Understanding The US Financial Crisis & Global Credit Crunch in 6 Steps

STEP 1

The Starting Point:

How political decision can be a cause of economic problem is found in the base of current US financial crisis. This financial crisis indeed started with the advent of a decision by the Clinton administration in 1994. In 1996, there would be a public election for electing president. Being a democrat, Clinton wanted to get the vote bank of 25% people of USA who didn’t possessed houses of their own. Clinton was definitely successful in achieving his political goal, but failed in terms of a economic manager if we consider the long run effect of that decision. Here in this report we are going to discuss the whole agenda in full detail to understand the situation better and we shall try to relate the phenomenon with the reality of Bangladesh.

STEP 2

The big flaw: Creating a Sub-prime Market

The sub-prime market differs from the prime market as it comprises all those people who do not meet the criteria for a mortgage in the mainstream markets. The adoption of the Depository Institution Deregulatory and Monetary Control Act in 1980 was part of the deregulation drive that eliminated many restrictions to lending, this resulted in loan reaching unprecedented levels which led to the mainstream mortgage market becoming saturated and reaching its peak of profitability. Those with patchy credit histories and of low income were turned away from mainstream mortgages at a time when the market was buoyant due to consumer spending and borrowing. The sub-prime market was carved out after this point as 25% of the US population fell into this category and represented a market opportunity. Hence US lenders gave mortgage to people who had little means to pay for a mortgage and charged them a rate of interest much higher than the commercial rate due to the increased default risk. They issued these mortgages sage in the knowledge that if the buyer defaults, then they would be able to repossess the property, and sell in a buoyant property market. By the start of 2007, the sub-prime market was valued at more then $1.3 trillion.

Traditional banks stayed away from this risky market and instead remained focused on prime lending and questioned some of the business practices of sub-prime companies such as their aggressive lending and accounting practices. Between 1994 and 1997 the number of sub-prime lenders tripled, gong from 70 to 210. because such institutions were not banks they possessed no customer deposits and in order to expand many lenders turned to the stock market for funding.

Companies such as Money Store, AMRESCO Inc, Dallas and Aames Financial Corporation, all raised capital through placing some of their companies on the stock market. Relatively young lender such as Long Corporation, Delta Funding Corporation, Irvine, California based New Century Financial Corporation, Delta Funding Corporation and Cityscape Financial all took their companies 100% public. By the end of 1997, the top 10 lenders accounted for 38% of all sub-prime lending.

STEP 3

Securitization

Most sub-prime lender then invented another of making money in a sector which was already highly risky. Many lender wanted to ensure they didn’t lose out at possible money making opportunities in the sub-prime market and developed a number of complex products; this was achieved by breaking down the value of the sub-prime mortgage market and various home loans in to financial sausage meat- just as wholesome as the real world equivalent- and selling them on to other institutions. Debt was sold to a third party, who would then receive the loan repayments and pay a fee for this privilege. Thus debt becomes tradable just like car. Hence the ability to securitize debt provided a way for risk to be sliced and diced and spread, thereby allowing more mortgages to be sold. Since 1994, the securitization rate of sub-prime loans increased from 32% to over 77% of total sub-prime loans. This process effectively increase the number of financial institutions with a stake in the sub-prime market. This was allowed to happen to the manner in which the original sub-prime loans were securitized.

Many institutions including mainstream Wall Street investment banks became owners of Collateralized Debt Obligation (CDOs). These are bonds created by a process of deconstructing and re-engineering asset-backed securities. This essentially works by proving investors with access to the regular payments received from debt payers in return for paying to have access to the CDO as well as management fees. Thus Wall Street investment banks made investment in the cash flown of the assts, rather than a direct investment in the underlying assets.

Many institutions also became owners of mortgage-backed securities (MBS), which were created out of the repackaging of sub-prime loans. In simple terms this is where a bank sells a set of debts as one product. In return for a fee, the new holder of this debt obligation receives the regular loan repayments. In most cases such a debt forms part of a pool of mortgage based debts lumped together into a form of asset or bond, each with different degrees of risk attached to them. Thus owners of MBS’s actually do not know the source of where the payments are coming from or even which sectors they’re being exposed to. The MBS market is worth $6 trillion currently, even more then US treasury bonds. The difference between CDOs and MBSs is in the later the property is placed as collateral. In any event of a downturn in the housing market, it would not only be the sub-prime providers who would lose out, but now all those who purchased collateral products would also be exposed.

STEP 4

The Role Of Credit Rating Agencies

Most debt carry ratings which indicate the amount of risk they entail, such a task is undertaken by credit rating agencies as an independent verification of credit worthiness. US home loans had been pooled and packaged into tradable securities by Wall Street banks, before being sold on to financial institution around the world. as they were bought and sold, these mortgage-backed securities were valued according to ther ratings given to them by the credit rating agencies. Credit agencies (dominate4d by the big three: Moody’s, S & P and Fitch) classify the risk of these repackaged securities according to their exposure to risky markets. CDOs were classified into tranches, the highest tranche was perceived to be very low risk and was often given an AAA rating- the same rating as high grade US Treasury Bonds. This is because in the even of default, the first to incur the loss would be the lower tranches and not the top tier. The mathematical models and simulations that the banks relied upon didn’t predict a scenario where defaults would become so numerous that even the top tier AAA-rated tranches would be affected.

STEP 5

Sub-prime Market Collapse & Effect On World Economies

As the housing sector continued to inflate due to the appetite for housing by Americans, the sub-prime sector continued to also grow. Commercial banks entered what they considered a buoyant market that could only rise, many Americans refinanced their homes by taking out second mortgages against the added value to use the fund for consumer spending. The first sign that the US housing bubble was in trouble was on the 2^nd April, 2007, when New Century Inc., the largest sub-prime mortgage lender in the US declared bankruptcy due to the increasing number of defaults from borrowers.

The crisis then spread to the owners of collateralized debt who were now in the position where the payments they were promised from the debt they had purchased was being defaulted upon. By being owners of various complex products, the constituent elements of such products resulted in many holders of such debt to sell other investments in order to balance losses incurred from exposure to the sub-rime sector or what is know as ‘covering a position’. This second round of selling to shore up funds and meet brokerage margin requirements is what caused the collapse in share prices across the world in August 2007, with the market getting into a vicious circle of falling prices leading to the further sales of shares to shore up losses.

What made matters worse was many investors caught in this vicious spiral of declining prices did not just sell sub-prime and related products, they sold anything that could be sold. This is why, share prices plummeted across the world and not just in those directly related to sub-prime mortgage. International institutes, who poured their money into the US housing sector realized they will not actually receive their money that they loaned out to investors as individual sub-prime mortgage holders were defaulting on mass on such loans; this resulted in all those who took positions in the housing sector not being able to pay the institutes they borrowed money from. It was for this reason central banks across the world intervened in the global economy in an unprecedented manner providing large amounts of cash to ensure such banks and institutes did not go bankrupt.

Major Sub-prime Losses (June, 2008)
Citigroup	$40.7 billion
UBS	$38 billion
Merrill Lynch	$31.7 billion
HSBC	$15.6 billion
Bank of America	$14.9 billion
Morgan Stanley	$12.6 billion
Royal Bank of Scotland	$12 billion
JP Morgan	$9.7 billion
Washington Mutual	$8.3 billion
Deutsche Bank	$7.5 billion
Wachovia	$7.3 billion
Others	$24.8 billion

The European Central Bank, America’s Federal Reserve and Japanese and Australian central banks injected over $300 billion into the banking system within 48 hours in a bid to avert financial crisis. They stepped in when banks, such Sentinel, a large American investment house, stopped investors from withdrawing their money, spooked by sudden and unexpected losses from bad loans in the American mortgage market, other institutions followed suit and suspended normal lending. Intervention by the world’s central banks in order to avert crisis cost them over $800 billion after only seven days.

STEP 6

Credit Crunch Across The World

Banks across the world fund the majority of their lending by borrowing from other banks or by raising money through the financial markets. As the realization dawned that sub-prime mortgage backed securities existed across the banking sector in the portfolios of banks and hedge funds around the world, from BNP Paribas to Bank of China. Many lenders stopped offering loans, some only offered loans at very high interest rates and most banks stopped lending to other banks to shore up their books. As no bank really knew how much each bank was exposed to the sub-prime crisis, many refused to lend to other banks, this led to credit crunch whereby those banks who made the majority of their loans from borrowed money found credit was drying up.

Northern Rock, the 5^th largest mortgage lender in UK, funded its lending by borrowing 80% from the financial markets. As the credit markets froze, it requested the Bank of England, as lender of last resort, for liquidity support facility due to problems in raising funds in the money markets. This created a run on the bank as depositors lost all confidence in the bank leading to queues developing across the nation as depositors withdrew their cash in panic. The British government took the controversial decision to nationalize Northern Rock as its collapse would have inevitably spread to other banks as panic stricken depositors attempted to withdraw their savings- the whole banking sector would have collapsed.

The Economic Recovery Myth

The Wall Street Journal reported today that Citigroup and Bank of America have both been told that they must raise billions of dollars of extra capital. The stress tests conducted by the US government on 19 banks found that Citi and Bank of America both need more funds to cover future losses caused by the economic downturn. 

 

 This report therefore suggests the financial crisis is far from over.

 For the last month various politicians have attempted to talk up the prospects of a recovery as both nationalization and continued stimulus packages have done little to stem the ‘great recession.’ 

 Capitalist nations are finding that lying to the public about the debt and unemployment scenario is really the best way to deal with the little faith that is left after a decade of excess.

 The problem fundamentally is down to the fact that Capitalist economies are not built upon anything real but contracts that are either derivatives of real assets or based upon future income streams. The boom of the last decade was built upon the real estate bubble, which was driven by debt – i.e. money that is built upon the prospect of future re-payments. The boom was also driven by a $500 trillion derivatives market built upon the illusion that the global economy will continue to grow. 

 Once such an illusion reached astronomical proportions and the financial industry realized that their future revenue streams were being defaulted upon on mass, the pack of cards came crumbling down. 

 Unless Western nations ditch such an approach to wealth creation, the global economy should expect another crisis – that’s if the global economy gets out of the current predicament. However the fact every thing can be commoditized, and that all participants of the ‘market’ can own whatever comes of the production line, whether real or not, means the current crisis is a result of idea’s that go right to the heart of Capitalism. 

 The way forward is not to lie to the public, but the discussion about alternatives based upon real wealth.

This is in response to the following article

Citigroup and Bank of America ‘must raise billions in extra capital’

The cost of bailing out capitalism

The International Monetary Fund’s latest Global Financial Stability Report has provided some conservative estimates of the potential global losses from bailing out the flawed capitalist financial system. According to the IMF, governments around the world will lose an estimated $4,400 billion on the loans and guarantees made to the financial sector over the last 18 months or so. 

$4,400 billion is the total value of all the good and services produced in 2007 in Japan, the second largest economy in the world. Yet this is a conservative estimate as it only covers banks’ losses on loans and securities and does not include the flawed an inactive derivatives market. 

Still this is an astonishing amount of expected loss that will need to be paid by ordinary taxpayers over decades. This is the price for bailing out capitalism. Despite governments’ committing nearly $9,000 billion in loans, asset purchase schemes and guarantees, with the justification of rescuing the real economy, the world economy is in the midst of a major global recession.

Driven by the venerated incentives of capitalism bankers took out huge loans to make colossal gambles which they lost. Rather than punishing this failure as capitalism espouses the bankers have been rescued with the world economy ending in deep recession. Private debt has been nationalised with the new debtors, taxpayers, unable to affect or influence the outcome of such a major catastrophe. 

Proponents of democracy champion the role played taxpayers in accounting democratic governments. It is argued democracy needs taxpayers. Yet we see taxpayers and their democratic representatives utterly powerless in influencing the course of events in the last 18 months when the tax burden has risen exponentially. 

The reality is political leaders are influenced more by rich bankers who can finance billion dollar election campaigns than ordinary citizens. This is demonstrated by the increasing role of bankers in government as detailed in “bankers own the congress.”

Thus this is not only a failure of capitalism but of democracy.

The absurdity of fiat currency

Martin Wolf, FT commentator, derides as absurd  gold replacing the fiat currency standard. We certainly live in strange times when the pick of so-called intellectual thinkers in the west considers gold, a currency with stable intrinsic value that has stood the test of time over centuries, unsound in favour of valueless fiat currencies, which are propped up by little more than the confidence one has in the governments that print and issue them.

Indeed, to appreciate the absurdity of fiat currencies need look no further then Zimbabwe today: Zimbabwe inflation hits 231 million per cent 

What’s more Zimbabwe is not an isolated example – there have been plenty of other fiat currency crashes: the Thai Bhat together with many other fiat currencies in the 1997/98 South East Asian crisis; the collapse of the Russian Ruble in 1998; Argentine Peso in 2001; Pound Sterling in 1992 etc.

What’s even more absurd is the idea that in the age of global finance with hundreds of millions in flight capital moving between financial centres with the ‘click of a mouse’ there will not be future fiat currency collapses or that such collapses may be averted by policymakers adjusting interest rates however loosely defined.

It their attempts to prolong the life of a fundamentally flawed capitalist financial model commentators like Martin Wolf have either lost sight of the obvious or are just deluded.

UK inequality proves bankruptcy of free market

Today’s data from the UK’s Department of Works and Pensions confirmed what many have known since Capitalism’s foundation. The income and wealth gap in the UK has got worse in the post war era and poverty has increased, especially amongst children in spite of annual real GDP growth of near 3% per annum. Whilst various critics have blamed the Labour party for the latest figures, wealth inequality is a problem all capitalist free market economies face. 

It should be remembered that until the downturn in the global economy politicians made many promises to eradicate and reduce poverty, however despite the supposed prosperity of the last decade a significant number of British society was not so fortunate.Statistics from HM Revenue and Customs show that the top 1% own over 21% of total wealth in the UK with the next 4% owning a further 18% of total wealth. The next 5% own a further 13% of the wealth generated in the UK. Thus 10% of the UK’s population own over 50% of total UK wealth! It is for this reason consumer debt in the UK is 1.4 trillion; the British economy itself is valued at £1.5 trillion.

Creating a level playing field where all of society can partake in wealth creation and circulation is the capitalism’s number one failure. This will always be the case since capitalism is only concerned with wealth creation; it pays little attention to the circulation of such wealth. Freedom of ownership, a revered principle underpinning capitalism, has only allowed the rich to get richer at the expense of the poor and no amount of tinkering with the free market will change this.

Stress testing banks will not address the credibility crisis facing capitalism

News that 10 US banks have failed the US Treasury’s ‘stress tests’ should not be surprising.

The capitalist baking model is flawed. Most intelligent commentators recognise that no bank is too big to fail. Banks create credit in multiples of actual Tier 1 capital such as cash and equity. By definition there will always be insufficient funds in banks if all depositors and borrowers came calling irrespective of the size of equity in a bank or how deep its pockets were. Indeed, attempting to rescue really big banks could potentially bring down national economies.

Why stress test banks then?

Capitalism faces not only a financial but a credibility crisis. The stress tests are aimed at persuading investors that these banks are viable businesses worth investing in in order to kick start flagging financial activity. The stress tests also suggest a kind of scientific approach to addressing the failure of banks as viable businesses. In actual fact the tests are half-baked attempts at concealing the systemic failure of the capitalist banking model.

The blame game

Did the financial crisis stem from market failure or government failure? Anti-capitalists argue the market spectacularly failed while conversely capitalists contend that the regulatory framework was responsible for the collapse in financial markets.

Both opinions falsely assumes the so called regulatory framework exists to control the market. In reality this could not be further from the truth.

Increasingly the ‘regulatory framework’ has been about promoting deregulation: the ‘big bang’ in the UK that liberalised financial markets in the mid 1980s; removal of exchange rate controls in the 1990; privatisations of the 1980s and 1990s; and the Basel banking accords encouraging riskier banking models and the promotion lose controls or ‘market discipline’.

There is little doubt the market failed – banks stopped lending even though that’s their primary purpose or raison detre. To deny this is just dogmatic – no matter how elaborate the reasoning. This market failure was not due to government regulation but because of an absence of government regulation. The poachers became the gamekeepers.

This has wider implications for western democratic societies and their ability to look after the interests of all thier citizens over an above those of the capitalist elites who dominate business, government and policymaking.