NINJA Loans & Speculative Purchases
People with no income, no jobs and assets were given home loans and mortgages, knowing that almost all of them will be unable to pay back (a.k.a subprime lending). (Liebowitz, 2009) The chart below shows the intensity of this game during 2008. Subprime mortgages spiked to nearly 20% and remained there through the 2005-2006 peak of the United States housing bubble. Also, in 2006, 22% of homes purchased (1.65 million units) were for investment purposes, with an additional 14% (1.07 million units) purchased as vacation homes.
Chinese mercantilism
China maintained an artificially weak currency to make Chinese goods relatively cheaper for foreign countries to purchase, thereby keeping its vast workforce occupied and encouraging exports to the U.S. One byproduct was a large accumulation of U.S. dollars by the Chinese government, which were then invested in U.S. government securities and those of Fannie Mae and Freddie Mac, providing additional funds for lending that contributed to the housing bubble. China's currency should have appreciated relative to the U.S. dollar beginning around 2001.
And Then the Bubble Burst!
U.S. households and financial institutions became increasingly indebted or overleveraged during the years preceding the crisis. This increased their vulnerability to the collapse of the housing bubble and worsened the ensuing economic downturn. The household debt as a percentage of annual disposable personal income was 127% at the end of 2007, versus 77% in 1990. Loans started going bad in enormous numbers to the extent that people lost their houses AND their money.
Role of Credit Rating Agencies
Credit rating agencies decided on the ratings, not on the basis of the position or return expected but on the level of compensation they would get from the bank. These high ratings enabled risky investments to be sold to investors, thereby financing the housing boom. During that time, one major rating agency had its stock increase six-fold and its earnings grew by 900%.
Role of Regulators
Regulators stopped doing what they had been appointed to do. They allowed excessive leverage; failed to criticize the large institutions’ business models and also, did not regulate derivatives.
Net Capital Rule Relaxed
In 2004, the Securities and Exchange Commission relaxed the net capital rule, which enabled investment banks to substantially increase the level of debt they were taking on, fueling the growth in mortgage-backed securities supporting subprime mortgages.
No Regulation of Shadow Banking System
Financial institutions in the shadow banking system were not subject to the same regulation as depository banks, allowing them to assume additional debt obligations relative to their financial cushion or capital base. Any institution performing the act of a bank is supposed to be regulated and that was overlooked.
Allowance to meddle with accounting rules
Regulators and accounting standard-setters allowed depository banks such as Citigroup to move significant amounts of assets and liabilities off-balance sheet into complex legal entities called structured investment vehicles, masking the weakness of the capital base of the firm or degree of leverage or risk taken. Off-balance sheet entities were also used by Enron as part of the scandal that brought down that company in 2001.
Self-regulation of derivatives
The U.S. Congress allowed the self-regulation of the derivatives market. Derivatives such as credit default swaps were used to hedge or speculate against particular credit risks. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47 trillion. (Loomis, 2009)
Removal of the Glass Steagall Act
(Eichengreen, 2012) In the days of fixed commissions, investment banks could make a comfortable living booking stock trades. Deregulation meant competition and thinner margins. Elimination of Glass-Steagall then allowed commercial banks to encroach on the investment banks’ other traditional preserves. In response, investment banks branched into new businesses like originating and distributing complex derivative securities. They borrowed money and put it to work to sustain their profitability. This gave rise to the first causes of the crisis: the originate-and-distribute model of securitization and the extensive use of leverage.
Corporate risk-taking and leverage
Leverage ratios of investment banks increased significantly during 2003–07. Debt taken on by financial institutions increased from 63.8% of U.S. gross domestic product in 1997 to 113.8% in 2007. This increased the vulnerability of investment banks to a financial shock. Five top institutions reported over $4.1 trillion in debt for fiscal year 2007, about 30% of USA nominal GDP for 2007. Lehman Brothers was liquidated, Bear Stearns and Merrill Lynch were sold at fire-sale prices, and Goldman Sachs and Morgan Stanley became commercial banks, subjecting themselves to more stringent regulation. Fannie Mae and Freddie Mac, owned or guaranteed nearly $5 trillion in mortgage obligations at the time they were placed into conservatorship by the U.S. government in September 2008.
Different names, one purpose (of investment portfolios)
One such investment portfolio was adjustable-rate mortgage; the bundling of subprime mortgages into mortgage-backed securities or collateralized debt obligations for sale to investors, a type of securitization; and a form of credit insurance called credit default swaps. The CDO in particular enabled financial institutions to obtain investor funds to finance subprime and other lending, extending or increasing the housing bubble and generating large fees. Approximately $1.6 trillion in CDO's were originated between 2003 and 2007. The pricing model for CDOs clearly did not reflect the level of risk they introduced into the system.
Another example relates to AIG, which insured obligations of various financial institutions through the usage of credit default swaps. The basic CDS transaction involved AIG receiving a premium in exchange for a promise to pay money to party A in the event party B defaulted. However, AIG did not have the financial strength to support its many CDS commitments. This is analogous to allowing many persons to buy insurance on the same house. Speculators that bought CDS insurance were betting that significant defaults would occur, while the sellers (such as AIG) bet they would not.
Mark-to-Market Accounting
Accounting rules require companies to adjust the value of such securities to market value, as opposed to the original price paid. Firms could use their own judgment in valuing assets. Many large financial institutions recognized significant losses during 2007 and 2008, as a result of marking-down MBS asset prices to market value. For some institutions, this also triggered a margin call, where lenders that had provided the funds using the MBS as collateral had contractual rights to get their money back. The combination of losses and margin calls resulted in further forced sales of MBS and emergency efforts to obtain liquidity. Writing down the assets presented both liquidity and solvency challenges.
Challenges facing economic managers of US and Eurozone today
The Federal Budget Deficit
The chart below shows the difference between actual and projected figures. Economic managers must work on reducing the federal deficit to begin paying down debt.
(Data)
Lengthy Recession
The following factors are making it difficult for economic managers to come out of the recession:
- Unemployment has fallen but it still remains high
- Low capital investment
- Economic output remains well below its potential
- Low consumer spending
- Weak consumer confidence
- Rising bank failures
- Increasing loan losses, spillover effects of mortgage problems and other asset backed securities.
- Fierce competition amongst banks for deposits
(Bureau of Labour Statistics)
(Bureau of Labour Statistics)
Risk of a country exiting EU
(LLP, 2012)The economic uncertainty affecting the Eurozone makes it increasingly important for investment managers to anticipate the impact of a "Eurozone event," such as the exit of a country from the Eurozone, and to plan the steps they would need to take in response to such a development. Managing this risk includes short and medium term steps to reduce risk or exposure, as well as the action that would need to be taken on the occurrence of an actual Eurozone exit.
Stimulus Programs
(LEVERGOOD, 2012) By their nature, stimulus programs cannot go on indefinitely. Having opted to stimulate the economy through public expenditure, public financial managers must consider which economic triggers should serve as a benchmark for phasing out economic recovery programs. For some countries, the ability to use public expenditures to boost economic activity is constrained by an inability to borrow at will to increase expenditures. When adopting a spending program, public financial managers must determine the focus of additional spending.
The Housing Market Remains a Challenge
Inventories of unsold homes are declining, but slowly. The overhang from the crisis continues to weigh on the prices.
Dodd Frank Act
(Zingales, 2012) Unfortunately the Dodd Frank act fails to address any problem suspected to have caused the financial crisis. Bond investors’ heavy reliance on credit-rating agencies, which tend to be laxer with powerful issuers, has not been fixed. The shadow banking sector’s dependence on the official banking sector’s liquidity and guarantees, and thus ultimately on the government, has not even been touched. And limits on financial institutions’ leverage will change only in the next decade. Money-market funds’ perverse incentives to take on excessive risk remain largely intact. Problems with incentive pay have been ignored.
Did companies that compensated their traders (and not just their CEOs) more highly take more risk? Was financial institutions’ assumption of excessive risk the result of incompetence or stupidity, or was it a rational response to the implicit guarantee offered by the government? Did the market see the spread of lax lending standards and price the relevant pools of loans accordingly, or was it fooled? Who were the ultimate buyers of these toxic products, and why did they buy them? How important a role was played by fraud? These are the questions that needed to be answered by the economic managers. Unfortunately, they are likely to remain unanswered without a major mandatory disclosure of data.
Position of the banking system in the U.S.
(BankScope, 2012) The US banking system is proportionally smaller than other advanced economies. Even with the consolidation of weaker players during the crisis, the U.S. continues to face challenges handling its banking industry.
Limited ability of Germany in EU’s bailout plan
(Scott, 2012) Germany can only go so far in bailing out Europe. The cost of recapitalizing European banks including those in Germany is estimated to be €420 billion just for non-performing loans. The cost of marking down sovereign debt would be much greater. As of last November, 20 of the largest banks in the European Union carried $4.2 trillion in PIIGS sovereign debt, about seven times the amount of their $620 billion in equity. Bailing out Europe is beyond the practical capacity of Germany, whose G.D.P. is approximately €2.6 trillion. Just as importantly, Germany faces severe political constraints on rescuing Europe. Chancellor Angela Merkel faces deep divisions within her own party, fueled by the constant negative drumbeat of the Bundesbank. If Germany does too much for Europe it could sink Merkel. If Germany does too little for Europe, it could cause deep resentment from those it refused to help. Too big a reparation burden on Germany after World War I contributed to the rise of the Nazis; in contrast, after World War II, we used the international approach of the Marshall Plan to rebuild Europe. Instead of placing another impossible burden on Germany, economic managers must take international action.
The European Central Bank can finance countries unable to borrow at affordable rates but this raises the specter of inflation and increases the debt burden of the sovereigns they are financing. The option of using exchange-rate adjustment, by abandoning the euro straightjacket of immutable fixed exchange rates, is beset by operational problems. The effective re-denomination of debt and temporary capital controls would require international approval. More fundamentally, it is feared that even a partial euro-zone breakup could be the start of the end of the European Union, a major step backward from decades of integration.
Austerity or no austerity
(Oumanski, 2012) Greece’s Parliament needs to approve an additional 11.5 billion euros in spending cuts for 2013-14. If it does, it will most likely prompt big protests in the streets. If it doesn’t, the so-called troika (the European Commission, the I.M.F. and the European Central Bank) won’t lend Greece the money to keep its economy afloat. If all sides get through intact, they’ll still be at loggerheads during the next phase of budget negotiations.
Pressure on fulfilling promises on Hollande
President François Hollande was elected, in part, for criticizing the austerity measures of Nicolas Sarkozy. Now Hollande is expected to cut more than 30 billion euros from his 2013 budget. Hollande has promised to increase the tax rate to 75 percent on incomes above 1 million euros, and he has imposed a one-time wealth tax on people worth more than 1.3 million euros. Some may have packed their bags for Belgium, but the tax isn’t as scary to the rich as it might appear. Very few people make 1 million euros in salary. On balance, this and other taxes on banks and businesses are expected to bring the government more money (about 7 billion euros a year) than they will scare away.
Effect of people’s perception of Mario Draghi
Since most countries left the gold standard over the last century, a currency’s value is based entirely on collective faith. With the dollar or the pound, people’s faith is rooted in centuries of good judgment by central bankers. But the euro is so young and under so much stress that, in many ways, its value is determined every day by what people think about the man in charge, , president of the European Central Bank.
Draghi could theoretically solve everything in an instant. The E.C.B. could buy up all the sovereign debt of Europe’s struggling countries, or at least enough of it to stop the world from panicking. That would allow each country to lend to its own troubled banks. Germany, fearing inflation, is telling him not to. But many economists are telling Draghi to do just that and more and to do it quickly.
Domino effect
About 20 percent of U.S. foreign trade is with the E.U. That’s significant, but if the European economy collapses, it’s quite likely that China, India, Brazil and several Gulf States will pick up much of the slack. And a truly collapsed euro would mean discounts on everything from French wine to Italian shoes to Greek yogurt. More worrying is if a) the euro zone faces an abrupt financial panic, and b) it turns out that many American banks are overly invested in those suddenly defunct European banks. There is a general assumption that U.S. banks are prepared for the worst. But many in the financial world thought they were prepared for the collapse of Lehman Brothers too.
Bibliography
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Eichengreen, B. (2012, November 14). Anatomy of a Crisis.
Koch, T. W. (n.d.). The Financial Crisis of 2007-2009. Colarado.
LEVERGOOD, D. N. (2012, January 15). Lessons learnt from global financial crisis.
Liebowitz, S. (2009, July 3). New Evidence on the Foreclosure Crisis. Wall Street Journal.
LLP, D. (2012). The Euro Crisis: Issues for Investment Managers and Financial Institutions.
Loomis. (2009, June). Fortune.
Oumanski, P. (2012, August 8). The Euro Crisis is Back from Vacation. The NewYork Times.
Scott, H. S. (2012, August). The Global (Not Eurozone Crisis). The NewYork Times.
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Wikipedia. (2012). Causes of the 2007–2012 global financial crisis.
Zingales, L. (2012, November 14). The Unexamined Crisis. Chicago.
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uzmaaltaf (student)
