From boom to doom PDF Print E-mail
Political Science
Written by Jayanta Kumar   

Global Financial crisis

After the Great Depression, the world is seeing one of the worst economic crisis, say experts. The need of the hour  is not just to bring the economy back on track, but also to delve into the factors responsible for the chaos. It is only through an honest introspection by all those involved, that such a crisis can be averted in future.

It was only in the 1990s and early 2000 that the global economy was on a high. This buoyant state fuelled the capitalist greed, which in turn wove dreams for the common man. But, as the wise saying goes, wants can be satisfied but not greed; the slowly diminishing liquidity from the market turned the dreams into a mirage. What followed was the Global Financial crisis.

The term “Global Financial Crisis” (GFC) refers to the financial crisis that first started with the collapse of the US housing bubble, then spread throughout the US financial system, and gradually throughout the financial markets across the world.

The GFC is widely accepted as having started on August 9, 2007, with the announcement by the French bank BNP Paribas, that it was suspending redemptions from three of its funds that were heavily exposed to the US securitisation market. In a press release, BNP Paribas said, “The complete evaporation of liquidity in certain market segments of the US securitisation market has made it impossible to value certain assets fairly regardless of their quality or credit rating. We are therefore unable to calculate a reliable net asset value (NAV) for the funds.”

(Securitisation means to convert an asset, especially a loan, into marketable securities, typically to raise cash by selling them to investors.)

"In order to protect the interests and ensure the equal treatment of our investors, during these exceptional times, BNP Paribas Investment Partners has decided to temporarily suspend the calculation of the net asset value as well as subscriptions/redemptions, in strict compliance with regulations, for these funds,” it added.

BNP Paribas said the three funds had declined rapidly in value in the past few weeks to 1.593 billion euros ($2.19 billion) on August 7, down from 2.075 billion on July 27. The bank has 326 billion euros under management. BNP Paribas Investment Partners said the decision affected its Parvest Dynamic ABS, BNP Paribas ABS Euribor and BNP Paribas ABS Eonia funds. Valuation of the funds would resume as soon as liquidity returned to the market and, in the continued absence of liquidity, additional information on the envisaged measures would be given to investors within a month, the firm said.

Then, on September 15, 2008, the American global financial firm, Lehman Brothers collapsed, triggering the onset of a world-wide financial crisis.

Causes of the financial crisis

Discussing the causes of the GFC, sources at BNP, Paribas, said:

“Today’s global crisis was triggered by the collapse of the US housing bubble, but it wasn’t caused only by it. America’s credit excesses were in residential mortgages, commercial mortgages, credit cards, auto loans and student loans. There were also massive excesses in the securitised products that converted these into toxic financial derivatives; in borrowing by local governments; in financing leveraged buyouts that should never have occurred; in corporate bonds… in the unregulated credit default swap market.”

(Securitised products are marketable securities, sold to raise cash. Securities are broadly categorised into debt securities-banknotes, bonds, debentures-and equity services-common stock.)

(Credit Default Swaps (CDS) are financial instruments used as a hedge and protection for debt holders, in particular MBS (mortgage-based securities) investors, from the risk of default.

Elaborating on the causes, Michael West, an authority on financial matters, said:

“Leverage speculation and lax regulation were broadly to blame; the main culprits being the Wall Street Banks and the kowtowing US Federal Reserve.

(Leverage means the ratio of a company’s loan capital (debt) to the value of its common stock (equity). It also means using borrowed capital for an investment, expecting the profits made to be greater than the interest payable.)

(Speculation means making risky investments in stocks, property or other ventures in the hope of making a profit but with the risk of making a loss.)
(Lax regulation means poor control and supervision of financial markets.)

Michael further said that in 2004, the US Securities and Exchange Commission revoked long-standing rules that required brokers/dealers to keep their debt-to-net-capital ratio to 15-1 meaning for every $15 of debt, the banks were required to have $1 of equity. But, thanks to the lobbying from Wall Street, this ceiling was dropped, and the likes of Bear Sterns soon ran up a gross debt ratio of 33-1.

Meanwhile, Ross Gittins, an Australian political and economic journalist and author blames weak regulations for this major downturn in the economy. He also says that interest rates in America and Europe were held too low for too long. “Financial institutions borrowed too heavily, lent unwisely and made too much use of financial instruments they did not understand.”

Some other causes, which he said, had caused this turmoil are:
1. Banks lost trust in each other and refused to lend because no one knew who was holding how much in bad debts.
2. Many banks had lent too much relative to their share capital and were unwilling to increase their lending.

Who is to blame for the GFC?

It is very difficult to exactly pin-point any particular person or policy, which brought about this economic downfall. Roughly, we can put forward certain points, which could have triggered the crisis:

1. Some blame it on good times -- the economic boom of the 1990s and too much money available in the market during these times, from which emerged the overconfidence of both the borrowers as well as the lenders.

2. The former chairman of the Federal Reserve, Alan Greenspan, too is in the line of fire. The super-low interest rates, Greenspan brought in the early 2000 and his long-standing disdain for regulation are now held up as leading causes of mortgage crisis.

3. Twisted regulations are also being held responsible for the chaos. Both government action and inaction has contributed to the crisis. Some are of the opinion that the current American regulatory framework is outdated. Then President George W. Bush stated in September 2008: “Once this crisis is resolved, there will be time to update our financial regulatory structures. Our 21st century global economy remains regulated largely by outdated 20th century laws.” The Securities and Exchange Commission (SEC) has conceded that self-regulation of investment banks contributed to the crisis. Alan Greenspan too had admitted at the Congressional hearing that he “made a mistake by presuming that financial firms could regulate themselves”.

4. The homeownership obsession--Low interest rates and large inflows of foreign funds created easy credit conditions for a number of years prior to the crisis, fueling a housing market boom and encouraging debt-financed consumption. The USA home ownership rate increased from 64% in 1994 (about where it had been since 1980) to an all-time high of 69.2% in 2004. Subprime lending was a major contributor to this increase in home ownership rates and in the overall demand for housing, which drove prices higher.

Between 1997 and 2006, the price of the typical American house increased by 124%. This housing bubble resulted in quite a few homeowners refinancing their homes at lower interest rates, or financing consumer spending by taking out second mortgages secured by the price appreciation. USA household debt as a percentage of annual disposable personal income was 127% at the end of 2007, versus 77% in 1990. While housing prices were increasing, consumers were saving less and both borrowing and spending more. Starting in 2005, American households have spent more than 99.5% of their disposable personal income on consumption or interest payments. This credit and housing price explosion led to a building boom and eventually to a surplus of unsold homes, which caused US housing prices to peak and begin declining in mid-2006.

Easy credit, and a belief that house prices would continue to appreciate, had encouraged many subprime borrowers to obtain adjustable-rate mortgages. These mortgages enticed borrowers with a below market interest rate for some pre-determined period, followed by market interest rates for the remainder of the mortgage’s term. Borrowers who could not make the higher payments once the initial grace period ended tried to refinance their mortgages. Refinancing became more difficult, once house prices began to decline in many parts of the USA. Borrowers who found themselves unable to escape higher monthly payments by refinancing began to default.
As more borrowers stopped paying their mortgage payments, foreclosures and the supply of homes for sale increased. This placed downward pressure on housing prices, which further lowered homeowners’ equity. The decline in mortgage payments also reduced the value of mortgage-backed securities, which eroded the net worth and financial health of banks. This vicious cycle is at the heart of the crisis.
By September 2008, average US housing prices had declined by over 20% from their mid-2006 peak. This major and unexpected decline in house prices meant that many borrowers had zero or negative equity in their homes, meaning their homes were worth less than their mortgages. As of March 2008, an estimated 8.8 million borrowers — 10.8% of all homeowners — had negative equity in their homes, a number that is believed to have risen to 12 million by November 2008. Borrowers in this situation have an incentive to “walk away” from their mortgages and abandon their homes, even though doing so will damage their credit rating for a number of years.
People who predicted the GFC
Robert Shiller: In 2003, Shiller published a paper called “Is There a Bubble in the Housing Market?” In this, he raised apprehensions regarding the present downfall. “From 1890 through 1990, the return on residential real estate was just about zero after inflation… Since1987 it’s been 6% (or 3% a year after inflation)… I am inclined to think there is a good chance that the return on real estate will be negative, substantially negative, over the next 10 years because all booms reverse in the end.”
Nouriel Roubini: On September 7, 2006, Roubini addressed an audience of economists at the International Monetary Fund, and warned that the US was likely to soon face the bursting of the housing bubble, an oil shock, declining confidence and a deep recession. He also warned of homeowners defaulting on mortgages and unraveling of trillions of dollars of mortgage-based securities. This, he said, would bring the global financial system to a halt.

Steve Keen: In July1996, Keen made a submission to the Wallis Committee, warning that the securitisation of loans could lead to a crisis exactly like the sub-prime crisis. Sub-prime mortgages are mortgages sold by lenders, some of whom were unscruplous, to uncreditworthy borrowers who were also often poor and vulnerable. In July 1998, Keen wrote to the RBA regarding his “Financial Instability Hypothesis”, which said “we are likely to face a Great Depression”.

Hans Redeker: In December 2006, Redeker predicted a sharp recession in the US, claiming the condition of the housing market was worse than the experts were stating and the flow-on effects will be far worse than expected. In October 2008, he repeats his warning that abundant foreign money has been available to Australia and much of it has been spent on real estate, creating a speculative bubble.

Impact of the global financial crisis in the US

Between June 2007 and November 2008, Americans lost more than a quarter of their net worth. By early November 2008, a broad U.S. stock index, the S&P 500, was down 45 percent from its 2007 high. Housing prices had dropped 20% from their 2006 peak, with futures markets signaling a 30-35% potential drop. Total home equity in the United States, which was valued at $13 trillion at its peak in 2006, had dropped to $8.8 trillion by mid-2008 and was still falling in late 2008. Total retirement assets, Americans' second-largest household asset, dropped by 22 percent, from $10.3 trillion in 2006 to $8 trillion in mid-2008. During the same period, savings and investment assets (apart from retirement savings) lost $1.2 trillion and pension assets lost $1.3 trillion. Taken together, these losses total a staggering $8.3 trillion.

The crisis began to affect the financial sector in February 2007, when HSBC, the world's largest (2008) bank, wrote down its holdings of subprime-related MBS by $10.5 billion, the first major subprime related loss to be reported. During 2007, at least 100 mortgage companies either shut down, suspended operations or were sold.

During 2007, the crisis caused panic in financial markets and encouraged investors to take their money out of risky mortgage bonds and shaky equities and put it into commodities as "stores of value".[153] Financial speculation in commodity futures following the collapse of the financial derivatives markets has contributed to the world food price crisis and oil price increases due to a "commodities super-cycle.”

As of August 2008, financial firms around the globe have written down their holdings of subprime related securities by US$501 billion. The IMF estimates that financial institutions around the globe will eventually have to write off $1.5 trillion of their holdings of subprime MBSs. About $750 billion in such losses had been recognized as of November 2008. These losses have wiped out much of the capital of the world banking system.

Steps taken to solve the crisis

Various actions have been taken since the crisis became apparent in August 2007. In September 2008, major instability in world financial markets increased awareness and attention to the crisis. Various agencies and regulators, as well as political officials, began to take additional, more comprehensive steps to handle the crisis. To date, various government agencies have committed or spent trillions of dollars in loans, asset purchases, guarentees, and direct spending.

The central bank of the USA, the Federal Reserve, in partnership with central banks around the world, has taken several steps to address the crisis. Federal Reserve Chairman Ben Bernanke stated in early 2008: “Broadly, the Federal Reserve’s response has followed two tracks: efforts to support market liquidity and functioning and the pursuit of our macroeconomic objectives through monetary policy.”

Regulators and legislators have contemplated taking action with respect to lending practices, bankruptcy protection, tax policies, affordable housing, credit counseling, education, and the licensing and qualifications of lenders. Regulations or guidelines can influence the transparency and reporting required of lenders and the types of loans they choose to issue. Congressional committees are also conducting hearings to help identify solutions and apply pressure to the various parties involved.
A lesson for future

While the investors built “castles in the air”, several homes got destroyed on the ground and those who tried to bring forward the ground realities, were rebuked. Very soon, the entire global financial system was in bedlam as the “castles” came crumbling down. Though, the authorities have sprung into action, yet, it will take some time before there are some concrete changes visible in the global financial system. Moreover, there are lots of lessons to be learnt to avoid making the same mistakes.