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the financial crisis in the advanced economies intensifies,
analyses of the causes of the crisis and its sources
have multiplied. The complexity of the financial sector
resulting from financial integration at many levels—markets,
institutions and instruments—has meant that there are
multiple elements to the crisis as it unfolds. Different
analyses, therefore, focus on different elements depending
on their concerns and timing, adducing different causes.
There are, however, strands that when knit together
provide a holistic picture.
There is a degree of implicit agreement that the crisis
can be traced to forces unleashed by the transformation
of US and global finance starting in the 1970s. Prior
to that, the US financial sector was an example of a
highly regulated and stable financial system in which
banks dominated, deposit rates were controlled, small
and medium deposits were guaranteed, bank profits were
determined by the difference between deposit and lending
rates, and banks were restrained from straying into
other areas like securities trading and the provision
of insurance. To quote one apt description, that was
a time when banks that lent to a business or provided
a mortgage, “would take the asset and put it on their
books much the way a museum would place a piece of art
on the wall or under glass – to be admired and valued
for its security and constant return.” This was the
“lend and hold” model.
A host of factors linked, among other things, to the
inability of the United States to ensure the continuance
of a combination of high growth, near full employment
and low inflation, disrupted this comfortable world.
With wages rising faster than productivity and commodity
prices—especially prices of oil—rising, inflation was
emerging as the principal problem. The response to inflation
resulted in rising interest rates outside the banking
sector, threatening the banking system with desertion
of it depositors. Using this opportunity, non-bank financial
companies expanded their activities and banks sought
to diversify by circumventing regulation and increasing
pressure on the government to deregulate the system.
The era of deregulation followed, paving the way for
the transformation of the financial structure.
That transformation, which unfolded over the next decade
and more, had many features. To start with, banks extended
their activity beyond conventional commercial banking
into merchant banking and insurance, either through
the route where a holding company invested in different
kinds of financial firms or by transforming themselves
into universal banks offering multiple services. Second,
within banking, there was a gradual shift in focus from
generating incomes from net interest margins to obtaining
them in the form of fees and commissions charged for
various financial services. Third, related to this was
a change in the focus of banking activity as well. While
banks did provide credit and create assets that promised
a stream of incomes into the future, they did not hold
those assets any more. Rather they structured them into
pools, “securitized” those pools, and sold these securities
for a fee to institutional investors and portfolio managers.
Banks transferred the risk for a fee, and those who
bought into the risk looked to the returns they would
earn in the long term. This “originate and sell” model
of banking meant, in the words of the OECD Secretariat,
that banks were no longer museums, but parking lots
which served as temporary holding spaces to bundle up
assets and sell them to investors looking for long-term
instruments. Many of these structure products were complex
derivatives, the risk associated with which was difficult
to assess. The role of assessing risk was given to private
rating agencies, which were paid to grade these instruments
according to their level of risk and monitor them regularly
for changes in risk profile. Fourth, financial liberalisation
increased the number of layers in an increasingly universalised
financial system, with the extent of regulation varying
across the layers. Where regulation was light, as in
the case of investment banks, hedge funds and private
equity firms, financial companies could make borrow
huge amounts based on a small amount of own capital
and undertake leveraged investments to create complex
products that were often traded over the counter rather
than through exchanges. Finally, while the many layers
of the financial structure were seen as independent
and were differentially regulated depending on how and
from whom they obtained their capital (such as small
depositors, pension funds or high net worth individuals),
they were in the final analysis integrated in ways that
were not always transparent. Banks that sold credit
assets to investment banks and claimed to have transferred
the risk lent to or invested in these investment banks
in order to earn higher returns from their less regulated
activities. Investment banks that sold derivatives to
hedge funds, served as prime brokers for these funds
and therefore provided them credit. Credit risk transfer
neither meant that the risk disappeared nor that some
segments were absolved from exposure to such risk.
That this complex structure which delivered extremely
high profits to the financial sector was prone to failure
has been clear for some time. For example, the number
of bank failures in the United States increased after
the 1980s; the Savings and Loan crisis was precipitated
by financial behaviour induced by liberalisation; and
the collapse of Long Term Capital Management pointed
to the dangers of leveraged speculation. Each time a
mini-crisis occurs there are calls for a reversal of
liberalisation and return to regulation. But financial
interests that had become extremely powerful and had
come to control the US Treasury managed to stave off
criticism, stall any reversal and even ensure further
liberalisation. The view that had come to dominate the
debate was that the financial sector had become too
complex to be regulated from outside; what was needed
was self-regulation.
In the event, a less regulated and more complex financial
structure than existed at the time of the S&L crisis,
was in place by the late 1990s. In an integrated system
of this kind, which is capable of building its own speculative
pyramid of assets, any increase in the liquidity it
commands or any expansion in its universe of borrowers
(or both) provides the fuel for a speculative boom.
Increases in liquidity can come from many sources: deposits
of the surpluses of oil exporters in the US banking
system; increased deficit-financed spending by the US
government, either based on the printing of the dollar
(the reserve currency) or on financing from abroad;
or reductions in interest rates that expand the set
of borrowers who can be fed with credit.
Factors like this also fuelled the housing and mortgage
lending boom that led up to the sub-prime crisis. From
late 2002 to the middle of 2005, the US Federal Reserve’s
federal funds rate stood at levels which implied that
when adjusted for inflation the “real” interest rate
was negative. This was the result of policy. Further,
by the middle of 2003, the fed funds rate had had been
reduced to 1 per cent, where it remained for more than
a year. Easy access to credit at low interest rates
triggered a housing boom, which in turn triggered inflation
in housing prices that encouraged more housing investment.
From 2001 to end 2007, real estate value of households
and corporate sector is estimated to have increased
by $14.5 trillion.Many believed that this process would
go on.
Sensing an opportunity based on that belief and the
interest rate environment, the financial system worked
to expand the circle of borrowers by inducting subprime
ones, or borrowers with low credit ratings and high
probability of default. Mortgage brokers attracted these
clients by relaxing income documentation requirements
or offering sweeteners like lower interest rates for
an initial period, after which they were reset. The
share of such sub-prime loans in all mortgages rose
sharply, from 5 per cent in 2001 to more than 20 per
cent by 2007. Borrowers chose to use this “opportunity”
partly because they were ill-informed about the commitments
they were taking on and partly because they were overly
optimistic about their ability to meet the repayment
commitments involved.
On the supply side, the increase in this type of credit
occurred because of the complex nature of current-day
finance centred around the “originate-and-sell” model.
Financial players discounted risk because they hoped
to make large profits even while transferring the risk
associated with the investments that earn those returns.
There were players at every layer involved. Mortgage
brokers sought out willing borrowers for a fee, turning
to subprime markets in search of volumes. Mortgage lenders
and banks financed these mortgages not because they
wanted to buy into the interest and amortization flows
associated with such lending, but because they wanted
to sell these instruments to less regulated intermediaries
like the Wall Street banks. The Wall Street banks bought
these mortgages in order to expand their business by
bundling assets with varying returns to create securities
that could be sold to institutional investors, hedge
funds and portfolio managers. To suit different tastes
for risk they bundled them into tranches with differing
probability of default and differential protection against
losses. Risk here was assessed by the rating agencies,
who not knowing the details of the specific borrowers
to whom the original credit was provided, used statistical
models to determine which kind of tranche can be rated
as being of high, medium or low risk. Once certified,
these tranches could be absorbed by banks, mutual funds,
pension funds and insurance companies, which can create
portfolios involving varying degrees of risk and different
streams of future cash flows linked to the original
mortgage. Whenever necessary, these institutions can
insure against default by turning to the insurance companies
and entering into arrangements such as credit default
swaps. Even government sponsored enterprises like Freddie
Mac and Fannie Mae, who were not expected to be involved
in or exposed to the subprime market had to cave in
because they feared they were losing business to new
rivals who were trying to cash in on the boom and poaching
the business of these specialist firms.
Because of this complex chain, institutions at every
level assumed that they were not carrying risk or were
insured against it. However, risk does not go away,
but resides somewhere in the system. And given financial
integration, each firm was exposed to many markets and
most firms were exposed to each other as lenders, investors
or borrowers. Any failure would have a domino effect
that would damage different firms to different extents.
In this case, the problems began with defaults on subprime
loans, in some cases before and in others after interest
rates were reset to higher levels. As the proportion
of default grew, the structure gave and all assets turned
illiquid. Rising foreclosures pushed down housing prices
as more properties were up for sale. On the other hand
the losses suffered by financial institutions were freezing
up credit, resulting in a fall in housing demand. As
housing prices collapsed the housing equity held by
many depreciated, and they found themselves paying back
loans which were much larger than the value of the assets
those loans financed. Default and foreclosure seemed
a better option than remaining trapped in this losing
deal.
It was only to be expected that soon the securities
built on these mortgages would lose value. They also
turned illiquid because there were few buyers for assets
whose values were unknown since there was no ready market
for them. Since mark-to-market accounting required taking
account of prevailing market prices when valuing assets,
many financial firms had to write down the values of
the assets they held and take the losses onto their
balance sheets. But since market value was unknown,
many firms took much smaller write downs than warranted.
But they could not hold out for ever. The extent of
the problem was partly revealed when a leading Wall
Street bank like Bear Stearns declared that investments
in two funds it created linked to mortgage-backed securities
were worthless. This signalled that many financial institutions
were near-insolvent.
In fact, given financial integration within and across
countries, almost all financial firms in the US and
abroad were severely affected. Fear forced firms from
lending to each other, affecting their ability to continue
with their business or meet short term cash needs. Insolvency
began threatening the best and largest firms. The independent
Wall Street investment banks, Bear Stearns, Lehman Brothers,
Merrill Lynch, Morgan Stanley and Goldman Sachs, shut
shop or merged into bigger banks or converted themselves
into bank holding companies that were subject to stricter
regulation. This was seen as the end of an era were
these independent investment banks epitomised the innovation
that financial liberalisation had unleashed. In time,
closures, mergers and takeovers became routine. But
that too was not enough to deal with fragility, forcing
the state to step in and begin reversing the rise to
dominance of private finance, even while not admitting
it. But the crisis is systemic and has begun to choke
consumption and investment in the real economy. The
recession is here, analysts have declared. Others say
a Depression is not too far behind.
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