The Global Financial Crisis: The American Origin
The Subprime Crisis and the Liquidity Crunch
The true extent of globalisation could be accurately expressed by the current financial crisis whereby contagion in the United States of America spread across the globe affecting all globalised economies. The linkage with the Asian Financial Crisis illustrates how globalisation has crossed not only national boundaries but even the time dimension and explores how past financial events have a bearing on the current scenario. The new banking ideology is studied and the factors which made the banking system vulnerable and unstable showcased. The effect of high liquidity in the market and the shift from medium and long term financing to short term financing including the emergence of commercial paper and repo agreements is also observed. The factors leading to the Subprime Housing Crisis and the Housing Bubble are amplified with the ensuing cascade effect also studied. That leads to the final and ongoing part of the crisis: The Liquidity Crunch. A link is drawn out between the fundamental changes in the banking sector, the shift to short term financing and the liquidity crunch.
Asian Financial Crisis:
Occurring in the late 90’s the Asian Financial Crisis was a currency crisis revolving around the emergence of the South East Asian countries as major exporters and the subsequent fiscal measures adopted by the government. Exporting nations are significantly dependant upon exchange rates and an unfriendly rate could have a major impact on the economy. Desiring a stable exchange rate the governments chose to peg the dollar against their currency which could insulate against fluctuations and thereby shield the exporting sector-the lifeline of the economy. Internal factors however such as inflation (partly induced due to export activities as lower supplies are available to the domestic market) and a falling stock market induced pressure on the governments. Thailand was the first to be affected followed by Malaysia, Taiwan, Philippines and subsequently other South East Asian countries. Rising foreign debt was also a cause of concern. Being weakened by internal factors the governments were not able to maintain the dollar peg and shifted towards a floating exchange rate. The currencies floated rapidly downward. While positively affecting exports in the short term the negative effects are numerous. Firstly inflation, already a cause of concern would worsen as price of essential imported commodities such as petroleum and steel would increase. And secondly the foreign debt would enlarge to unaffordable levels. Crashing exchange rates were a cause of worry and concern and the Asian countries were looking for a mechanism which could give them greater influence upon the exchange rate.
With the dawn of the new millennium the Asian countries had found their instrument of influence- US securities. This could work in both directions- assist in maintaining an export friendly rate and act as a mechanism against excess depreciation.
On buying the US securities they would be converting their domestic currency to dollars consequently leading to an excess supply of their currency and a reduced supply of dollars in the exchange market. This would lead to their domestic currency depreciating and the value of the dollar appreciating. This would promote an export friendly exchange rate.
On the other hand the excess depreciation would be extremely damaging as was exemplified by the financial crisis of the 90’s. To prevent this government could sell US securities, get paid in dollars, and convert the dollars to their domestic currency which would lead to an excess supply of dollars and a reduced supply of their domestic currency in the forex market.
Thus Asian countries started actively investing in America which led to a substantial increase in the liquidity scenario, a prime factor in the ensuing housing bubble.
Changes in the American Banking Sector:
Introduction of Subprime Loans:
A significant transformation occurred in the American banking sector with the introduction of off balance sheet Special Purpose Vehicles, the securitization of loans and the surge in short term asset backed financing instruments.
Originating approximately in the financial year 2004-05 the grouping of loans and receivables into pools and their subsequent sale to SPVs (Special Purpose Vehicles) freed up an enormous amount of capital for banks. This excess capital allowed banks to issue more loans and caused lending standards to decrease. Since banks were facing only a ‘pipeline risk’ over the loans being issued, a further drop in lending standards occurs. This excess capital allows banks to start a new trend-subprime loans. These loans are given to that section of the borrower’s market that has an unstable income, a poor credit history and few assets. These loans however command a higher rate of interest due to the risks involved. Previously banks had avoided this demographic but since banks started offloading risks onto SPVs this sector steadily rose to prominence. The rising real estate prices further nullified the associated risks (a mortgage default prior to the Burst of the Real Estate Bubble would have been highly profitable to the lender as mortgage values exceeded the loan given) and banks introduced attractive installment schemes to expand their subprime loan section. These installment schemes included those with a special ‘introductory period’ of marginal installments, this period usually stretched upto 2.5 years and was a major stimulus to borrowers(In this period borrowers paid only a fraction of installments they would pay at the end of the introductory period). In accordance to the American economics model based largely on consumption fueled by debt these loans were a major hit with the subprime borrowers.
In conclusion to this section we observe that subprime loans had rapidly gained a significant share of the loan market chiefly due to offloading of risk and freeing up of capital (By virtue of the sale of these loans to SPVs). We now move on to the next section to where we examine this process of securitization in detail.
The first step taken in this direction was the formation of ‘off-balance sheet’ vehicles/entities which came to be known as Special Purpose Vehicles. The second step taken towards securitization was creation of diversified portfolios of mortgages, other types of loans such as car loans personal loans and receivables such as credit card receivables. This step worked towards the transformation of illiquid assets into transferable securities. The diversified mortgage pool was bought by SPVs and subsequently sliced or tranched into different classes according to their credit risk.
The SPV obtained finance though the issuance of asset backed securities. These asset backed securities were debt instruments and were classified into different groups in accordance to the collateral supporting the commercial paper. The different classifications were super senior ‘AAA’, senior ‘AA’, mezzanine ‘BBB’ and subordinated ‘B’. The lower rated securities were backed by a mix of risky and low rated mortgages and subsequently paid a higher rate of interest.
Take for example the case of a pension fund. Regulations allow pension funds to invest only in very low risk securities. The SPV sells ‘AAA’ rated securities to the pension fund for a short term period of 3 months. The assets backing the securities sold to the pension fund are the prime loans with a low risk rating. Since there is a low risk rating therefore the interest paid out is proportionately lower. For securities backed by more risky subordinate ‘B’ tranches the proportionate interest rate paid is higher.
To obtain a higher rating for the securities issued by it the SPVs use various methods ( A lower risk rating on it’s asset backed securities resulted in a lower interest being paid on the securities) which included obtaining ‘liquidity backstops’ and buying Credit Default Swaps from the originating bank. A liquidity backstop meant that in case the SPV was unable to honour it’s obligations to the holdersof the asset backed securities issued by it the bank providing a liquidity backstop would guarantee payment to the SPV’s creditor’s. Credit Default Swaps followed a similar function of neutralizing the risk for investors.
SPVs followed a system of short term financing which meant that they had to roll over their debt regularly. Investors usually prefer assets with short term maturities and thus issuance of short term commercial paper made sense as there was a larger market for them and it was easier to obtain finance. The roll over of debt depended on the risk level associated with the underlying loans which were kept as collateral. A fall in value or an increase in the risk rating of the collateral would be detrimental factors as investors would steer clear of risky or under-collateralized securities. Thus SPVs depended upon the value of the underlying loans to obtain finance.
Repo financing was another method financing used by SPVs. They were also known as repurchase agreements. In this system conduits temporarily sold their assets with a contractual agreement to buy them back at a later date. This mode of finance was also short term and had to be rolled over regularly.
Banks: On sale of mortgage pools to SPVs banks recorded a cash inflow.
This capital was used to give further loans and was recorded as cash outflow.
SPVs: On buying the mortgage pools they recorded a cash outflow. However the mortgage pools are assets which generate inflows. To finance the procurement of these assets the SPVs issue securities and subsequently result in cash inflows. The cash inflows from the underlying pool of assets (which are kept as collateral) is used to repay the interest on the securities issued. There is however a difference between the cash inflow received by the SPV from its assets (the mortgage pool) and the cash outflow in lieu of its liabilities (the asset backed securities) which turns out to be the profit for the SPV.
Repo finance: They record cash inflow by temporarily selling their assets on a contractual agreement to buy them back. Cash inflow is recorded at the time of sale and outflow is recorded at the expiry of the term agreement.
Investors: Their cash outflow is recorded when they buy the asset backed securities and their inflow is recorded when they redeem these securities at the end of the term. Their cash inflow is higher than their cash outflow as they are paid interest by the SPVs.
The Housing Bubble:
In the section relating to subprime loans we observed that excess capital and supposed (the real risks of mortgage defaults had never left the banking sector as we shall observe in the next section) offloading of risk allowed banks to make a large number of loans to the subprime sector.
However in the following years as the introductory period of low installments ended the subprime borrowers gradually started defaulting on their payments. The volume of subprime loans was large and subprime borrowers were spread throughout the nation. As the borrowers defaulted their mortgages came in possession of the owners of the loans-the SPVs. Due to this firstly a part of the inflow of SPVs was reduced. They came in possession of the mortgage. They put up the mortgages up for sale at the prevailing market conditions. However subprime borrowers had now started to consistently default and the consequently the SPVs put up more and more real estate on the open market. There wasn’t a proportionate amount of demand for these properties for 2 reasons: (i) They were over priced. The credit boom had resulted in a surge in real estate prices which was not backed by the sound fundamentals of demand-supply. (ii) Subprime borrowers who were the untapped potential of the market had raised the excess demand for real estate. With subprime borrowers defaulting across the US there weren’t enough buyers for the excess property on the market.
However a major market failure took place. Real estate prices which would steadily have come down in lieu of the excess supply sustained those astronomical levels. And steadily as more and more supply piled up on the market there was increasing pressure on the real estate prices to lower.
Finally in the last months of 2007 the US housing bubble burst and real estate prices across the US crashed uniformly. This had an enormous cascading effect which we shall examine in a narrow sense in the next section-The Liquidity Crunch.
The Liquidity Crunch:
This section shall analyse how the US real estate debacle was the first step to a global financial crisis. SPVs possess loans (which are assets). SPVs use varied methods of financing but here the effect of the housing debacle on the 2 prominent credit channels is examined : (1) Asset Backed Commercial Paper. (2) Repo financing.
These loans are financed through issuance of short term asset backed securities. However the assets backing the securities issued by banks are the loans in possession of SPVs. With the large number of defaults the SPVs were left with mortgages, the sale of which would have resulted in a cash inflow. However the burst of the bubble converted these mortgages into non-performing assets (NPA). It was now increasingly difficult for the SPVs to procure finance since the sale of asset backed commercial paper depended upon the risk rating and value of the underlying collateral. Since a large amount of their collateral was now converted into NPAs the investors abstained from investing in the asset backed securities issued by SPVs.
Repo financing was similarly affected. With large decrease in the value of assets held by SPVs it was very difficult to obtain sufficient financing through this medium. This was a situation of liquidity crunch whereby it was difficult for financial institutes to raise money.
The SPVs are now in possession of a large amount of NPAs financed on short term debt. With the inability to raise sufficient funds the conduits turned towards the ‘originators’ or ‘monolines’ which had guaranteed liquidity backstops. This directly transferred the supposed off-balance sheet risk onto banks. The banks consequently had to sell a large number of assets held by them throughout the globe to provide the liquidity backstop. This large scale sale of assets across the globe conveyed negative sentiments from the largest economy in the world. Panic sales followed in financial markets throughout the world. Banks unable to raise funds in the liquidity crunch scenario had to declare bankruptcy.
The amount of outstanding liabilities of the banks was massive and widespread sales caused rapid downward spirals which meant banks had to sell a larger amount of assets to settle their outstanding liabilities.
On conclusion it is noted that a higher level of transparency and regulation is required to prevent such a widespread global crisis in the future. The American model of deregulation needs to be reformed to reduce the opaqueness of the financial system and a greater level of awareness is required with regard to the complex derivates which have gained prominence in the recent years.