The Global Financial Turmoil
By Teodor Petrov and Maya Pangarova
Статията е публикувана в бр. 2/2008 г. на сп. „Финанси“
It has become increasingly clear that the macroeconomic effects of the financial market crisis will be serious and that no regions will escape entirely unscathed. Thus, it is no wonder now that the financial turmoil triggered by the US mortgage problem has been affecting financial markets on a global scale. There are many reasons and explanations for this problem with the US mortgages, but generally it was driven by the improper way of giving house loans and rating the risk related with each one of them.
1. Global financial turmoil: genesis
At the beginning of 2008, an advisory group to the Japanese Minister Watanabe, called the Financial Markets Strategy Team, released an initial report that analyses the backgrounds and causes of the global market turmoil. It points out that there appear to have been various problems in terms of information transmission and risk control in the process of securitization of subprime loans. The so-called “originate-to-distribute“ business model involves a chain of stages with different counterparties transferring risks between them. At the beginning of the chain, a mortgage company provides a housing loan to a borrower, categorized as “sub-prime“ due to their less creditworthiness.
Then, the lender, or the originator of the mortgage loan, sells it to commercial banks and investment banks, which then bundle different loans together to form securitized products such as mortgage-backed securities (MBS – securities backed by mortgage loans that have monthly payments) and collateralized loan obligations (CDOs – have semiannual payments). In this process, these arrangers of securitized products deal with credit rating agencies to obtain ratings from them. In the final phase of the process, these securitized products are sold to end-investors through large investment banks (such as Lehman Brothers and Bear Stearns). At each stage of this process, credit risk is transferred from one party to its counterparty. In general, accurate information on the risk should also be transferred from one party to another in due manner in this process.
In reality, unfortunately, this was not the case. Rather, there is a possibility that in many cases information was transmitted in a distorted manner and accurate information was not transmitted between counterparties. For a party who was going to transfer credit risk by selling its claims to the counterparty, there might have been little incentive to carefully examine the quality of the credit due to be sold. Moreover, there may have been disincentives for the party in question to disclose accurate information to its counterparty. Thus in many cases, end-investors, and probably arrangers and distributors as well, may not have been adequately informed of, and may not have fully understood, the true nature of the risks they were bearing. In this case, institutional investors and individual investors that do not want to meet credit risk can purchase Treasury bonds, as a long-term investment, and hold them to maturity. However, they will miss the higher expected return, because Treasury bonds usually do not offer risk premium. So, investors must weight the future potential for higher return against the exposure to risk when investing in mortgages.
Securitization offers many advantages, but it also has potential side effects. There appear to be some vulnerabilities in the securitization process, due to moral hazard (the possibility that one party of a transaction could engage in a behavior that is undesirable from the other’s party point of view, after the transaction) and asymmetric information (when managers act in their own self-interest, rather than in the interest of the owners – investors, which is also called an agency problem). These vulnerabilities fully materialized as the external economic and financial conditions got worse in USA. A large number of rating downgrades in August-September 2007 on subprime-related securitized products caused a serious loss of confidence in the relevant markets. The drawback by investors from these products led to the inability of the markets to value these products, as the sellers could not find any investors who were willing to purchase them at an agreeable price.
This pricing uncertainty caused a huge spread risk and liquidity uncertainty. Therefore, it has become increasingly difficult to identify the location and the level of risks in the United States’ financial system, making the situation more complex and illegible.
Many analysts have argued that the huge run-up in U.S. housing prices is justified by financial innovation (such as sub-prime mortgages), as well as by the huge inflow of capital from Asia and petroleum exporters. The huge run-up in equity prices was similarly argued to be sustainable thanks to a surge in U.S. productivity growth and a fall in risk that accompanied the “Great Moderation” in macroeconomic volatility. As for the extraordinary string of outsized U.S. current account deficit, which at their peak accounted for more than two thirds of all the world’s current account surpluses, many analysts have argued that these, too, could be justified by new elements of the global economy. Thanks to a combination of a flexible economy and the innovation of the tech boom, the United States could be expected to enjoy superior productivity growth for decades, while superior American know-how meant higher returns on physical and financial investment that foreigners could expect in the United States.
In reality the situation was and is quite different for the USA. Starting in the summer of 2007, the United States experienced a striking contraction in wealth, increase in risk spreads, and deterioration in credit market functioning. The United States sub-prime crisis, of course, has its roots in falling U.S. housing prices, which have in turn led to higher default levels particularly among less credit-worthy borrowers. The impact of these defaults on the financial sector has been greatly magnified due to the complex bundling of obligations that was thought to spread risk efficiently. Unfortunately, that innovation also made the resulting instruments extremely nontransparent and illiquid in the face of falling house prices. In other words, this credit crisis started from risky loans and has extended to all varieties of credit and risk: consumer loans, credit cards, businesses, and so on. The problem with this crisis lies in how credit was traded from one hand to another on an unprecedented scale. This was done through financial innovations called derivatives.
Derivatives are contracts that allow companies to trade risks that derive from some other underlying assets. For example, a currency futures contract lets you to lock into a specific foreign exchange rate. It’s a sensible move if you trade abroad and do not wish to carry the risk of a sudden change in exchange rates. When borrowers are local, financial institutions have greater opportunity to follow how they are affected by economic conditions, than if they purchased mortgages from other countries, or other regions of the country.
Recent years have brought much riskier derivatives, such as “over-the-counter credit default swaps (CDS).” Credit derivatives permit lenders to transfer their credit risks (mortgage defaults) to third parties, such as hedge funds. Thus banks can do more business and earn more profits. In the 1990s and 2000s, credit derivatives were considered as massive global gamble. If used properly, derivatives are useful and ethically unobjectionable. They enable efficient risk allocation that benefits all parties concerned. But their improper usage can be a nightmare for investors and regulators. Derivatives could, for instance, be used to circumvent regulations that protect investors and the public. These stakeholders lack the time or ability to track the risks taken by companies, which is why financial institutions cannot freely invest in risky asset classes. But through derivatives, many institutions can make complex speculative bets without regulators catching on. And if this does work, companies can make abnormal profits. If it does not work, then as it happens usually someone else bears the losses. In this case, these are the investors and bank depositors, whose savings are eroded by inflation that causes upward pressure on interest rates, and consequently on the required return on mortgages.
Such financial innovations and liberalization of the financial markets in the USA has led one of the world’s largest (formerly the most powerful) economy into a huge crisis. As documented in a study made by Graciela L. Kaminsky (a professor in the George Washington University) and Carmen M. Reinhart (a professor in the University of Maryland) for finding the leading indicators of currency crises in 1999, the majority of financial crises are always preceded by financial liberalization, as it is now the case in the United States. New unregulated, or lightly regulated, financial entities have come to play a much larger role in the financial system, undoubtedly enhancing stability against some kinds of shocks, but possibly increasing vulnerabilities against others.
During the 1970s, the U.S. banking system stood as an intermediary between oil-exporter surpluses and emerging market borrowers in Latin America and elsewhere. While much praised at the time, 1970s petro-dollar recycling ultimately led to the 1980s debt crisis, which in turn placed enormous strain on money center banks. It is true that this time, a large volume of petro-dollars are again flowing into the United States, but many emerging markets have been running current account surpluses, lending rather than borrowing. Instead, a large chunk of money has effectively been recycled to a developing economy that exists within the United States’ own borders. Over a trillion dollars was channeled into the sub-prime mortgage market, which is comprised of the poorest and least credit worth borrowers within the United States, leading to the development of a “credit crunch”. This situation could have been avoided and financial institutions could have limited the exposure to credit (default) risk, if they have maintained the mortgages they have originated.
2. The credit crunch and the US economy
The credit crunch means banks and businesses are finding it more difficult to borrow money and lend. If they are able to borrow, it is more expensive to do so. Small businesses borrow money from banks. Big businesses, like banks, borrow some of their money directly or indirectly from the wholesale money markets. In Great Britain, for example, they pay the London Interbank Offered Rate (LIBOR) – the rate that banks are prepared to lend to each other. From the end of July 2007 to December 2007 a three-month LIBOR*[1] has increased from 6.04% to 6.88% – an historic high, compared to the Bank of England base rate.
Experts worry that banks will struggle even more to borrow money and they will find their only way to refilling their “coffers” is to charge their customers more. If mortgage payments increase, this could trigger a wider consumer downturn as people cannot longer afford to pay their mortgage installments. Weak economy could reduce income, and thus increase the default risk by issuers that are sensitive to economic conditions. Moreover, a decrease of economic growth could lead to a decrease in risk-free interest rate, and consequently to a lower required rate of return on mortgages and higher mortgage prices.
Actually, it all comes from the chaos in the American housing market, when US banks offered mortgages to people in no position to repay the loans. These mortgages, now worthless thanks to a US housing market crash, were then re-packaged and sold to investors and banks around the world. Many banks still do not know exactly how badly they are exposed and are unwilling to lend money to anyone else until they find out.
The cost of borrowing is just of one of many costs for businesses – along with staff wages, utility bills and paying the rent. However, in recent years, many businesses, especially those owned by private equity firms, have started to borrow increasingly large sums of money. In order to repay their loans they will either be forced to pass on the costs to their customers by putting up the price of their goods (this could mean more expensive clothes, food or household goods in shops), or it could mean the increase of sales from many retailers, hotel chains or leisure businesses as they try to attract more customers. If companies are not able to succeed in the 2nd scenario, for sure they will be forced to cut costs, and that inevitably means firing employees.
Unfortunately, this is exactly the case right now in the United States of America. The huge financial crisis that began in USA with subprime mortgages has spread through the whole economy and particularly to the credit markets causing havoc on municipal bonds, hedge funds, complex structured investments, and agency debt. The US Labor Department has reported at the beginning of March 2008 that US employers have cut 63,000 jobs in February, which is the biggest monthly decline in five years.This jobcutting was added to the 22,000 jobs that were lost in January 2008, and to the 52,000 lost jobs in manufacturing and 331,000 in construction since 2006. The Labor Department also has reported that worker productivity has slowed significantly in the last quarter of 2007 and the first of 2008 due to the growing crisis, leading to higher labor costs and inflationary pressures. All that makes it harder for the Fed to lower the interest rates to stimulate the economy without inviting the “dreaded stagflation” – slow growth and rising prices. As the Pure Keynesian Theory (developed by John Maynard Keynes) suggests, the Federal Reserve can use open market operations to increase the money supply, which means to reduce interest rates, and thus stimulating more borrowing and spending, which results in higher economic growth. However, this growth in the money supply could cause inflationary expectations coming from higher demand for money.
Moreover, participants in the labour market will pretend higher wages, which will compensate the expected higher inflation. Hence, the level of savings will decrease, whereas the level of borrowing and spending will increase, and because credit risk rises during weak economy, many borrowers fail to pay their debt.
The effects of the financial crisis on commercial construction in the United States are being equally disastrous. The Commerce Department has been reporting several times a big decline in spending on nonresidential construction, which includes everything from hospitals to office parks and shopping malls. The statistics, according to Real Capital Analytics, a New York real-estate research group, show that office space sold in the fourth quarter of 2007 has dropped 42 per cent from a year earlier, and sales of large retail properties declined 31 per cent. Specialists say that if spending continues to slow, construction workers will have to face even more layoffs.
Many experts predict that homeowners and shoppers worldwide will notice increasingly the effects. Forecasts show that the biggest impact of the financial turmoil will be on Commercial real estate. Since August 2007, although there is a tremendous oversupply of retail spaces in USA, builders have continued to put up shopping malls and office buildings, even though residential real estate is presently considered as the worst investment in the States. The injured party of course will be the banks, which will have to repossess the thousands of empty building space in newly build malls with no chance of leasing them out in the near future. Because of these factors, from December 2007 to January 2008 spending on commercial construction took its biggest drop in 14 years. This to a certain extent unexpected downturn has been adding more and more people to the unemployment rate of USA.
The increase in unemployment and inflation, the decrease in worker’s productivity and commercial real estate spending, and of course the losing positions of the dollar, all mean that once considered to be the most stable economy is now going inevitably into recession*[2].
This is strongly felt on the housing market, where home sales are down 65 per cent from their peak in 2005, and the number of vacant homes now numbers about 2 million; an increase of 800,000 since 2005. This situation in the housing market is considered by many to be the worst ever in the American history. Sales of existing homes in October 2007 have decreased by 23.5% from the previous year. Prices on new homes have dropped 13% year over year (figure 1). Also, the number of foreclosures has reached the level of 635,000, which is a 94% increase over October 2006 and an all-time high on the so called “Misery-Meter”. Unfortunately, according to many specialists, the present situation is going to be a lot worse by the end of 2008. For example, The Mortgage Bankers Association in one of its reports has estimated that the number of foreclosures only in 2008 will be about 1.40 million.
Figure 1
This deflating housing market is being felt in the whole US economy, adding to the shrinking of the GDP and the dollar’s historic lows. The mostly affected state in the US has been California. The 9.9% decrease in house prices for 1 month, has been the largest year-to-year decline in US history, according to The California Association of Realtors (CAR). Similar situations have occurred many times in history. For example, when Japan experienced such a credit and real estate downturn, it took the country more than 10 years to recover. The situation in the United States is expected to be worse, and there are no reasons at this moment to believe that the present crisis will end any faster.
Even after several years of rapid price increases, the house prices in the United States are falling sharply since 2007. Real residential investment has also slowed in the United States by about 3percentage points of GDP since its peak four years ago (figure 2).
Figure 2
The main reason for this, of course, is the mortgage problem nowadays and the change in the way of how housing is financed in the United States (by lending long-term mortgages that are getting bad debts). This change has entailed a shift toward a more competitive housing finance model. The new model has made it easier for households to access housing-related credit through diverse funding sources, lender types, and loan products, contributing to the rapid growth of mortgage debt in the USA. This rapid growth has made it possible for the United States to become the country with the most “developed” mortgage market in the world (figure 3).
Figure 3
What is particularly distressing about the current situation in the United States is that over 60% of the mortgage-backed securities were rated by rating agencies, such as S&P (Standard & Poor’s Corporation), Double-A or Higher. This means that even the “best” of these mortgage-backed bonds are a pure waste for investors. This, in reality, can be considered as the worst possible news for Wall Street, and particularly, for the biggest investment banks. It means that trillions of dollars of bonds, which are currently held by domestic investment banks (such as Lehman Brothers), insurance companies, foreign banks and hedge funds, will only be worth to approximately $.27 on $1, or even lower, according to financial analysts. Another major problem for the “injured” banks is that they will have to maintain enough reserves in order to meet the new capital requirements on the falling value of their assets. Therefore, this means that they will have less money to loan to businesses and consumers (or, in other words, they will incur huge operating losses).
In fact, this situation has already taken place in the USA. This, of course, was the reason why the Federal Reserve, as the institution responsible for the managing of the financial markets, is continuing to decrease its interest rates as a way to keep the liquidity of the banking system, at least in short-term. That is why; the Federal Reserve has moved remarkably aggressively, cutting rates by 1.25 percentage points in 8 days, a rate-cutting almost unheard of in central banking history. For less then 2 years the Federal Reserve has decreased its target rate from 5.25% to 2.25% (figure 4). And now, because of this interest rate decrease, the real interest rates in the US are negative. For this reason, it is expected that the value of the dollar will be further reduced, and food and energy prices will continue to rise.
Figure 4
Some financial experts reckon that this crisis was entirely avoidable, but the Federal Reserve’s policies have made it an unpreventable event. The fixation of interest rates below the rate of inflation for 3 years by the Federal Reserve, have led to a mass speculation in housing and created a false perception of prosperity. The truth actually was a “falsely” created asset-inflation by the expansion of debt. By repealing certain types of regulatory legislation, the Federal Reserve allowed commercial banks freely to trade their mortgage-backed securities to domestic and international investors. Presently, more and more investors continue to “move away” from these mortgage securities, because of their huge risk. Currently the mortgage-backed bonds are trading at only 13% of their face value. And as the number of mortgage foreclosures continues to rise, the risk related with these bonds will intensify, which will leave large parts of the financial system dysfunctional.
In order to recognize future changes in the strength of the economy, that leads to changes in the risk-free interest rate and in the required return from mortgage investment, mortgage market participants frequently monitor economic indicators (such as indicators of inflation-consumer price index and producer price index, announcements about the government’s deficit, indicators of economic growth in the real estate sector, and etc.). A decline in indicators (housing) is a signal of a reduction in the issuance of mortgages, which places downward pressure on mortgage rates and upward pressure on mortgage prices. Exactly these signals reflect a weaker economy, as it is the situation in the moment, which increases the default risk premium on some mortgages, because the borrowers may face difficulties meeting their debt payments.
According to the estimates of the banking giant UBS, these credit problems would end up costing financial institutions nearly $600 billion, three times more than the originally predicted $200 billion. But the thing is that UBS’s forecasts do not take into account the $6 trillion of lost home equity if housing prices fall 30 per cent in the next two years, as forecasted, which nowadays seems realistic (figure 5). UBS’s forecasts also do not take into account the potential losses in the financial market, where $7.8 trillion of loans have been “frozen”. The final outcome could not be known for sure, but according to analysts the $7 trillion lost in the “dot.com bust” will be a comparatively small figure.
Figure 5 – US Housing Prices
There is absolutely no doubt now that the fast developing financial crisis will strongly “injure” Wall Street. Let’s take into account NASDAQ (The National Association of Securities Dealers Automated Quotation), the World’s first electronic market. On March 24, 2000, the NASDAQ Composite index reached a level of 5048, mainly because of the increase in technology stocks, most of which were listed on the NASDAQ. The same index in September, 2001 fell back to 1423, because of the downturn in the US economy at that time, and on October 9, 2002 it bottomed-out at 1114, which was estimated as a loss of approximately 80 per cent. Financial analysts are worried that this trend could happen again, but this time with even more damaging results. Some experts predict that the Dow Jones Industrial Average (the most widely reported stock market index) would be 7,000 by the end of 2008.
An interesting article in the Wall Street Journal, called the “Mortgage Fallout Exposes Holes in New Bank-risk Rules”, explained how the banks changed standards at the Basel meetings in Switzerland to give themselves greater autonomy in deciding issues, which should normally have been governed by strict regulations. The arguments of the central bank governors of the G-10 countries were that banks should be given more freedom in deciding how much risk to take on, simply because they are in a better position than regulators “to make the call”.
It is widely considered, that exactly this banking deregulation has led the US financial system to a potential disaster, because of the incorrectly given mortgage loans and misleadingly rated (by agencies, such as S&P) mortgage-backed securities, which fooled many investors. Even though the United States is about to enter a period of recession, the banks are stillonly interested in finding a way tosave themselves.At the beginning of March 2008, the New York Times revealed a “confidential proposal” from Bank of America to members of Congress asking the US government to guarantee $739 billion in mortgages that are at “moderate to high risk” of defaulting to save the banks from potential losses. This greed of the banks is leading to an unstable financial system, because of the sale of the subprime securities that lost investors billions of dollars.
As a measure of trying to preserve the financial stability of the banks, The Federal Reserve has lowered the Fed Funds rate by 2.25 basis points to 3 per cent (more than a full-point below the current rate of inflation) to help the banks recoup some of their losses from their bad bets. The Federal Reserve’s interest rate cuts and Bush’s “Stimulus Plan”*[3] are unlikely to stop housing prices from continuing to fall, nor will they fix the problems in the credit markets. In comparison to the recession of 2000 to 2001, which was a collapse of business spending that only represented a 13% of GDP, the present impending recession is considered to be six times more severe (representing 78 % of GDP), according to the Federal Reserve. Therefore, it is incorrectly to believe that interest rate cuts are likely to halt the decline in nationwide home prices; as it was the case in 1983, when the Federal Reserve extremely “loosened” the money supply, which reduced interest rates and increased economic growth, and put the United States out of the recession. A more effective strategy, considered by specialists, would be to try to move the economy away from consumption and toward exports and long-term needed investments in infrastructure.
Based on the so called Monetarist approach, the economy could be empowered by low growth in the money supply (opposite of the Keynesian approach). In the case of recession, monetarists avoid loose money policy in order to „miss“ the higher inflation expectations that increase the demand for money and the pressure for higher interest rates. They would rather not revise the already existing monetary policy and will stay passive, expecting that the stagnant economy will reduce corporate and household borrowing, which will lead to lower interest rates. So, when interest rates are low enough, they will stimulate borrowing and spending, as well as economic growth.
Another measure of the Federal Reserve has been to encourage American banks to lower the principal on the mortgages and in that way to keep the homeowners making payments on their loans. But, since most people are risk averse, experts say that the wisest choice for homeowners would be foreclosure, because otherwise most of them (low to average income people) will be stuck with a fastly declining in value asset for the rest of their lives. Therefore, homeowners should base their decisions on what is in their best long-term financial interests. Unfortunately, for the US financial system presently this means “walking away” from the mortgages.
The Federal Reserve is continuously being criticized by the public for adopting those measures, particularly cutting interest rates. In that way, with oil, gold and food prices increasing, the Federal Reserve is said to be risking another decrease of the value of the dollar (on March 26 the dollar fell to $1.58 on the euro). According to Ben Bernanke, the chief of the Federal Reserve, the United States is at the beginning of a consumer-led recession and the Fed’s increases to the money supply via low interest rates will not affect this economic slowdown that is at present evident (this is actually the key criticism of the Keynesian view that assumes that the quantity of loanable funds demanded is not changed by the adjustment in money supply).
Another thing is that since the mortgage crisis began in USA, the prices of food and energy have considerably increased. A logical explanation would seem to be justified by the forces of demand and supply. But the reality is that investors in the real estate market moved their funds from the losing continuously value assets to commodity funds and foreign currencies as a hedge against inflation. This whole price increase is again a speculation, a similar one that occurred in the real estate market in the US, with which the present financial crisis began. Of course, these speculative price gains are in the short-run, therefore specialists predict that at the beginning of 2009 prices of these commodities will be lower, not higher.
A proof for this speculation is the increase of the price of petroleum products at the same time when the demand for these products went down by 3.4 % during the end of February this year. This most probably means that prices will decrease once this speculative process is over. Bloomberg (the web-site for business and financial news) says that the reason for this speculation is that investors are simply looking for somewhere to put their money rather than in “shaky corporate bonds or overpriced equities”. And since commodities are a good alternative, investors are widely putting their money in different products. It is forecasted, that if the consumer spending falls, the prices of the assets will fall also, including gold and oil.
But before proceeding further with the consequences of the mortgage-driven financial crisis on the US economy, let us explain how did everything developed in such a way as to bring almost the US financial sector into its knees. A view of John Taylor, a professor in Stanford University, implies that this crisis is a product of a fundamentally defective financial system and a “slack” US monetary policy, which has led to the collapse of Wall Street in 2000 and 2001*[4], and now is contributing to the present financial turmoil in USA. He reckons that there was a huge financial innovation and a risk-taking enthusiasm that generated rapid increases in credit, which drove up the asset prices. This, of course, automatically leads to more credit expansion and even higher asset prices (and this was, and is, the actual situation in USA). The final outcome is a top to asset prices, panic selling, a so called “credit freeze”, mass insolvency and recession.
Thus, this unregulated credit system, as every other became unstable and destabilized. Another view is that the financial deregulation and securitization encouraged an unusually huge circle of people to believe they would be winners, while somebody else would bear the risks and, mainly, the costs. In other words, this is the result of the interaction of “asymmetric information”, according to specialists, or the well-known fact that insiders know more than anybody else what is going on the markets. This is related with the issue of moral hazard, or in other words, the perception that the government will rescue financial institutions if enough of them fall into difficulty at the same time.
A good case for this is the recent widely publicized downturn of America’s fifth-biggest bank – Bear Stearns. A year ago Bear Stearns’ shares were quoted at the top of $170. At 17th of March the investment bank nearly went to bankruptcy, but thanks to JPMorgan Chase (Bear Stearns’ clearing bank) and the intervention of the Federal Reserve, which secured the deal with JPMorgan Chase for $2 per share, this did not happen. The deal costed JPMorgan $236 million. But in order this deal to be completed the Federal Reserve had to finance $30 billion of Bear Stearns’ “weakest” assets. This enormous risk taking by the Federal Reserve could cause, and probably will cause, huge losses if these assets continue to fall in value. This is simply because the enactment of fiscal policies by the federal government, in which the expenditures are more than tax revenues, could lead to increase in budget deficit. This will put upward pressure on interest rates, because the higher deficit increases the quantity demanded for loanable funds at any interest rate when the supply of such loans is not changed.
After the announcement for the sale of Bear Stearns on the 17th of March, the shares of the 4th biggest investment bank on Wall Street, Lehman Brothers, also decreased their value by 38%. An analysis from Henry Blodget (a former analyst in Merill Lynch) in yahoo finance shows that like Bear Stearns portfolio, that of Lehman Brothers is also not enough diversified. This means that if the mortgage securities owned by Lehman Brothers depreciate in value, the investment bank will probably follow the “grief path” of Bear Stearns. Another proof for this is the relatively high leverage of the bank, which is estimated to be 30 to 1, the same as that of Bear Stearns.
But despite the big correlation between the investment portfolios of the two banks, Lehman Brothers is considered by specialists to be bigger than Bear Stearns, and a possible bankruptcy by the bank would be prevented by the Federal Reserve; as it was the case with Bear Stearns, when the Federal Reserve found a “last minute” buyer for the investment bank shares, in the face of JP Morgan Chase.
Another widely adopted by experts view is that the crisis is the result of global macroeconomic disorder, particularly the massive flows of surplus capital from Asian emerging economies (notably China), oil exporters and a few high-income countries and, in addition, the financial surpluses of the corporate sectors of many countries. In this perspective, central banks and financial markets have been merely reacting to the global economic environment. Surplus savings meant not only low real interest rates, but a need to generate high levels of offsetting demand in capital-importing countries, of which the US was much the most important. In this view, the Federal Reserve could have avoided pursuing what seems like excessively expansionary monetary policies only if it had been willing to accept a long recession. But, of course, it had no desire to do such thing. The Federal Reserve’s actual dilemma was that the only way to sustain domestic demand at levels high enough to offset the capital inflow from other countries was by a credit boom, which generated excessively high asset prices, particularly in housing.
When members of FOMC (Federal Open Market Committee) face high inflation as well as high unemployment, as is the situation now in USA, the implementation of proper policy is difficult. On the one hand, loose monetary policy may stimulate the economy and reduce unemployment in the short-run, but this policy could increase inflation. On the other hand, tight monetary policy could avoid increases in inflation, but would not solve the problem with unemployment. So, in such a cases the Federal Reserve must determine whether unemployment or inflation is the more serious problem, because it could not cure or eliminate both of them.
These global macroeconomic imbalances played a huge part in driving US’s monetary policy decisions. In the current environment in the United States, monetary policy may be less effective than in the past. But still, in USA, where the growth has slowed significantly, the temporary fiscal stimulus should help at least to support demand. But fiscal stimulus in the United States must be strictly temporary – the longer-term fiscal problems are too significant to give up on the progress that has been made in recent years. Of course, the rest of the world will not be immune to the slowdown in the United States, especially if it becomes even more serious.
The growing financial turbulence of the past several months represents a massive stress test for the global financial system, one that has become more pervasive and more worrisome in recent weeks. The financial crisis that started in a relatively small part of the U.S. financial system today has grown into a global challenge. A problem that seemed at first to be essentially financial in nature, by now has evolved through the increasingly complex interlinkages between financial markets and the real economy into a threat to the sustained and stable global growth that has prevailed over the past five years.
By now, there is little doubt that risks of further escalation of this crisis are rising, and decisive policy action will be required to put the global financial system and global economy on a firmer footing. The first priority must be to reverse the spreading strains in global financial markets, and to restore the normal functioning of the financial system in advanced economies. For public authorities, this will require making available adequate short-term liquidity, while striking the right balance between market solutions and public sector intervention. The actions that have been taken recently by several central banks (including the Federal Reserve) are helpful, as they reflect recognition of this critical need to assure market liquidity.
With regard to actions of a more structural nature in the financial sector, steps are needed to make sure that banks are adequately capitalized, as well as to increase financial institutions’ transparency, and to improve their disclosure. Even as these financial sector policies take hold, the global economy, and advanced economies in particular, will continue to face pressures from tightening credit conditions. If so, there is likely to be a role in some countries for stepped-up countercyclical macroeconomic policy measures to help support demand. Already, the U.S. authorities have enacted a temporary fiscal stimulus, while several central banks have eased their monetary policy stance.
As we now know all too well, what was initially considered to be an isolated, and widely anticipated, weakening in the US housing market, has spread unexpectedly across markets and economies. Of course, there is no question of returning to the unsustainable market conditions of early 2007, when spreads and market volatility were exceptionally low by historical standards.
Thus, certain sectors of the securities markets have become virtually immobilized at the same time that several major banks are suffering large losses. This differs from past crisis episodes in the USA, where one of these two sectors has been able to help compensate for weakness in the other. Moreover, monetary policy support typically has proved to be highly effective in the past, as reductions in policy rates have facilitated the normalization of credit conditions.
At present, the effective intermediation of savings has been hampered and there is a risk of a broader and more intense tightening in credit conditions, with potentially significant macroeconomic consequences, notwithstanding aggressive efforts by central banks.
A world of financially integrated markets also implies more rapid and stronger spillovers across economies through traditional as well as novel channels. Spillovers through the traditional trade channel remain a central transmission mechanism of disturbances, even though global trade patterns have become more diversified. At the same time, financial spillovers have become more important. Moreover, the impact of such linkages can become progressively more pressing, as confidence and balance sheet effects can become relatively more serious as an initial disturbance grows in scale. In other words, the effects could be nonlinear. The high and rising correlation of global equity prices and the potential for sudden capital flow reversals imply that shocks at the core can be transmitted rapidly throughout the entire global financial system.
3. The impact on the rest of the world
3.1. Global growth
Although the current distribution of risks to global growth appear to be skewed to the downside, the possibility cannot be ignored that an upside risk exists as well. In particular, we cannot simply ignore the possibility, given the uncertainties, that what now seems to represent appropriate fiscal stimulus and monetary policy easing would turn out to be overly aggressive, leading to excessive global liquidity growth and subsequent overheating. Unexpectedly strong domestic demand growth and supply constraints are resulting in further increases in energy and commodity prices, accelerating inflation pressures and deteriorating inflation expectations. At the same time, the housing blowup is largely causing terrible effects on global financial markets. The credit crunch has spread fastly not only throughout whole Europe, but also in Asian and Latin American countries where lending standards are tightening and industrial growth is threatened by the falling dollar. Consumer confidence has also plummeted in these countries just like in the US. And the fact that stock markets are continuing to move back and forth furiously every day (soaring 100 points one day and then, plunging 200 the next), means that this volatility of the financial markets is one of the indications that the US, and to a certain extent the global economy, is going into recession.
Now this problem is becoming a major concern for developed and developing countries such as China, Japan, India, Great Britain and even Bulgaria. The impact of the financial crisis on each one of them varies in size according to the way they have been affected. For instance, the share values in three of the largest Asian economies (China, Japan and India) have plummeted by about 30 percent, 20 percent and 30 percent respectively this year. These falls outpace more than twice the decline in US shares, with the S&P 500 Index falling 13 percent since January 1.
3.2. Great Britain
The financial crisis absorbing the British economy has lurched to a new low as £51 billion was wiped off the value of the country’s top companies. On the 19th of March 2008 the pound incurred its worst one-day fall since being ejected from the Exchange Rate Mechanism on the so called “Black Wednesday” in 1992. In addition, the stock market in Great Britain was hit by the shockwaves from America’s latest corporate meltdown, because of which most experts are worried that Britain is going to head for its worst financial crisis in decades. The reasons for these extreme predictions were mainly forced by the loss of 13% in the stock value of the Britain’s biggest mortgage lender, Halifax Bank of Scotland. This event spread rapidly fears that the profits of the British banking giant will be severely affected by the global credit crunch.
The consequence of this occurrence was the drop of the FTSE 100 index by 4% (a 2 year low), which led to the decrease of both Barclays and Royal Bank of Scotland’s shares by 9%. This sudden reduction of the banks share values instantaneously made it possible for analysts to speculate that another major investment bank could be in serious trouble following the near collapse of the American Bear Stearns.
As a measure of response, The Bank of England pumped £5 billion on the 17th of March into the money markets in an attempt to restore the previously developed confidence in the banking system. However, many analysts point out that this intervention is not enough to prevent the large spreading of the crisis through the economy. Similar to the Federal Reserve in the United States, The Bank of England’s capital injection is just a temporary solution for the improvement of the financial sector’s liquidity. Hence, the British government is now considering injecting $100 billion into the Banking system by devising a lending plan that allows banks to swap the possessed mortgage-backed securities for British Treasury bills.
The financial crisis that is affecting Great Britain is also having serious effects on pension funds. Anyone with a pension which requires them to use their pension pot to buy an annuity is expected to see the size of their pension fund severely depleted by the stock market losses, experts predicted, and some people may even end up having to postpone their retirement as a result.
A statistic recently made by the British Telegraph shows that since the beginning of the financial crisis, the value of Britain’s top 100 companies has fallen by nearly 20%. The same statistic shows that 3 million homeowners face an increase of up to £300 a month in their mortgage bill, as they have to take out new home loans at a much higher interest rate than when they were first arranged. The impact of this is considered to be enormous across households in whole of Great Britain, which is leading to the steadily increase of household bills, which began in August 2007.
Now, the biggest fear facing the British financial system is whether there will be a British equivalent of Bear Stearns. Some specialists indicate that at this point this could not happen. But others are not so confident and are continuously recalling the case of Northern Rock, which collapsed because of the knocking effects from the US mortgage bubble bursting. Those knocking effects are as widely ranged and unpredictable, as they are because of the historic expansion and restructuring of global financial markets in the last couple of decades. A restructuring that has brought the creation of a new sort of securities, called “credit derivatives”. These derivatives have enabled mortgage lenders in Great Britain (and worldwide) not just to hold on to your mortgage agreement and wait for your repayments, but also to convert a bundle of mortgage agreements into a “financial asset” and sell it on, thus getting their cash quicker.
3.3. Bulgaria
According to some financial analysts in Bulgaria, the effects of the global financial turmoil on the Bulgarian financial system can be considered as small and limited to the amount of securities, issued in the United States, and purchased by Bulgarian financial institutions. For instance, one such institution is First Investment Bank. According to official information from the executive director of the bank, First Investment Bank has been exposed to such risky securities since 2007. These securities purchased by the bank amount to more than $7 million.
Another effect that the US crisis has had on the Bulgarian financial system is the increase in the credit interest rates at the end of 2007, along with the increase of the minimum required reserves by the Bulgarian National Bank. This trend was due to the intensified mistrust between banks on the international money markets, originated by the fear of bankruptcy of some financial institutions, such as Northern Rock and Bear Stearns, which led to the rise of interest rates to nearly 0.5%.
In addition to the interest rate increase, the huge amount of Bulgarian share sales by foreign investors is considered to be another major influential factor of the mortgage crisis. The reason for these sales is the attempt of foreigners to minimize the losses on their securities (such as the mortgage-backed securities). One such case is that of BTC, in which the major shareholder is the American insurance company AIG. AIG incurred big losses, because of the possession of American uncollateralized debt obligations. Now, on the 14th of April 2008, on the board of shareholders meeting, the Bulgarian Telecommunications Company has voted, as expected, for the biggest dividend in the history of the company, amounting to ?235 million. This dividend is bigger than the amount of short-term assets that the company has. Financial commentators believe that the only purpose of this dividend is the improvement of AIG’s liquidity, which is presently threatened by the company’s investment in mortgage securities.
3. 4. Current trends
Examples like this only show us the severe reality facing financial institutions and investors, which are struggling to recuperate their huge amounts of losses from the wrongly made investments on the mortgage market. And even though central banks across the globe are undertaking huge efforts in major markets to prevent a liquidity crisis by making large scale money injections, these efforts have been only helpful to restore the market confidence in the short run. The truth is that neither the Federal Reserve’s interest rate cuts, nor the federal Stimulus plan are likely to fully resolve the problem with the financial crisis in the USA. This means that because of the US economy’s entry into recession, the global economy will be extremely unfavorably affected by slow economic growth and inflationary pressures, which cannot be suppressed before the complete and unabridged obviation of the present financial turmoil.
*[1] The LIBOR has decreased in April 2008 to 2.69% due to the huge capital injections by The Bank of England, which has significantly improved the liquidity of the British Banking System
*[2] This was officially confirmed by the chief of the Federal Reserve Ben Bernanke on the 2nd of April 2008
*[3] According to the stimulus plan, individuals who pay income taxes would get up to 600 dollars, working couples 1,200 dollars and those with children an additional 300 dollars per child – as George Bush says “it is a package that is robust, temporary, and puts money back into the hands of American workers and businesses”
*[4] After the terrorist attack, when the weak economy reduced the demand for loans that decreased the interest rates, The Federal Reserve also increased the supply of money that additionally decreases the interest rates