Introduction
Historically the world has faced quite a few financial crises -The Panic of 1907, Wall Street Crash of 1929 which led to Great Depression, Long Term Capital Bailout (1998). Dot Com Bubble (2000), California Electricity Crisis (2001) created by Enron. But at present the financial crisis is of much greater level spreading across not to few countries but through out the globe. The base of the financial crisis is the housing loan which were converted into financial instruments mainly derivatives and sold to every big financial institution across the globe and as a result a common man who is no where related to capital markets and his happy with investments in secured product has also not been spared.
The derivative instruments have correctly withstood their name ‘weapons of mass destruction’ as given by Warren Buffet. The derivatives have not only made investment banks like Lehman Brothers, Morgan Stanely, Goldman Sachs, become things of past, but also biggest insurance company globally- AIG, world biggest financial service Citi Group and several other banks and asset management company spread across globe have drowned in this financial tsunami. The fire has just not been in capital market across globe it has spread to commodity market, pension funds resulting in liquidity crunch across globes. A bust of housing bubble in USA had its effect shower across the globe in unrelated markets. This reflects the integration of world capital markets along with different markets across the globe. Therefore we should have a look at different aspects of the financial meltdown and the reason for its occurrence.
Housing Bubble
The end of era of Dot Com Bubble started another bigger and dangerous era called housing bubble. From 2000 to 2005 US housing market were in a boom phase. The sale price of existing homes increased in an exponential manner and speculative investment in properties skyrocketed the property prices. As the property prices increased availability of housing loan became easier and absolutely without any security. There was no credit check required to avail a housing loan. This started products called subprime
Ø Adjustable-Rate Mortgage (ARMs) which was based on variable interest rate.
Ø Moratorium Interest where the buyer has to pay only interest.
Ø Negative Amortization loan (NegAm) which let the borrower pay a portion of the monthly payment irrespective of interest and the due amount would be added back to principal would increase the amount of the loan.
The housing loan was based on recourse concept i.e. the financial institutions were giving loans against the properties. In case of default they would take back the property on which loan was given and as property rates were increasing the loan looked secured. The sub prime loans accounted for 15% of the USA mortgage market in 2006vs 3% in 2002 (Source: Danske Bank. March 30, 2008). To compete with private lenders, Fannie Mae and Freddie Mac lowered lending standards and provided mortgage loan to sub prime borrowers. This fuelled an unprecedented bubble in property prices. Buying a house and renovating or with minor repairing and again selling the house became an increasing trend. To be precise property were treated like commodity which was leading to speculative trading in them.
Derivative on Housing Loans
The effect of housing bubble passed across the globe and may unrelated financial institution thanks to derivate instruments based on the housing loan. Housing loans were securitized i.e. leveraging an already leveraged market. Securitization can be defined as mixing of different financial products with different risk category and trying to generate more than market return with less risk. Securitization process started with Freddie Mac, Fannie Mae and 12 Federal Home Loan Banks pooled together mortgages and bundled them up into asset-backed securities (ABSs) and sold the securitized product to generate more capital for providing more home loans. The sub prime loans had different categories of risk which were also taken care by financial institutions. The ABSs were pooled together to create Collateralized Debt Obligations (CDOs) and mix it with pension funds (the safest financial instrument across globe/across countries) and increase its credit rating. The credit rating are provided by rating agencies like Moody’s and S&P who rated such risky financial instruments as AAA – the safest rating for a financial instrument. As a result trillions of dollars of ASBs and CDOs were distributed through out the financial system. Increase in property price increased the price of derivatives and the notional profits of the institutions which made banks and other financial take more exposures in it and make the bubble bigger.
Decline
Decline of the instruments took place when defaults on the sub prime loans increased. As a result lot of property came on the block for sell and the supply for property surpassed the demand in the sector. The loan which seemed to be secured became unsecured and the global financial melt down began.
Aftermath – USA
The financial crisis hit the US financial markets worst of all. As the exposure of financial institutions in USA was much more in sub prime the down fall of sub prime based instruments even bought many companies down fall. The investment banks, commercial banks, hedge funds and private equity who had borrowed money to invest in ABSs, CDOs and structured products related to it faced a double edged sword. First of all the market for ABSs and CDOs dried up and companies found that their holdings of ABSs and CDOs were worth far less than what they had paid. Secondly the debt they had taken on their books was costing companies a lot. The interest cost was rising and there was no means to repay the loan. Moreover the investment banks like Lehman Brother had debt as much as forty times its paid up capital which resulted in their bankruptcy. Due to excessive lending in housing market and default rate rising liquidity crunch hit the system. Primary reason for the liquidity crunch was that in system there was no actual money on which credit creation was created. Credit creation and building of other instruments on it was based anticipation of money i.e. notional money. The rise in devaluation of MBSs prices market called for Credit-default Swap (or CDS) which in simple terms is insurance on debt i.e. banks buy CDS to protect against the company’s defaulting on its bond payments, In case of a default, the bank go to the insurer and cash in its CDS which took AIG down. The downfall of AIG was more dangerous than downfall of housing mortgage industry because in AIG lot of common man’s money was invested in safe products like insurance, pension funds etc which came under fire. Liquidity crunch made interest rise further causing more defaulters in mortgage industry. At higher interest rate refinancing was also out of option for a borrower. As the prices of houses declined the selling of houses even did not recover the mortgage amount which made NPA`s rise. Financial institution were facing liquidity crunch bad debt both from retail and corporate side and it was eroding their capital USA being a country running on credit faced heat in their core industries due to liquidity crunch. Investments in business declined due to lack of funds and demand in market which resulted in cut in production across sectors resulting in lay off and job cuts. The scenario brought in government participation in a capital economy.
Aftermath in Europe
In Europe the scenario was no different than USA. European economy suffers same kind of ailment as USA. European bank leverage levels are also very high. Europe has 38 x ratios for Assets/ Equity while in USA it is 21x (Citibank,”Downward Spiral”, 17th September 2008.). It also suffers with high house prices and UK Household Debt/ Income percentage in 2008 is around 160% (Citibank,”Downward Spiral”, 17th September 2008).Europe’s largest bank by asset- RBS was recapitalized by British government. The UK government injected capital in HBOS & LLyods TSB after making them as a merged entity. Northern Rock and Bradford & Bingley – two of the UK’s largest mortgage lenders became bankrupt and were nationalized. France and Belgium bailed out Dexia which sixteenth largest bank in Europe. Fortis was partly nationalized and rest sold off. There are three main reasons for European banks to face the financial crisis. First of all most of them high leveraged banking operations and secondly huge exposure in sub prime instrument and US markets. Thirdly the fluctuations in currency market having its effect on euro – dollar exchange rates. To control the situation and save from future damage European Central Banks are offering unlimited dollar funding to commercial banks in order to unclog inter bank lending. Thus the financial crisis in Europe was same as in USA.
Aftermath in GCC (Gulf Cooperation Council)
The Gulf Cooperation Council (GCC) constitutes of Saudi Arabia, the United Arab Emirates (UAE), Kuwait, Bahrain, Qatar and Oman – the oil rich countries. The financial melt down has not even spared GCC countries irrespective of its fundamental economic health and having large oil deposits. After the collapse of Lehman Brothers, the Saudi (TASI) equity index was down almost by one-third from year – to – year basis , and DUBAI stock market was down by 51%. Even the highly buoyant Qatar market was down 14% year-to-date and UAE and Kuwait also faced the same music. The reason for this meltdown was first off all lots of capital inflows were taken out by foreign investors due to redemption pressure, liquidity crunch and so on. Secondly the GCC countries have significant exposure in US markets example ADIA’s investment in Citigroup, Gulf institutions and investors are long-time holders of US debt instruments, commercial paper, and financial stocks and have felt the pinch of collapsing asset values in their international portfolios. And as a result the domestic stock market took the hit. Outflow of FDI from GCC countries is due to world wide bearish sentiment in financial market and pulling out money from GCC countries to finance capital requirement at domestic markets (USA & Europe) which was facing liquidity crunch. Third and the primary reason is the fall in the oil prices. Oil prices in September 2008 was hovering around $150 a barrel and at present it is trading around $40 a barrel. As the GCC primary and majority of the income is dependent on oil the huge decline in oil prices due to reduction in speculative activity in oil futures and decrease in demand. This had a direct impact at their income. Thus it reflects has the global markets (including different markets like capital market, commodity market, forex market) have integrated and so GCC are not immune to financial crisis even though their fundamental economic indicators remain positive.
The Savior Act -Government Response
The government was left with no choice than to recapitalize economy, inject capital into the system and take up stakes in private organization. The capitalist economy was in such a financial crisis that they had to resort to last resort i.e. government funding. The Federal Reserve has to travel in two boats inject capital in the system and lower interest rate. Federal Reserve has to lower rate for housing loan in order to generate demand for houses and most importantly the people who are becoming forceful defaulter’s thanks high interest rate can be saved. Fed is trying to get demand supply equation balanced in housing market as the supply of properties due to rise in default has surpassed the demand. Stabilizing the demand supply would result in stopping of further fall in property prices and instruments related to it. In relation to do so Federal reserve had announced two major moves in order to unfreeze credit for homebuyers, consumers and small business and committing $800 billion for the same.
The bailout of USA financial system started with Economic Stabilization Act 2008. As per the act the United States Secretary of the Treasury have rights to spend $700 billion in order to purchase distressed assets, especially mortgage-backed securities, and make capital injections into banks. The act mainly tries to stabilize the economy and save financial institution from becoming involvement. This move may also improve liquidity in the system.
The Federal Reserve not only was acting outside the financial system but was supporting from inside also like Bear Stearns buy out by J.P. Morgan Chase. In March 2008 J.P. Morgan revised the offer from $2 per share of Bear Stearns to $ 10 a share which increased the total offer from $500 million to $1.2 billion. In five days the deal was approved by Federal Reserve and for it Federal Reserve even issued a non recourse loan of $29billion to Bear Stearns. This meant that the loan is collateralized by mortgage debt. In case the collateral becomes insufficient to repay the loan Federal Reserve cannot take action against J.P. Morgan’s asset. Thus it meant that J.P. Morgan had only purchased asset of Bear Stearns and transferred all the liabilities to Federal Reserve. On the other hand Federal Reserve agreed to such a deal because if it had not agreed then $210 billion worth Bear Stearns’s MBA and other asset would have gone for sale causing a huge fall in the market across different securities. This was the extent of step taken by Federal Reserve in capital market and injection of capital in direct and indirect way.
Federal Reserve even attacked the base of the entire problem Housing Loan by Housing and Economic Recovery Act of 2008. The act in snapshot is about improving capital standards, management standards, more stringent audit and internal controls. It even establishes number of regulatory control, restrict asset growth and capital distributions for undercapitalized institutions and review and approve new product offerings. The act is formed to achieve as expressed by Federal Reserve Chairman Bernanke creating new equity for troubled homeowners in order to avoid foreclosures. Proper credit appraisal system to avoid future defaults. Investors and/or lenders will have to take significant losses in order to benefit from the proceeds of the loans refinanced with government insurance. Borrowers will have to share their new equity and future appreciation equally with FHA. Borrowers will pay for the FHA insurance.
The aim of Federal Reserve is to stabilize the market and pull it out of fear of future bigger losses. As credit markets are fearful and frozen in part because banks and other financial institutions do not know what their subprime mortgages and related securities are worth. The uncertainty is forcing lenders to hoard capital and stop the lending necessary for economic growth. Therefore these acts and injection of capital would restore investor’s confidence and would solve the problem of liquidity crunch in the market. The same kind of steps is taken by European government the UK Government is guaranteeing bank debt and injecting ₤50 billion into banks including RBS, HBOS, and
Lloyds TSB. Germany is guaranteeing up to $544 billion of bank debt and plans to buy equity stakes worth up to $109 billion. Iceland has nationalized its entire banking system, same is the scenario in France and Spain.
Conclusion
We can conclude that the global market including capital market , foreign exchange commodity market all have been integrated in such a manner that effect of one passes on to another at much bigger scale. The scenario is clearly reflected as the bubble of housing property busted its effect across globe in different markets. The government has tried to act and intervene in market and provide capital as well as guarantee for future losses. But it may not be sufficient to generate growth in economy. There has to be much more stringent audit checks, executive pay checks and accountability which has to be pushed in. The government has to create norms and mark the limit of exposure for every kind of business.
In short the government has to control the invisible hand in a capital economy in order to avoid future losses of this magnitude.
Works Cited Page
Ø Paul Muolo and Mathew Padilla. Chain of Blame, 2008
Ø Richard Bitner. Confessions of a Subprime Lender,2008
Ø Jim Stanford. The Global Financial Crisis for Beginners, 19th June2008
Ø HSBC Global Research. Global Economics Q4,2008
Ø James Quinn. Our Coming Depression,27th June 2008
Ø Shah Gilani. The Real Reason for the Global Financial Crisis…the Story No One’s Talking About, 18th September 2008
Ø Housing and Economic Recovery Act of 2008
Ø Emergency Economy Stabilizing Act 2008
Ø Souhail Karam. Global financial crisis exposes Gulf divisions, October 2008
Ø Sabhat Khan. Report for the Institute for Near East and Gulf Military Analysis, 2008
