taking by banks.  Securitization thus promoted a massive drop in lending standards, and increase in lending, because the bank that originated the loan was no longer the creditor of the loan.     

 

Not everyone was seduced by this fancy financial innovation.  Way back in 2002, Warren Buffet, the "Oracle of Omaha", and arguably the world' greastest investor denounced financial derivatives as "financial instruments of mass destruction, carrying dangers that, while now latent, are potentially lethal".  

 

But is there any institution which might be there to control the quality of the mortgage-backed securities?  This is where credit rating agencies come in.  They provided credit ratings on MBSs.  They even helped banks design MBSs in such a way that they could get a high rating for their securities!  After all, it was the banks who were paying the fees of the credit rating agencies.  And when poor investors saw the high credit ratings on the MBSs, they thought that they were a sure bet.  In fact, many low grade loans were packaged as AAA and became toxic assets.

 

Even if the holder of the MBS got nervous about the quality of his asset, there was another way out.  He could buy credit protection in the form of a “credit default swap” (CDS).  The seller of the CDS receives a fee for guaranteeing the credit worthiness of the MBS.  The buyer of a CDS will be entitled to the par value of the bond by the seller of the swap, should the MBS default in its payments.  And the seller of the CDS could manage their risks by pooling large numbers of them, again spreading the risk.  This is what the big US insurance company AIG was doing, selling large numbers of CDSs.

 

It is of course very clear by now that all of this is rather messy and risky.  Is there someone who should be watching over these silly games?  Is there a pilot in the plane?  In fact, this is the job of the board of directors.  But they were not always kept properly informed by banks’ management.  What’s more, even when they were informed, they did not always understand the information.  Not surprising, given the complexity of financial markets.  But it is the responsibility of the board of directors to understand what the institution is doing, and the full consequences of that.

 

The ultimate security was that there had never been a nationwide fall in housing prices since the 1930s.  So these investments were as safe as houses?  No.  The housing price bubble did burst as irrational exuberance hit up against hard reality.

 

Some of the biggest holders of these mortgage backed securities were the "shadow banks" like investment banks, finance companies, money market funds, hedge funds, etc.  The shadow banking system had grown to about the same size as the real banking system just prior to the crisis.  Shadow banks perform bank-like financial activities by borrowing short-term and lending long-term.  But unlike banks, they are very lightly regulated, and they were extremely highly leveraged.  They do not benefit from deposit insurance or lender of last resort facilities.  These shadow banks suffered a bank run, that is, a fast loss of deposits and other short-term liquidity, and were left short of liquidity.  This spilled over to commercial banks which were obliged under backstop agreements to provide funds to these shadow banks. 

 

It was this run on the shadow banking system that really started the global financial crisis.  To save the financial system, the government stepped in and provided funding, even though these shadow banks had no right to such funding. 

 

History shows that economic memories are short, even though the world is littered with financial crises.  But always, on the way up people believe or imagine that “this time is different”.  But that is rarely the case.  And this time it was also not the case.

 

The world economy went into recession in 2009.  Governments mobilized massive resources to keep financial systems functioning.  They guaranteed deposits to stop runs on banks, removed toxic assets from bank balance sheets, and recapitalised asset-cleansed banks.  They also started work on improving the regulation of financial markets to stop further crises like this happening again.

 

Major drivers of the crisis were MBSs and CDSs.  Ironically, they were supposed to improve risk management by diversifying risk.  Overall, the regulatory system failed massively. 

 

Without our financial systems, and especially banks, our complex modern economies could not exist.  They are at the heart of the payments systems, they are safe places to store money, and they bridge the gap between savers and borrowers.  But in its current form the financial system is contributing to financial instability.  New rules are needed.

 

Financial market regulation should aim to achieve the following objectives:

 

* Make financial systems less pro-cyclical.  Our economies move in cycles, and regrettably banks tend to lend too much in the good times helping fuel bubbles, and lend too little in bad times.  Regulations should aim to dampen this effect

* Restrict leverage.  Leverage refers to the proportion of funds borrowed for an investment.  If you borrow a very large proportion, in good times you can make lots of money, but in bad times your whole capital can be very quickly wiped out.  Banks’ leverage rations need to be better regulated.

* Improve risk management.  In theory banks had all the tools necessary for managing risk, but many of these fancy mathematical models did not work very well.

* Penalize mistakes.  As Professor Nouriel Roubini has argued, the present system involves the privatization of profits and the socialization of losses.  In other words, in the good times bankers get to keep their winnings, and in the bad times taxpayers pick up the tab.  OECD governments made commitments of over $11 trillion to support troubled banks and financial institutions.  This raises questions of social equity and justice, and highlights the problem of moral hazard.  More banks need to be allowed to fail.

 

Many reforms are being implemented, based in part on rules and guidelines from the Financial Stability Board, the Bank for International Settlements and the OECD.  The main lines of action have been:

 

* Improve transparency of banks’ exposure to risk;

* Increase surveillance of banks and financial institutions;

* Increase banks’ capital and liquidity requirements;

* Strengthen risk management and corporate governance;

* Limit executive pay;

* End “too big to fail” for banks or parts of banks that do not represent a systemic risk;

* Set high quality global accounting standards.

 

While some of these efforts to reform financial sector regulations are impressive, overall they are greatly insufficient.  The lobbying of Wall Street, and the power of money in the American political system, provide strong resistance against the necessary reforms.  In the UK, the power of “The City” is also too strong.

 

But beyond regulations, there is the issue of implementation.  This is very difficult especially since the staff of regulatory authorities are often young and lowly paid.  If they are any good, they are then offered a job on Wall Street.  And lastly, financial innovation is so dynamic that financial regulators are always fighting the last war.  New tricks are being invented all the time.

 

The ultimate risk in all this is to our societies.  If crises persist, along with their attendant social injustices, we could one day see a social uprising or revolution.  Don’t rule it out.

 

References:

From Crisis to Recovery, OECD Insights Series

http://www.oecd.org/document/3/0,3746,en_21571361_37705603_44006467_1_1_1_1,00.html  

 

 


rssfeed
Email Drucken Favoriten Twitter Facebook Myspace blogger google Yahoo
 

Copyright © 2011 Mr Globalization - Tackling the paradoxes of globalisation. All Rights Reserved.

United_States.jpg
San_Marino.jpg
Turkey.jpg
Zambia.jpg
Mozambique.jpg
Haiti.jpg
Laos.jpg
France.jpg
Monaco.jpg
Argentina.jpg
Namibia.jpg
Algeria.jpg
Mauritania.jpg
Israel.jpg
Costa_Rica.jpg
Sweden.jpg
Moldova.jpg
Vietnam.jpg
New_Zealand.jpg
Portugal.jpg