university of stellenbosch |
The Global Financial Crisis |
John Maynard Keynes said that ‘financial speculation should be the bubbles on the stream of enterprise and productivity and not the other way around’ |
|
Fritz H Dausab-15161269 |
5/6/2013 |
“A sound banker, alas! Is not one who foresees danger and avoids it, but one who, when he is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him”. John Maynard Keynes, The Consequences to banks of the collapse in Money Values,” 1931 |
Table of Contents
Introduction 2
The Problem Statement 2
Pre-2008 Crises 3
The 2008 Crises 4
The Greed Factor 4
Banks regulation 4
Poor Risk management and Excessive leverage 5
Credit enhancement and securitization 5
Consequences 6
Possible solutions 6
Conclusion 7
Bibliography 7
Introduction
Banking crises captures headlines when they are overt, this leads to bank runs (People and institutions getting the money out of the banks or financial institutions like stock markets, in shortest possible time) in the form of capital flight, which usually results in a “credit crunch”, this leaves banks reluctant to lend, but also leaves the ordinary person on the street reluctant to use banks for savings. (Honohan & Laeven, 2005: IV)
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The (Global Financial Crisis) GBC was caused by the greediness and the interconnectedness of giant bank conglomerates and other shadow banks using higher risk structures like the hedge funds, investment banks and bank created Special Investment Vehicles. There was a link between the subprime-mortgage businesses in the USA, where banks gave high risk loans to people with very poor credit history. Yet commercial banks are regulated much more than other types of financial institutions such as investment banks.
The USA used the Keynesian economic model to their own peril as the model calls for government to have a bigger say in the economy. This view is contrary to Adam Smith’s view that the economy should not have any or only little government invention. This paper looks at how the subprime crisis came to be. It addresses the following questions: Why did no one heeded the warnings from Australia and Europe, why were there no early warning systems to warn the government and agencies such as the Security and Exchange Commission? Lastly what regulatory responses were put in place after the 1929 crash?
The Problem Statement
We examine why secondary market discipline has failed to halt the securitization (the term securitization revers to the financial technology of integrating the market of mortgages with the capital markets), of predatory loans. The problem is that Wall Street finances up to Eighty percent of Subprime home loans through securitization. The subprime sector of the USA is designed for borrowers with blemished credit records, people who have been dogged by predatory lending charges and many which have been substantiated. This is problem since subprime securitization grew, it has come about that securitization has turned a blind eye to abusive. (Engel & McCoy, 2007:2039)
In this paper one can argue that three basic issues were at the root of the GFC, the first is a questionable public-partnership-program- the national Homeowners Strategy-, which was conceived in Washington by politicians and which involves hundreds of companies, associations and even government institutions. This partnership was established to create affordable housing by using creative financing techniques. In the second place, regulatory agencies have encouraged the use of Over-the-counter derivatives and securities by any type of financial institution. The third blame falls firmly on the back of the SEC and the Financial Accounting Standards Board (FASB) in the use of the “fair value accounting”. (Whalen, 2008: 3)
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Washington consultant Robert Feinberg said in a March 2008 interview that in the US lobbyist created a myth that stated that you could not have too many houses in the US and it was up to the government to make sure it happened. That said you could not have enough housing and it was up to the government to make sure that happened. The home builders had a quota of 2 million units that had to be constructed every year. They really didn’t care what happened to those homes once they were built. (Whalen, R. 2008: 3)
Throughout the building up of the GFC, in the housing finance value chain, most of the contributors participate in the creation of bad mortgages and the selling of bad securities in the chain. This they did as they felt they would not be held accountable for any of their actions. Looking at this scenario, a bank could sell mortgages to non-creditworthy applicant home-owners; then a trader can sell toxic securities to investors, without any fear of reprisals if those contracts failed. Thus it was in the interest of brokers, banks, traders and other participators in the subprime mortgage game to make huge profits, while passing the problems onward until the pyramid scheme itself collapse, because the value of the houses went down. (Jickling, 2009: CSR2)
* Pre-2008 Crises
After WWI there was wide scaled depression and exchange controls after countries tried by al means to protect their currencies, markets and gold reserves. These controls were put on trade as well as capital movements. In part private capital movements from individuals were disrupted by the extensive debt of 1930’s leading into worse debt between countries in WWII. The two major components in 1930-1933 were the loss of confidence in financial institutions and the widespread insolvency. (Bernanke, 1983:4)
It was thus that exchange controls were put on hold after WWII and countries like US and Britain, hammered out a deal after WWII for the International Monetary System, which were subsequently approved at Bretton Woods in July 1944 and following acceptance by more trading partners, it was implemented in 1946. It sat up institutions like the International Monetary Fund (IMF) and the International Bank for reconstruction and Development (IBRD).
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The IBRD as the most important arm of IMF was setup to address the question of long-term capital movements after reconstruction of the First World countries, capital should be allowed to flow freely to third world countries as well. (Cooper, Tarrullo & Williamson, 1999: 96)
* The 2008 Crises
The current GFC started in the 1990’s in the USA and accelerated in the mid 2000’s. This can arguably trace its origins to the market for agency debt, in particular to paper issued by government-sponsored entities (GSE’s), presented by companies such as Fannie Mae and Freddie Mac. What basically caused the bubble to burst was the increasing greed by banks and mortgage brokers who relied on fees earned by writing mortgages for new homeowners. In turn the banks took these mortgages and sold them to capital markets as MBS (Mortgage Bond Securities) and as CDO’s (Collateralized Debt Obligations).
It is this lack of accountability with securities based model of mortgage finance, which became the greatest risk of all.
In September 2008, the Reserve Primary Fund announced to the investing world that it occurred losses on commercial paper it hold for Lehman brothers, this event in turn triggered a bank run for three days, and was only stopped by the intervention by the US government when it announced that it will provide deposit insurance in the money market funds. Even in 1970’s when the first ever large corporate company Penn Central defaulted and declared bankruptcy, the US Federal reserve also started lending aggressively to banks to stabilise the market.
These two events were the major crisis’s from 1970’s, and called into play the US governments role to respond to the free market crisis by either lending into the market or bring about policy changes. (Kacperczyk & Schnabl, 2009: 18)
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* The Greed Factor
“We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time — perhaps for a long time.” So wrote John Maynard Keynes in an essay titled “The Great Slump of 1930,” in which he tried to explain the catastrophe then overtaking the world. (Krugman, 2009)
* Banks regulation
Mortgage lending criteria were relaxed in early 2000’s and that rate of foreclosures played a huge role in brings the GFC about. It was against the backdrop of abundant credit for housing, the very low interest rates from the Federal Reserve and the rising house prises that many people could buy houses they could not afford or were credit worthy for. So when interest rates were raised, these home owners could not afford the mortgages on their homes.
The growth in the “markets” for OTC asset classes and related phenomena represents a reversal of nearly a century of regulatory and prudential practices in the U.S. Following the financial market crises of the 19th and early 20th centuries, the U.S. Congress substituted personal market discipline for regulation. The U.S. put in place legal strictures and market guidelines that required virtually all financial instruments to be traded on exchanges, with price discovery and counterparty credit risk issues exposed to the full light of public scrutiny and, thus, market discipline. However, with the “Big Bang” of decimalization in March 2001, the sell-side consensus surrounding the exchange-traded model, which already was under pressure, completely unravelled.
* Poor Risk management and Excessive leverage
In addition to regulatory collapse and inaction, the real problem was caused by the use of the Subprime mortgages as collateral to be sold on the international markets. The way they were packaged as ordinary shares to be traded on markets outside the bounds of established regulatory controls was the reason for the collapse. These were not ordinary shares of companies, but inferior assets of mortgage bond holders, who bought houses while they were not credit worthy. The regulators not only allow for the creation of these new but unregistered asset classes which have caused the public to lose money, but it also could not stop the use of structured products by banks to fund new and volatile inferior assets.
The Term Paper on The Causes Of Subprime Mortgage Financial Crisis
... of the subprime mortgage crisis. So the deregulation of the government exacerbated the formation of this financial crisis 2.6 Abuse of Financial Innovation Products Mortgage market bubble formed ... also eroded the worth and financial health of banks. This vicious cycle is the core of the financial crisis. 2.3 Inaccurate Credit Ratings Credit ...
* Credit enhancement and securitization
It should be noted that before securitization lenders- like commercial banks- would handle loans from beginning to the end. Thus they solicited loan applicants, underwrote and financed the mortgages, serviced the loans and the loans in the bank’s portfolio until maturity. In turn the lenders, e.g. the banks, made their profits from interest payments which were due on the loans. It is then that before the advent of securitization, lenders bore the full risk of default -When borrower cannot pay the mortgage further- thus initially lenders had the full right to turn down risky borrowers.
Securitization “the originate-to-distribute model,” was then put in place to alter this relationship between the lender and borrower, this was done by unbundling the tasks in lending and putting it as parcels among a string of market actors. In doing this the mortgage broker may recruit loan applicants, a lender may originate the loan, a specialist firm may provide the servicing the loan, then a trust can hold the loans and outside investors may provide the financing. This model reduced the lenders incentives to be prudent, especially in the vast demand from investors for these subprime loans, which were packaged as AAA bonds. Thus these mortgage-backed securities which were widely owned by investors all over the world caused worldwide repercussions when mortgage loans collapsed in 2007.
Consequences
In essence the GFC has resulted in a dead weight loss for society, in the sense of banking institutions through greediness and gambling with investor’s money to make more money that won after the government bailed them out after the market crash. This resulted in the government using taxes, printing more money to bail-out the financial institutions, with no benefit for the public. The one thing which stood from the GFC is the nationalisation of financial institutions like banks by the government, and it should thus be questioned whether the GFC was caused by little oversight and full knowledge by government?
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Even though the crisis’ which happened to the financial has been patched up by governments all over, many people are still worried that it may collapse. This is due to the movement of large sums of money moving across borders at the press of a button, this allows investors to take risks and as such increase the occurrences of crises. If one just has to look at large sums of money put on the future of company profits, whether interest rates or rise or fall, the hedging on exchange rates and many other economic indicators, it is no wonder that many economists like Susan Strange called financial markets “Casinos.” (O’Brien & Williams, 2010: 243)
Possible solutions
The first job of the government will be to rebuild the market confidence in structured assets which will need the market to go back to original principles on issues such as market transparency, the standardisation of contracts and accounting treatment. This can be done in providing investors with information they need to analyse collateral, for example by requiring SEC registration and public pricing of assets, much of the current liquidity problem is ameliorated.
Looking at Regulatory changes after the GFC is numerous, as these will include the prudential regulation for banks, and also stop the abuse of taxpayer’s money by Fannie Mae and Freddie Mac. Secondly it should assist with reform of the regulatory use of rating agencies like Moody’s opinions and lastly reform the asset manager’s fee structure to improve manager’s incentives to reduce riskier behaviours. It would also be good to get back to the systematic old way of buying a home, by paying a down payment matching assistance for new home owners. (Calomiris, 2008: 12)
Conclusion
The (Global Financial Crisis) GBC was caused by the greediness and the interconnectedness of giant bank conglomerates and other shadow banks using higher risk structures like the hedge funds, investment banks and bank created Special Investment Vehicles. The USA used the Keynesian economic model to their own peril as the model calls for government to have a bigger say in the economy. This view is contrary to Adam Smith’s view that the economy should not have any or only little government invention. The subprime sector of the USA is designed for borrowers with blemished credit records, people who have been dogged by predatory lending charges and many which have been substantiated. They really didn’t care what happened to those homes once they were built. Throughout the building up of the GFC, in the housing finance value chain, most of the contributors participate in the creation of bad mortgages and the selling of bad securities in the chain. This they did as they felt they would not be held accountable for any of their actions.
These two events were the major crisis’s from 1970’s, and called into play the US governments role to respond to the free market crisis by either lending into the market or bring about policy changes. It was against the backdrop of abundant credit for housing, the very low interest rates from the Federal Reserve and the rising house prises that many people could buy houses they could not afford or were credit worthy for. In addition to regulatory collapse and inaction, the real problem was caused by the use of the Subprime mortgages as collateral to be sold on the international markets.
Securitization “the originate-to-distribute model,” was then put in place to alter this relationship between the lender and borrower, this was done by unbundling the tasks in lending and putting it as parcels among a string of market actors. In essence the GFC has resulted in a dead weight loss for society, in the sense of banking institutions through greediness and gambling with investor’s money to make more money that won after the government bailed them out after the market crash.
The first job of the government will be to rebuild the market confidence in structured assets which will need the market to go back to original principles on issues such as market transparency, the standardisation of contracts and accounting treatment. Secondly it should assist with reform of the regulatory use of rating agencies like Moody’s opinions and lastly reform the asset manager’s fee structure to improve manager’s incentives to reduce riskier behaviours.
Bibliography
Bernanke, B.S. 1983. Non-Monetary effects of the financial crisis in the Propagation of the great Depression. NBER Working Paper Series 1054. Pp1-54
Calomiris, C.W. 2009. The Subprime Turmoil: What’s Old, What’s New, and What’s Next? The Journal of Structured Finance: Spring 2009, 15(1): 6-52
Cooper, R.N, Tarrullo, K.D. & Williamson, J. 1999. Should Capital Controls be banished? Brooking papers on Economic Activity, Vol. 1999, (1), 89-141
Engel, K. C. and McCoy, P. A. 2007. Turning a Blind Eye: Wall Street Finance of Predatory Lending (October 24, 2012).
Fordham Law Review, Vol. 75: 2039
GSE Nation: Interview with Robert Feinberg, The Institutional Risk Analyst, March 17, 2008
Honohan, P & Laeven, L. (Ed.).
2005. Systemic Financial Crises: Containment and Resolution. Cambridge University Press. Cambridge. Pg. iv-v
Jickling, M. (2009).
Causes of the financial crisis (R40173).
Washington, DC: Congressional Research Service. Pp. CRS 1-CRS 7
Kacperczyk, M & Schnabl, P. 2009. When safety Proved Risky: Commercial Paper during the Financial Crisis of 2007-2009. NBER working Paper 15538
Krugman, P. 2009. How did Economists get it so wrong? New York Times Magazine [September_6_2009]
O’Brien, R & Williams, M. 2010. Global Political Economy: Evolution and Dynamics. United Kingdom: Palgrave Macmillan
Whalen, R. C., “The Subprime Crisis-Cause, Effect and Consequences,” Network Financial Institute, March 4, 2008. Pp. 1-17
