The Search for the Real Causes of the Current Global Financial Crisis: Role of Financial Innovations

Transcription

1 The Search for the Real Causes of the Current Global Financial Crisis: Role of Financial Innovations Presentation at The Korea Institute for International Economic Policy Seoul, Korea Yoon-shik Park Professor of International Finance George Washington University February 27, 2009

2 Conventional Explanation for the Causes of the Current Crisis Global imbalance between the U.S. and the rest of the world, especially East Asian countries such as China and Japan. Massive FX reserves accumulated in East Asia were promptly recycled back to the U.S., resulting in excessive liquidity there. The flood of foreign capital into the U.S. lowered interest rates, inducing Americans to run down their own savings and to keep spending. U.S. FRB s prolonged low interest rate policy also contributed to the crisis by encouraging banks and investors around the world to search for high yields at greater risks. Strong U.S. political pressure for home ownership, even in low-income areas, eventually leading to widespread subprime mortgage lending. To top it off, Wall Street greed and incompetence have also been blamed for the crisis.

3 Alternative Explanation for the Causes of the Current Crisis However, the world had lived with global imbalances in previous decades without necessarily having a massive global crisis. A deeper reason can be found in the phenomenal growth of finance in recent decades compared to the real sector of the economy. The share of the profits of the financial services industry in the United States rose from 10% of total corporate profits in early 1980s to 40% in 2007, four times in less than 3 decades. Such a rapid growth in the financial sector has been made possible through revolutionary new financial products and techniques. Overall, financial innovations have played a constructive role in global financial markets, where their scale of magnitude can be estimated at (as of mid 2008): Daily FX trading volume: almost $4 trillion ($20 trillion a week!) Outstanding derivatives (in NPAs): $767 trillion In recent years, however, there had been an increasing abuse of new and sophisticated financial innovations. Even if only a small portion of such a massive market is misused, it can result in catastrophic losses for impacted financial institutions and investors.

4 Explosive Growth of Subprime Mortgage Loans The current global financial crisis began in the summer of 2007 as a subprime mortgage crisis in the United States. Prior to 2007, there was a phenomenal growth in new mortgage loans in the United States, including subprime mortgage loans such as no doc (documents) loans, liar s loans, ninja (no income, no job and no assets) loans Total mortgage originations ($tn) Subprime mortgage loans ($bn) SM loans as % of mortgages (%) SM-backed securities ($bn) Meanwhile, the delinquency rate on subprime mortgage loans rose from around 11% in 2004 to 19% in 2008.

5 Two Phases of the Current Global Financial Crisis Phase 1 (August 2007 September 7, 2008): Subprime Mortgage Crisis 1st half of 2007: The market for subprime mortgage-related related securities started to crack due to the burst of U.S. housing market bubble. 8/07: Subprime mortgage crisis produced its first financial casualties when two German banks (IKB and SachsenLB), that had invested heavily in subprime mortgage-related related securities through their off-balance sheet vehicles and suffered huge losses, had to be bailed out by the German authorities. 9/07: Northern Rock, Britain s 5 th largest mortgage lender, experienced liquidity crisis, triggering the first British bank run in 150 years. 3/08: Bear Sterns had to be merged with JPMorgan Chase and, since then, other financial institutions had to announce huge write-downs of their subprime mortgage-related related investments. At this first stage of the crisis, however, mostly long-term bonds were affected including MBS, CMOs, CDOs and the $330 billion auction-rate notes. Subprime mortgage crisis appeared to reach its climax with the U.S. government rescue of Fannie Mae and Freddie Mac on 9/7/08.

6 Phase 2 (September 15, 2008 Now): Global Financial Market Crisis 9/15/08: New financial crisis started with the bankruptcy of Lehman Brothers, which had $700 billion assets and $740 billion in derivatives contracts with over 5,000 counterparties around the world. On the same day, September 15, Merrill Lynch was merged into BOA through stock swap worth $50 billion. On the next day, September 16, the world s largest insurance company AIG was bailed out by the U.S. government with 2- year $85 billion loan from the FRB at the punitive interest rate of 3-month LIBOR plus 8.5%. (AIG received $152 billion so far from the government.) Eurodollar inter-bank market frozen (3-month LIBOR doubled); $3.5 trillion MMFs, $1.3 trillion CP market, and $58 trillion CDS market also frozen. On 9/21, both Goldman Sachs and Morgan Stanley were turned into BHCs, thus ending the 75-year history of U.S. mono-line investment banks. On Friday, October 3 (after initial failure on 9/29), Congress passed $700 billion bank bailout package, but the U.S. stock market experienced the worst weekly decline of 18% the following week.

7 Abandoning the Too-Big-To-Fail Principle and the Current Crisis The crisis was born in excess liquidity due to easy monetary policy (especially during the Greenspan era) and the government policy to make mortgage loans easily available to low-income areas (the first cause of subprime mortgage phenomenon). But much of the blame for the current global financial crisis should be placed on both the abuse of financial innovations by Wall Street and the regulatory failure in the U.S. as the government ignored the too-big big-to-fail (TBTF) principle. 1984: Continental Illinois Bank (7th largest with $45 billion assets) was saved by the government. 1998: LTCM (Long Term Capital Management) hedge fund (with $120 billion assets) was bailed out. 2008: Lehman Brothers (4 th largest investment bank with $700 billion assets and $740 billion derivative contracts outstanding) was allowed to fail, even though BOA was willing to take over with $65 billion cover for losses (as in the Bear Stearns takeover by JPMorgan Chase with $29 billion cover by the U.S. for possible losses). As in the 1994 Mexican peso crisis and the 1997 IMF crisis in Korea, Lame-duck phenomenon Political criticisms of the Bear Stearns (3/08) and Fannie Mae & Freddie Mac (9/7/08) bailouts were too much for the lame-duck Bush administration.

8 U.S. Regulatory Problems in the Financial Crisis Unlike the unified regulatory framework in other advanced countries (FSA in UK, FSA in Japan, FSC in Korea, etc.), the US financial regulatory system is antiquated. 6 Federal regulatory agencies (OCC, FRB, FDIC, OTS, CFTC, SEC) for commercial and investment banks, plus 50 state regulators. No Federal regulator for the insurance industry, with only 50 state regulators for insurance companies. Regulatory asymmetry: Commercial banks have been more tightly regulated than investment banks, encouraging the latter to higher and riskier leverage and trading in esoteric financial products. US regulators such as SEC were more relaxed towards investment banks in terms of capital ratios and others, unlike commercial banks accepting deposits from the public.

9 Fair Value Accounting in the Current Financial Crisis In the aftermath of the U.S. S&L crisis in the 1980s and the Japanese banking crisis in the 1990s, both FASB and IASB adopted fair value (or mark-to to- market) accounting. In late 2007, SEC required all U.S. companies to adopt the mark-to-market accounting standards. When there are no normal market activities during a financial crisis, M-T-M accounting is pro pro-cyclical, as some assets are disposed at fire sale prices to raise cash and thus forcing all the similar asset classes in the industry to be written down. As asset write-downs reached hundreds of billions dollars, banks have been forced to further liquidate other assets to raise cash and to meet the BIS capital adequacy ratios. For example, $1 billion write-down due to the M-T-M M accounting rule leads to $10 billion reduction in loans due to a typical 10-to-1 leverage ratio maintained by banks. US regulators such as SEC should have suspended the fair value accounting at the beginning of the current crisis, thus preventing the further deterioration of financial markets.

10 Major Financial Market Liberalization In addition to the macroeconomic missteps mentioned earlier, series of global financial deregulations also played a part. U.S. May Day in 1975: removed fixed brokerage commissions. U.K. Big Bang in 1986: Abolition of fixed brokerage commissions. Opening up U.K. exchanges to outsiders. Replacement of trading floor by computers. New competition in gilts trading. Easier to have M&As among financial firms. Japanese Big Bang in 1996: Gradual deregulation of Japanese financial markets.

11 Transformation of the U.S. Financial System 1933: Glass-Steagall Act was passed, separating commercial banks from investment banks. For example, in 1934 J. P. Morgan & Co. was split into Morgan Guaranty Trust commercial bank (today s JPMorgan Chase) and Morgan Stanley investment bank (IB). Commercial banks relied on deposits to fund loans and earned interest income, while investment banks depended on stock brokerage commission income. 1975: The May Day financial deregulation in the U.S. removed fixed stock brokerage commission rates, pushing IBs to look for alternative revenue sources. IBs leveraged their capital up to 30 or more times to engage in proprietary trading and private equity investments, and they also developed and traded esoteric financial products for a high risk-high return strategy. Their strategy worked until 2006, when the total bonuses at Wall Street firms amounted to $62 billion. 1999: Glass-Steagall Act was repealed, allowing commercial banks to merge with investment banks and even insurance companies to form universal banks (Citigroup model). Since 1999, many Wall Street investment banks disappeared. By the early 2008, only five investment banks were left in Wall Street: Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley, and Goldman Sachs.

12 Problem with Credit Rating Agencies Rating agencies are paid by underwriters of the asset-backed securities such as MBS and CDOs after the issue. Rating agencies play an active role in structuring securitization before the issue so that the rated securities can obtain the highest possible ratings. (As in the case of Arthur Andersen s conflict of interests between auditing and consulting in the Enron scandal, conflict of interests between rating and consulting for the rating agencies.) Grade inflation therefore is likely to take place. Investment-grade securitized products experienced 10 times the default rate of the same-grade regular bonds over Banks, pension funds and insurance companies require minimum ratings for their eligible investment securities, thereby increasing the demand for highly rated securities.

13 Assets-backed Commercial Paper (ABCP) ABCP first emerged in the 1980s and it became a significant source of funding in the 1990s. The outstanding volume of ABCP was under $50 billion in 1992, but it reached $1.3 trillion by ABCP is short-term term CP issued by an SPV (special purpose vehicle) backed by assets, and it trades like conventional commercial paper. The SPV used in ABCP is known as a conduit or SIV,, which is usually sponsored by a commercial bank to issue ABCP. ABCP became popular with many money market funds, one of which, Reserve Primary Fund established by pioneer Henry Brown, started to invest in CP in early This fund broke the buck due to its loss on Lehman Brothers CP and triggered a crisis in the $3.5 trillion money market funds.

14 Liquidity Squeeze in the ABCP Market Many financial institutions set up structured investment vehicles (SIVs) or conduits to issue ABCP. SIVs and conduits raised short-term term funds through ABCP in order to invest in long-term and higher-yield securitized products such as CMOs, MBS or CDOs backed by subprime mortgage loans. SIVs and conduits were not shown on the balance sheet of the sponsor banks. Citigroup, for example, set up many SIVs with combined total assets of over $100 billion. German Landesbanks lost state guarantees in 2005, thus becoming active in SIVs and conduits in order to enhance their earnings, resulting in SachsenLB and IKB fiascos.

15 Asset Securitization: Origin of the Crisis Securitization: packaging illiquid assets into marketable securities. It can take place in two types: Pass-through securities (certificates of ownership or participation certificates): Investors have ownership interest in the collateralized assets. Examples are MBS (mortgage-backed securities), ABS (asset-backed securities), CARs (certificates for automobile receivables) and CARDs (certificates for amortizing revolving debts). Pay-through securities (collateralized debt obligations): Investors do not have any ownership interest in the collateralized assets but their securities are serviced by the cash flows generated by the assets. Examples are CMOs (collateralized mortgage obligations) and CDOs (collateralized debt obligations).

16 History of Mortgage Loan Securitization Mortgage-related related securitization: MBS and CMOs Non-mortgage securitization: ABS 1970: GNMA (Ginnie Mae) pioneered MBS, which are pass- through securities on mortgage loans. 1983: FNMA (Fannie Mae) marketed the first CMOs, which are pay-through securities on mortgage loans. 1985: first ABS was marketed by Sperry Lease Finance Corp. backed by its computer lease receivables.

17 Volume of Securitization By 2007, over half of non-financial debt in the U.S. was securitized, compared to just 28% in As of end-2007, compared to $7 trillion of government debt securities held by the public and international investors, $10 trillion of securitized instruments outstanding ($8.3 trillion of MBS and CMOs, and $1.8 trillion of ABS). New issue of mortgage-related related securitization (in $ billions): Total issues $ ,966 2,003 1,351 Non-agency issues

18 CDOs (Collateralized Debt Obligations) (The Real Villain of the Current Crisis) CDOs are called structured finance products and packaged as pay-through securities. CDOs first emerged in the 1990s due to banks desire to off-load high risk loans such as leveraged loans used in M&As. Wall Street firms acting as CDO underwriters earned fees of 2.5% 3.5%. Merrill Lynch alone launched about $150 billion CDOs during , 07, earning fee income of over $5 billion. Citibank, Bear Stearns and other U.S. banks made tons of money the same way. Wall Street investment banks were eager to create and market more CMOs but their new volume was constrained by the availability of mortgage loans which are used as the collaterals for CMOs. Wall Street had un-satiable appetite for more collaterals, thus resulting in an increasing demand for even subprime mortgage loans, and then Wall Street finally proceeded to create CDOs which do not need mortgage loans as collaterals.

19 CDOs and Subprime Mortgage Crisis Collaterals for CDOs are three types: Mortgage loans: plain vanilla CDOs MBS, CMOs, and other ABS: CDOs squared Derivatives such as credit default swaps (CDS) related to mortgage loans: synthetic CDOs Thus, CDOs allowed Wall Street firms to issue new class of bonds without waiting for supplies of new mortgage loans. CDOs were able to pay higher interest rates than comparably rated regular bonds due to their unique tranching (or layering) feature. CDO issue volume ($ billions): (1 st half) $

20 A Case Study of CDOs called Norma (1) CDOs: the key to understanding the origin of the current global financial crisis. 3/07: Merrill Lynch launched $1.5 billion CDOs known as Norma. Norma s collaterals carried an average of BBB ratings generating a yield of 6.5%, but Norma CDOs had 5 tranches: 75% ($1,125 million): AAA 9% ($136 million): AA 5% ($74 million): A 7.7% ($115 million): BBB 3.3% ($50 million): un-rated A modern alchemy performed by the wizards of Wall Street: BBB-rated assets turned into 89% AAA, AA, and A-rated assets. (Similar to a class of 100 students with average B grades magically turned into almost 90 students getting A grades!)

21 A Case Study of CDOs called Norma (2) At that time, the actual bond market yields (and the differences from the 6.5% average yields of the Norma collaterals in % and $s for respective tranches) were : AAA bonds: 5.3% (1.2%, or $13.5 million) AA bonds: 5.66% (0.84%, or $1.14 million) A bonds: 5.84% (0.66%, or $0.49 million) BBB bonds: 6.27% (0.23%, or $0.26 million) Total additional interest income: $15.4 million per year. Even if the unrated 3.3% ($50 million) tranche is paid 15% or $7.5 million per year, the remaining $7.9 million can be distributed to the remaining upper tranches ($1,450 million) for an extra yield of 0.54% or 54 basis points above the comparably rated bonds.

22 Reasons for CDOs Popularity among Investors Too much liquidity in the financial market pushed asset managers around the world into intense competition for extra yield. Higher investment returns led to more success for the investment manager: in 2006, a Credit Suisse money market fund achieved an investment yield just 31 basis points higher than the industry average. The fund size increased from $1 billion to $26 billion in just 6 months in early CDOs were the perfect investments of choice among asset managers hungry for higher yields to stay competitive. Wall Street underwriters of CDOs such as Merrill Lynch and Citibank sold liquidity puts, which allow buyers to return CDOs later at the purchase price. ($25 billion puts were exercised on Citibank alone.) They along with other firms such as UBS and HSBC also invested in CDOs for their own portfolios due to their high yields. CDOs were able to provide higher yields through the magic of tranching in securitization and rating inflation due to willing cooperation of rating agencies eager for extra fee income.

23 Conduits and Structured Investment Vehicles (SIVs) Both conduits and SIVs are established as separate legal entities by sponsoring banks in order to create off-balance sheet investment vehicles, as they are not consolidated into sponsor bank financial statements. Conduits: full credit back-up facilities from sponsor banks. SIVs: only partial or even no credit back-up from sponsor banks. Conduits and SIVs issued ABCP at low short-term term interest rates and used the proceeds to invest in high-yield long-term CDOs. The first sign of the current financial crisis involved conduits set up by two small German banks, IKB and SachsenLB, which had to be bailed out. Many conduits and SIVs were closed down, with their assets put on the balance sheets of sponsor banks which are thus further weakened financially.

24 Lessons from the Current Financial Crisis (Longer term) High leverage ratios for investment banks should have been lowered by SEC to that of commercial banks (from 30 times to about 10 times equity capital). As securitization became wildly popular in the US, the regulator should have introduced the European-style covered bonds in lieu of the American-style securitization. In this way, the subprime mortgage loans would still be on the balance sheet of originating banks, motivating them to be selective in credit quality. SIVs and conduits should have been required to be consolidated with the sponsor banks, thus injecting transparency in this murky area. In this way, the financial crises of IKB and SachsenLB would have been avoided, along with many other banks.

25 Lessons from the Current Financial Crisis (During the Crisis) From September 2007, when Northern Rock triggered the first British bank run in 150 years, or at least from October 2007 when mortgage- related securities were massively downgraded by major credit rating agencies, the U.S. SEC should have suspended the mark-to-market accounting rules temporarily. Banks could thus avoid massive write-downs which required further fire sale of securities in order to raise cash and to meet capital requirements and then still more write-downs at the new lower fire sale prices and so on in a vicious circle. Lehman Brothers should have been bailed out like Bear Stearns. The government mistake here turned the original subprime mortgage crisis into the current global financial and economic crisis. Regulatory dilemma: choosing among the spectrum from lightly-regulated but highly innovative financial system to heavily-regulated but stodgy financial system a tradeoff between the costs and benefits.

26 Regulatory Failures in the AIG Case There is no Federal-level level insurance regulator; instead the insurance companies are regulated by 50 state governments in the U.S. AIG s Financial Products subsidiary in London acted like an investment bank but without any SEC supervision since it is part of an insurance company. From 1998, AIG sold more than $500 billion of CDS (credit default swaps) to hundreds of counterparties such as Merrill Lynch, Goldman Sachs, and others earning additional profits for AIG. Including CDS, AIG had outstanding total swap contracts worth $2.7 trillion with about 2,000 counterparties as of AIG simulation model predicted 99.9% probability of never paying out any money on its CDS contracts, which were bought by many banks who could save on their BIS capital ratio by turning their CDOs and other investments into AAA-rated assets. Furthermore, CDS was not considered an insurance product, so the New York State Insurance Commissioner did not exercise any supervision of AIG s CDS operations, which were run by a unit located in London as part of AIG s small French subsidiary.

27 Proactive Role of the U.S. Federal Reserve Between September and December of 2008, FRB injected $900 billion into the U.S. financial system ($500 billion for banks, $270 billion for CP market, $70 billion for MMFs, $50 billion for investment firms) FRB also lowered the Fed fund rate from 5.25% in the summer of 2007 to near zero (0 0.25%) now. FRB announced to inject another $800 billion ($600 billion for mortgage-backed securities and Fannie Mae and Freddie Mac securities, and $200 billion for student and car loans, etc.) FRB has moved from LLR (Lender of Last Resort) to commercial banks to LLR to other financial firms (such as AIG) and even industrial companies (through its purchase of CP), as banks now account for a much smaller share of all lending in the U.S. Some even call FRB now as Lender of First Resort. FRB has also become Investor of Last Resort (ILR) by directly buying shares of banks and insurance companies.

28 Proactive Role of the U.S. Administration U.S. Treasury Department has administered its $700 billion TARP (Troubled Asset Relief Program) appropriation by injecting capital into banks and other financial institutions. Congress and the new Obama Administration agreed on an economic stimulus package of almost $800 billion (about 6% of GDP). The Obama Administration also announced $2.5 trillion bailout package for the U.S. financial system, including $350 billion TARP fund not yet used. For the first time, there is a worldwide movement towards adopting massive and globally synchronized economic stimulus packages and financial bailout schemes via Group of Twenty (G-20) meetings. The world economy is likely to recover later this year as a result.

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