Causes of Global Financial Crisis
The current global financial crisis is in nature synchronised and once in lifetime. There are different views regarding causes of the current financial crisis which has gripped the whole world. Some attribute it to failure of regulators and policy makers others say it is financial institutions. Yet others put the onus on savings of emerging market countries especially China.
No doubt current crisis clearly reflect lack of vision on part of policy makers. The free market and deregulation mantra rigorously promoted by leading policy makers during the last decade shifted the attention of all stakeholders away from regulating even the riskiest and complex financial derivative instruments which are hardly comprehendible for anyone except few mathematical and statistical magicians. If there would have been even a reasonable level of oversight of these complex financial derivatives, things would not be that worse as they are today. The chart below gives a very high level overview of the increase in the notional amount of outstanding over the counter (OTC) derivatives that multiplied almost seven times from just USD 94 trillion in June 2000 to USD 683.7 trillion in June 2008 as reported by Bank for International Settlements.
Chart o/s otc derivatives june 2000 to june 2008
The ignorance of regulators even added fuel to the fire. Regulators are not just there to ensure compliance with existing laws but to identify and rectify any loopholes in the existing regulations. On one hand, US federal reserve kept the interest rates at very low levels for extended period of time in order to avoid natural downturn in the economy and thereby created abundant liquidity in the system and promoted a culture of extravagance and living beyond means. The world will not finance US consumer spending forever as the debt needs repayment which is not possible if you spend more than you earn. Savings as a percentage of household disposable income gradually decreased from 9% In 1980 to 1% in 2007 as published by Federal agencies which clearly reflect this culture. Even at one point in 2005 it went into negative zone which means US consumers were spending more than they were earning.
On the other hand, assumption that the financial market participants can look after their interests better than anyone else, promoted an illusion that there is no need to regulate the financial system. This assumption was flawed and completely ignored two factors, the element of competition in the financial services industry and greed. If I put myself into the shoes of those banking executives I might do the same as they did because if I adopt a conservative approach towards risk short term profitability will be hit and there would be huge pressure and criticism from various groups e.g. investors, media etc. regarding the performance of my organisation as compared to other market players. Though short sighted criticism by media or analysts does not prove legitimatecy for blind risk taking in order to boost short term profitability at the cost of long term survival of the organisation. Moreover, linkage between short term performance and remuneration packages of executives provoked them to take unusually high risk which produce huge profits in short term.
In addition to that, not only financial institutions but also credit rating agencies mispriced the risk. They failed to price risk attributable to externalities. The simplest example of pricing externalities is taking into account impact of failure of the organisation in question on the whole financial system e.g. in case failure of Citibank there will huge impact on the financial system as compared to failure of any small regional financial institution making it more expensive to bet on Citibank. Risks are generally mispriced not only in the financial services industry but also in other industries e.g. automobile industry, the price of a car only includes manufacturing cost plus margin, taxes etc. but the pricing mechanism does not take into account the cost of impact of that car on the environment and decline in the available energy resources.
Financial engineering has proved too expensive for the global economy so far. Complex derivative financial instruments like Credit Default Swaps (CDS) and Collateral Debt Obligations (CDO) no doubt increased the liquidity in the system but at the same time encouraged reckless lending practices e.g. sub prime lending and speculation.
CDO is a security whose principal and interest are repaid by the cash flows generated by a portfolio of assets (usually loans and bonds). The portfolio of assets is the collateral and it is usually in the balance sheet of a separate entity, called special purpose vehicle, which has the CDO as its only liability and the assets in the portfolio as its only assets. It is CDOs and similar financial instruments that enabled the originators of loans to sell loan portfolios and thereby increased the liquidity of the long term loans. It is interesting that a financial institution can now sell the loan it has originated to someone sitting at the other corner of the globe through instruments like CDOs thus transferring the inherent credit risk involved in the lending and promoted careless lending practices. This is simple logic which also applies at individual level e.g. if one knows he can sell the loan he lent to anyone and earn a profit then one will not hesitate to give the money even to a person to whom no one will lend a penny. This is what exactly happened in the case of sub prime lending.
CDS is an instrument in which the buyer makes periodic payments to the seller, and in return receives a compensation if an underlying financial instrument defaults. It is effectively insurance against default by the counterparty with the difference that in case of insurance insurer is regulated and adhere to insurance regulations e.g. capital requirements whilst in the case of CDS the writer or seller need not to be a regulated entity thus increasing the counterparty risk which in my view is a huge regulatory failure. Due to this flaw huge amount of CDS were sold by hedge funds without any consideration whether the entity will be capable to pay the compensation if it is required in the future. On top of that market participants bought and sold CDS for speculative purposes i.e. without having the underlying asset similar to short selling o f equities.The following table illustrate the outstanding notional amount of CDS and corresponding market values from June 2007 to June 2008. Though outstanding notional amount has just increased by 35% corresponding market values has soared to USD 3.1 trillion more than 4 times of market value at June 2007 that gives clear idea of increase in counterparty default risk since this crisis began. The recoverability of these USD 3.1 trillion is questionable if called.
Table CDS june 2007 to 2008
Savings of the emerging market countries especially China is said to be among one of the main causes of the current financial crisis. The main argument is that the savings of emerging markets have to find a home and instead of investment in the real economic assets they were made available to consumers in west notably Americans to mortgage a house or to buy a car etc. I can not understand the logic behind sky rocket hike in the price of a dwelling house which is not contributing to real economy. Almost all economists were agreed that the model of 'Asians make it, Americans buy it' is not sustainable in the long term and that Asians have to increase their domestic consumption in order to maintain economic growth in the long term. Whilst, Chinese savings were increasing sharply and reached to .... in .... US saving both on national and individual level was decreasing as noted above. One need not to be a rocket scientist to determine that one can not live on borrowing forever as one will loose his credibility sooner or later and Americans have to reduce consumption and increase savings. It is evident from the recent data that Americans saving rate at individual level has increased since the inception of the crisis from .... In jan 2008 To ... in jan 2009.
No matter what are causes of the crisis there is no doubt about that we are in huge trouble. The vicious spiral of decrease in overall economic output, as demonstrated below, has begun and no one knows where it will end and how many will it take away with it. Interestingly, none of the five giant investment banks has sustained this crisis. Bear Stern and Merrill Lynch were acquired by JP Morgan and Bank of America respectively, Lehman Brothers gone bankrupt and the remaining two Goldman Sachs and Morgan Stanley changed their status from investment bank to deposit accepting institutions. We have witnessed events beyond imagination for instance freezing of commercial paper market, fall of stock markets by more than 40% in a year etc.
The current global financial crisis is in nature synchronised and once in lifetime. There are different views regarding causes of the current financial crisis which has gripped the whole world. Some attribute it to failure of regulators and policy makers others say it is financial institutions. Yet others put the onus on savings of emerging market countries especially China.
No doubt current crisis clearly reflect lack of vision on part of policy makers. The free market and deregulation mantra rigorously promoted by leading policy makers during the last decade shifted the attention of all stakeholders away from regulating even the riskiest and complex financial derivative instruments which are hardly comprehendible for anyone except few mathematical and statistical magicians. If there would have been even a reasonable level of oversight of these complex financial derivatives, things would not be that worse as they are today. The chart below gives a very high level overview of the increase in the notional amount of outstanding over the counter (OTC) derivatives that multiplied almost seven times from just USD 94 trillion in June 2000 to USD 683.7 trillion in June 2008 as reported by Bank for International Settlements.
Chart o/s otc derivatives june 2000 to june 2008
The ignorance of regulators even added fuel to the fire. Regulators are not just there to ensure compliance with existing laws but to identify and rectify any loopholes in the existing regulations. On one hand, US federal reserve kept the interest rates at very low levels for extended period of time in order to avoid natural downturn in the economy and thereby created abundant liquidity in the system and promoted a culture of extravagance and living beyond means. The world will not finance US consumer spending forever as the debt needs repayment which is not possible if you spend more than you earn. Savings as a percentage of household disposable income gradually decreased from 9% In 1980 to 1% in 2007 as published by Federal agencies which clearly reflect this culture. Even at one point in 2005 it went into negative zone which means US consumers were spending more than they were earning.
On the other hand, assumption that the financial market participants can look after their interests better than anyone else, promoted an illusion that there is no need to regulate the financial system. This assumption was flawed and completely ignored two factors, the element of competition in the financial services industry and greed. If I put myself into the shoes of those banking executives I might do the same as they did because if I adopt a conservative approach towards risk short term profitability will be hit and there would be huge pressure and criticism from various groups e.g. investors, media etc. regarding the performance of my organisation as compared to other market players. Though short sighted criticism by media or analysts does not prove legitimatecy for blind risk taking in order to boost short term profitability at the cost of long term survival of the organisation. Moreover, linkage between short term performance and remuneration packages of executives provoked them to take unusually high risk which produce huge profits in short term.
In addition to that, not only financial institutions but also credit rating agencies mispriced the risk. They failed to price risk attributable to externalities. The simplest example of pricing externalities is taking into account impact of failure of the organisation in question on the whole financial system e.g. in case failure of Citibank there will huge impact on the financial system as compared to failure of any small regional financial institution making it more expensive to bet on Citibank. Risks are generally mispriced not only in the financial services industry but also in other industries e.g. automobile industry, the price of a car only includes manufacturing cost plus margin, taxes etc. but the pricing mechanism does not take into account the cost of impact of that car on the environment and decline in the available energy resources.
Financial engineering has proved too expensive for the global economy so far. Complex derivative financial instruments like Credit Default Swaps (CDS) and Collateral Debt Obligations (CDO) no doubt increased the liquidity in the system but at the same time encouraged reckless lending practices e.g. sub prime lending and speculation.
CDO is a security whose principal and interest are repaid by the cash flows generated by a portfolio of assets (usually loans and bonds). The portfolio of assets is the collateral and it is usually in the balance sheet of a separate entity, called special purpose vehicle, which has the CDO as its only liability and the assets in the portfolio as its only assets. It is CDOs and similar financial instruments that enabled the originators of loans to sell loan portfolios and thereby increased the liquidity of the long term loans. It is interesting that a financial institution can now sell the loan it has originated to someone sitting at the other corner of the globe through instruments like CDOs thus transferring the inherent credit risk involved in the lending and promoted careless lending practices. This is simple logic which also applies at individual level e.g. if one knows he can sell the loan he lent to anyone and earn a profit then one will not hesitate to give the money even to a person to whom no one will lend a penny. This is what exactly happened in the case of sub prime lending.
CDS is an instrument in which the buyer makes periodic payments to the seller, and in return receives a compensation if an underlying financial instrument defaults. It is effectively insurance against default by the counterparty with the difference that in case of insurance insurer is regulated and adhere to insurance regulations e.g. capital requirements whilst in the case of CDS the writer or seller need not to be a regulated entity thus increasing the counterparty risk which in my view is a huge regulatory failure. Due to this flaw huge amount of CDS were sold by hedge funds without any consideration whether the entity will be capable to pay the compensation if it is required in the future. On top of that market participants bought and sold CDS for speculative purposes i.e. without having the underlying asset similar to short selling o f equities.The following table illustrate the outstanding notional amount of CDS and corresponding market values from June 2007 to June 2008. Though outstanding notional amount has just increased by 35% corresponding market values has soared to USD 3.1 trillion more than 4 times of market value at June 2007 that gives clear idea of increase in counterparty default risk since this crisis began. The recoverability of these USD 3.1 trillion is questionable if called.
Table CDS june 2007 to 2008
Savings of the emerging market countries especially China is said to be among one of the main causes of the current financial crisis. The main argument is that the savings of emerging markets have to find a home and instead of investment in the real economic assets they were made available to consumers in west notably Americans to mortgage a house or to buy a car etc. I can not understand the logic behind sky rocket hike in the price of a dwelling house which is not contributing to real economy. Almost all economists were agreed that the model of 'Asians make it, Americans buy it' is not sustainable in the long term and that Asians have to increase their domestic consumption in order to maintain economic growth in the long term. Whilst, Chinese savings were increasing sharply and reached to .... in .... US saving both on national and individual level was decreasing as noted above. One need not to be a rocket scientist to determine that one can not live on borrowing forever as one will loose his credibility sooner or later and Americans have to reduce consumption and increase savings. It is evident from the recent data that Americans saving rate at individual level has increased since the inception of the crisis from .... In jan 2008 To ... in jan 2009.
No matter what are causes of the crisis there is no doubt about that we are in huge trouble. The vicious spiral of decrease in overall economic output, as demonstrated below, has begun and no one knows where it will end and how many will it take away with it. Interestingly, none of the five giant investment banks has sustained this crisis. Bear Stern and Merrill Lynch were acquired by JP Morgan and Bank of America respectively, Lehman Brothers gone bankrupt and the remaining two Goldman Sachs and Morgan Stanley changed their status from investment bank to deposit accepting institutions. We have witnessed events beyond imagination for instance freezing of commercial paper market, fall of stock markets by more than 40% in a year etc.