Global Financial Crisis 2012 Essays

All signs point to 2012 witnessing an acceleration of the negative economic and fiscal metrics that plagued advanced and major emerging economies in 2011. In particular, the eurozone debt crisis, which dramatically worsened in 2011, shows no sign of abating in 2012. A clear indication of this is that eurozone cheerleaders President Nicolas Sarkozy of France and Chancellor Angela Merkel of Germany, in New Year's messages, warned that things with respect to the eurozone crisis will be even more dire in 2012.

A sign of how bad things look in Europe is the latest PMI data on European manufacturing, which was continuing to contract towards the tail end of 2011. This all points to a recession. In fact, there is now a clear consensus among economists that the eurozone will enter a double-dip recession in 2012, if it in fact has not already done so. Clearly, nations such as Greece, Ireland and Portugal are currently in a recession so deep, it meets the definition of a full-blown economic depression.

And what about the United States? With 2012 a presidential election year in America, expect the Obama administration to spin economic data seven ways to Sunday in an effort to make things look more rosy. Thus, an unprecedented reduction in the total size of the American work force is twisted into a lowering of the unemployment rate. But such gimmicks will probably become totally inoperative, once the impact of the looming eurozone recession and banking crisis migrates to American shores.

In 2009, in my book , Global Economic Forecast 2010-2015: Recession Into Depression,(www.globaleconomiccrisis.com) I forecasted that the massive transfer of private debt into public debt by sovereigns as a synchronized response to the global financial and economic crisis unleashed in 2008 by the collapse of Lehman Brothers would fail to resolve the crisis, and would lay the seeds for an even more virulent global economic crisis by 2012.

With a global sovereign debt crisis now an established reality, and the eurozone teetering while America has had its previous AAA credit rating downgraded by at least one major ratings agency, neither a continuation of failed policies nor gimmickry by politicians and central banks will bring an end to the global economic crisis in 2012. Instead of a return to economic growth, the most optimistic forecast one could make is stagnation which, at a time of structural mega-deficits and ballooning national debts, is a guarantee of further long-term economic misery for a great many of the planet's inhabitants.

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The 2007 to 2011 Financial Crisis Causes, Effects and Lessons

rodrigo | January 25, 2013

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Abstract

This paper provides a brief examination of the immediate causes and effects of the 2007 financial crisis, as well as an overview of lessons learned from it. I conclude that failure to properly regulate and supervise financial institutions set the stage for the crisis, while the US residential mortgage boom and bust triggered it. A credit freeze, bankruptcies, and hundreds of billions in government rescue ensued, resulting in a general economic downturn. The legacy of the crisis should be seen as an opportunity to revise the financial system as a whole.

 Introduction

The financial crisis that started in 2007 is the result of complex, interconnected, and simultaneous developments[1]. As such, I focus my analysis on the United States[2] and two distinct direct causes: (1) erroneous bank regulation – which destabilized the financial system – and (2) the pre-crisis real estate boom and bust. Whereas the former conditioned the crisis, the latter was its catalyst. In this brief essay, I discuss only the most important and immediate effects of the crisis – those that emerged between 2007 and 2012 – and discuss the conclusions that can be drawn accordingly.

1. Regulation destabilized the financial system

Regulation of US banks by the Fed, SEC, and FDIC,[3] as well as other regulatory agencies, contributed significantly to the erosion of financial system stability (Barth, Caprio and Levine, 2012, p.86). For example, in 1996, the Fed legitimized the use of Credit Default Swaps (CDS) as risk-hedging instruments (Levine 2010, p. 202, Appendix 1) and as a result many banks developed massive exposures (Figure 1) – AIG held over $500 billion in 2007 – while others were able to reduce their capital reserves by up to half in percentage terms (Barth, Caprio and Levine, 2012, p.92).

Figure 1: CDS market volume Q1 2001 to Q2 2007, trillion US$

         (International Securities and Derivatives Association cited in Baily, Litan and Johnson, 2008)

Another example is the SEC’s use of the “NRSRO” designation,[4] which led to a serious misalignment of credit rating agencies’ business incentives and resulted in inflationary provisions of investment-grade ratings for risky securities. This further deteriorated the viability of banks’ balance sheets (see Appendix 2).

1.1 Residential mortgage boom and bust

Simultaneously, the US residential real estate bubble (inspired by the assumption that housing prices would only go up) fueled excessive issuance of home mortgages (Figure 2). In turn, unsound lending practices, especially in sub-prime mortgage lending, bolstered housing prices by pushing demand, while filling institutions’ balance sheets with unrecognized risk (Barth 2009, p.92). The attractiveness of mortgages as “fail-safe” investments prompted many banks to shift their business model from “originate-to-hold” to “originate-to-sell”; instead of buying mortgages as an investment that generated a steady cash flow, banks securitized and sold them (Barth 2009, p.22). This effectively removed any incentive to analyze and control risk. However, this “out-of-sight-out-of-mind” mentality did not account for the fact that banks that securitized mortgages and invested in mortgage-backed securities (MBS) were often identical. Thus, risk was absent from balance sheets, but implicitly present in securities holdings (Appendix 3).

Figure 2: S&P-Shiller housing prices index (monthly), January 2001 to August 2012

(Standard & Poor’s Financial Services LLC, 2012)

The convoluted system of securitization faltered when housing prices started to decline and mortgage borrowers defaulted (Figure 3). This dried up the cash flow of mortgage-backed securities and made them virtually worthless; banks that relied on them to meet their obligations encountered trouble. Moreover, complex securitization practices made the extent of any one institution’s exposure anyone’s guess. Since, no one could be certain which banks would live to see another day, interbank lending froze. In short, not only did financial institutions possess worthless assets, but they were also unable to bridge shortages in cash (Figure 4).[5] In addition, mass defaults activated billions of dollars in CDS obligations and bankrupted all who were over-exposed.

Figure 3: Increase of delinquency rates (percent) of subprime loans between 2003 and 2007

(Arentsen, Mauer, Rosenlund, Zhang and Zhao, 2012, p.39)

Figure 4: Increase of the Federal Funds rate (percent, monthly) indicates interbank lending crisis

(Federal Reserve Bank of St. Louis, 2012)

2. Financial collapse and economic downturn

The immediate effects of the crisis are well known. Banks previously considered untouchable filed for bankruptcy (e.g. Lehmann Brothers), while others were acquired (Merrill Lynch by Bank of America), bailed-out, or taken over by the government (AIG and the GSEs Fannie Mae and Freddie Mac). Soon, the credit freeze affected the remaining economy as financing investments and borrowing became increasingly difficult. For example, between 2007 and 2009, approximately 8.8 million American jobs disappeared, U.S. GDP fell by more than five percent from its pre-recession peak (Treasury 2012), and the S&P 500 lost about 57 percent of its value (Lleo and Ziemba, 2011). Perhaps most famously, without governmental assistance, American automobile manufacturers GM and Chrysler would have become insolvent (Stewart 2012). Yet another legacy cost is the enormous government debt that resulted from rescues and other economic resuscitation programs (Barth 2009).

The crisis spread internationally (and most damagingly to Europe) because substantial loan derivatives were sold abroad. This does not imply that the U.S. is to blame for the crisis; every government had access to the same information as Fed, SEC, and FDIC, yet nearly all failed to recognize and address the systemic problem (Cox, Faucette and Lickstein, 2010).

4. Lessons

Mostly importantly, the crisis exposed the colossal failure of bank regulators,[6] and prompted a fundamental restructuring of banking regulation (such as the 2010 Dodd-Frank Act). In addition, the excessive complexity and behemoth size of the financial system have come under intense scrutiny. An important question has emerged from this examination, which asks, considering TARP[7], are some financial institutions “too big to fail?” (Greeley 2012). Moreover, the crisis has spawned a reexamination of the desirability of “laissez-faire” within the financial markets – that is, to what degree can market forces be relied upon to avert crises (Barth, Caprio and Levine, 2012, p.90)?

 

Conclusion

The financial crisis that began in 2007 still troubles us today. While some financial institutions have collapsed, those that remain have had to fundamentally rethink their role as credit providers. Governments were left with tremendous financial commitments, tasked with deconstructing the moral hazard of bank bailouts, and with regulating and supervising the financial system more efficiently. History has shown us that financial crises are a cyclical occurrence. Thus the question must be, can the cycle be broken, or is the next crisis waiting in the wings?

 

Bibliography

Arentsen, E., Mauer, D.C., Rosenlund, B., Zhang, H.H., Zhao, F., 2012. Subprime Mortgage Defaults and Credit Default Swaps. [pdf] University of British Columbia Sauder School of Business. Available at: <http://finance.sauder.ubc.ca/conferences/summer2012/files/papers/Mauer_CDSMS_Jan_1_2012.pdf> [Accessed 25 November 2012].

Baily, M.N., Litan, R.E. and Johnson, M.S., 2008. The Origins of the Financial Crisis. [online] Brookings Institution. Available at: <http://www.brookings.edu/~/media/research/files/papers/2008/11/origin%20crisis%20baily%20litan/11_origins_crisis_baily_litan> [Accessed 25 November 2012].

Bank of International Settlement (BIS), 2012. Detailed tables on semiannual OTC derivatives statistics at end-June 2012. [online] Available at: <http://www.bis.org/statistics/derdetailed.htm> [Accessed 26 November 2012].

Barth J.R., 2009. The Rise and Fall of the U.S. Mortgage and Credit Market. Hoboken, New Jersey: John Wiley & Sons, Inc.

Barth, J.R., Caprio, G. and Levine, R., 2012. Guardians of Finance, making regulators work for us. Cambridge, Massachusetts: The MIT Press.

Barth, J.R., Caprio, G. and Levine, R., 2012. Rethinking Bank Regulation, till angels govern. New York, New York: Cambridge University Press.

Congressional Budget Office, 2012. Report on the Troubled Asset Relief Program—October 2012. [pdf]. Available at: <http://www.cbo.gov/sites/default/files/cbofiles/attachments/TARP10-2012_0.pdf> [Accessed 25 November 2012].

Cox, J., Faucette, J. and Lickstein, C.V., 2010. Why Did the Credit Crisis Spread to Global Markets? [pdf] The University of Iowa Center for International Finance and Development. Available at: <http://blogs.law.uiowa.edu/ebook/uicifd-ebook/part-5-ii-why-did-credit-crisis-spread-global-markets> [Accessed 25 November 2012].

Federal Reserve Bank of St. Louis, 2012. Effective Federal Funds Rate (FEDFUNDS). [online] Available at: <http://research.stlouisfed.org/fred2/series/FEDFUNDS/downloaddata?cid=118> [Accessed 26 November 2012].

 

Greeley, B., 2012. The Price of Too Big Too Fail. Bloomberg Businessweek, [online] Available at: <http://www.businessweek.com/articles/2012-07-05/the-price-of-too-big-to-fail> [Accessed 26 November 2012].

 

Jickling, M., 2009. Causes of the Financial Crisis. [online] Congressional Research Service. Available at: <http://digitalcommons.ilr.cornell.edu/key_workplace/600/> [Accessed 25 November 2012].

Kohn D.L., 2010. The Federal Reserve’s Policy Actions during the Financial Crisis and Lessons for the Future. [online] Board of Governors of the Federal Reserve System. Available at: <http://www.federalreserve.gov/newsevents/speech/kohn20100513a.htm> [Accessed 25 November 2012].

Levine, R., 2010. An autopsy of the US financial system: accident, suicide, or negligent homicide, Journal of Financial Economic Policy. [online] Available at: <http://www.econ.brown.edu/fac/Ross_Levine/other%20files/Autopsy-4-13.pdf> [Accessed 25 November 2012].

Lleo, S. and Ziemba, W.T., 2011. Stock Market Crashes in 2007-2009: Were We Able to Predict Them? [pdf] Available through Social Sciences Research Network website <http://ssrn.com/abstract=1884081> [Accessed 25 November 2012].

Pagliari, S. and Young, K.L., 2012. Leveraged Interests: Financial Industry Power and the Role of Private Sector Coalitions. [pdf] Available at: <http://www.princeton.edu/politics/about/file-repository/public/Leveraged-Interests-November-2011.pdf> [Accessed 25 November 2012].

Standard & Poor’s Financial Services LLC, 2012. S&P Dow Jones Indices. [online] Available at: <http://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices/en/us/?indexId=spusa-cashpidff%E2%80%94p-us—-> [Accessed 25 November 2012].

Stewart, J.B., 2012. When Debating the Auto Bailout, Consider Lehman’s Fate. The New York Times, [online] 9 March. Available at: <http://www.nytimes.com/2012/03/10/business/when-debating-the-auto-bailout-consider-lehmans-fate.html?pagewanted=all> [Accessed 25 November 2012].

U.S. Department of the Treasury, 2012. The Financial Crisis Response In Charts [pdf] Available at: <http://www.treasury.gov/resource-center/data-chart-center/Documents/20120413_FinancialCrisisResponse.pdf> [Accessed 26 November 2012].

 

 Appendex

Appendix 1

A CDS is a derivative that enables the buyer to claim compensation from the seller if the underlying asset (such as a Mortgage Backed Securities or MBS) defaults. While useful for hedging purposes and as assessment tool for credit risk (a rising CDS premium indicates increasing risk for the underlying asset), it can be misused for speculative investing, as it does not require the buyer (or the seller) to actually hold the underlying asset.

Appendix 2

The SEC required every issuer of a new security to acquire a risk rating from a NRSRO in order to enable potential buyers to assess its risk and allow regulators to determine capital requirements (which were based on risk-adjusted assets). Those credit rating agencies privileged enough to have received NRSRO designation (namely the big three, S&P, Moody’s, and Fitch) slowly realigned their business models to accommodate issuers’ needs to purchase ratings by incentivizing employees to issue AAA ratings in order to grow the customer base. As a result, 56 percent of MBS issued between 2005 and 2007 and rated by S&P were eventually downgraded (Barth 2009, p.156).

Appendix 3

A common practice in the precursor to the crisis was to package mortgage loans into asset-backed securities (ABS, most notoriously, collateralized debt obligations or CDOs) and other securities according to tranches. These tranches were associated with different degrees of risk in order to cater to different investors. Oftentimes, ABS were re-packaged into CDOs squared and cubed. The common misconception prevailed that this would reduce risk by spreading it. In the wake of the crisis, with default rates skyrocketing, it became apparent that this system had become too complex for anyone to unravel, thus making any exposure assessment impossib



[1]    Rapid economic growth in BRIC countries, and the resulting flood of rent-seeking financial assets, mishaps in bank regulation and supervision, immoral business conduct of key-stakeholders, or the general failure to recognize the emergence of a bubble all conditioned each other and shaped the environment that resulted in the most severe meltdown since the Great Depression.

[2]    Though the financial crisis was markedly a global phenomenon, the United States were at the epicenter in terms of both causes and effects (Jickling 2009).

[3]    Federal Reserve Bank, Securities Exchange Commission, and Federal Deposit Insurance Corporation, respectively all regulate and supervise different (but sometimes overlapping) aspects of the US banking system (Barth, Caprio and Levine, 2012).

[4]    NRSRO – Nationally Recognized Statistical Rating Organizations.

[5]    To put the extent of the liquidity crunch into perspective, the Federal Reserve reacted by purchasing approximately US$1.25 trillion worth of securities (including Treasuries) between 2007 and 2010, compared to US$15 billion over the years prior (Kohn, 2010).

[6]    This is not to put blame solely on government agencies: Regulators and supervisors were heavily influenced by financial services lobbies (Pagliari and Young, 2012).

[7]    The Troubled Assets Relieve Program (TARP) is a government program that disbursed approximately US$431 billion to save financial institutions and other business from bankruptcy (CBO 2012, p.1).

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