Feature. Global Financial Crisis Overview KIM Kyeong-Won, KIM Hwa-Nyeon

Transcription

1 Feature Global Financial Crisis Overview

2 Since the summer of 2007, people all over the world have became familiar with subprime mortgage loans loans granted to borrowers whose credit history disqualifies them from conventional mortgage loans which triggered the current global financial crisis and resulted in the worst global recession since the Great Depression of the 1930s. It is sometimes referred to as the Great Recession. The Evolution of the Financial Crisis The current crisis has had four distinct elements: 1) subprime mortgage crisis, 2) credit crunch, 3) global financial crisis, and 4) global economic crisis. This indicates the different phases marking the evolution of the crisis. The first phase of the crisis began when New Century Financial, the second-largest subprime loan lender, filed for bankruptcy in March At the time, most people did not expect the crisis to last very long nor become very big. With the interest cut by US Federal Reserve, world capital markets showed resilience to the extent that in October 2007, the Dow Jones Industrial Average hit a record high of 14,164 points. Slowly, however, the crisis began infiltrating various areas of the global financial system. Most financial institutions began to run low on cash and, although governments released massive amounts of money into the credit market, a credit crunch began to squeeze major financial institutions. As a result, investment banks either collapsed or were merged. Even Goldman Sachs, the largest investment bank, became a commercial bank. In March 2009, Citigroup, generally regarded as a symbol of capitalism, was essentially nationalized as the US government converted the preferred shares to common stock. After the crisis began, eight instabilities appeared in global financial markets. The first was rising delinquency rates due to resets of adjustable rate subprime mortgages or ARMs, loans that started out at a low fixed rate but reset to higher, floating rates after 2-3 years. The resetting of ARMs peaked in the first quarter of Figure 1 VIX Trends Following Major Events Jan.-05 Mortgage Lenders Insolvency Apr.-05 Unstable Stable Increasing Losses in MBS & CDO Heightened Concerns over Global Recession SIV Liquidity Crisis Monoline Risk Lehman Brothers Chapter 11 Bear Stearns Insolvency GSEs Risk Note: VIX is the Chicago Board Options Exchange Volatility Index, a popular measure of the implied volatility of S&P 500 index options. Source: Datastream Citigroup & GM Liquidity Risk (12/5) Obama Election Jul.-05 Oct.-05 Jan.-05 Apr.-05 Jul.-05 Oct.-05 Dec April 2009 SERI Quarterly 13

3 Global Financial Crisis Overview The second instability resulted from falling prices of mortgage-backed securities (MBS) and collateralized debt obligations (CDO) based on subprime mortgages. Outstanding issuance of CDOs in the US amounted US$1.9 trillion and CDOs at risk of turning bad are estimated at US$250 billion. The third instability arose because of the liquidity crisis of structured investment vehicles (SIVs), which are finance companies established by banks to manage high-risk assets separately from their own books. As it is difficult for banks to invest in high-risk assets on their own, they employ SIVs as an indirect method of investment. The total amount of assets invested by SIVs is estimated at US$320 billion, and the proportion of MBS and CDOs exceeds 40% of the total assets. SIVs financial troubles have spread to banks, their parent companies, resulting in massive losses at major banks. Citigroup, for example, owns seven SIVs, which manage US$ 83 billion in assets. Although the bank is not responsible for the SIV defaults by law, it voluntarily acquired the SIV assets due to fears of reputation risk. The fourth instability was mainly due to the downgrade of bond insurers in January Concerns grew that bond insurers which guaranteed CDOs or purchased CDS (Credit Default Swap) may become insolvent. Share prices of MBIA and Ambac, the two largest bond insurers, plummeted after credit rating agencies lowered Ambac s credit rating from AAA to AA. Subsequently, fears over possible insolvencies spread across financial markets, which put downward pressure on the credit ratings of other bonds guaranteed by those bond insurers. The credit ratings for 4,991 bond issues insured by Ambac declined. The contours of the current crisis changed completely when Lehman Brothers filed for Chapter 11. Capital markets were thrown into a panic, and people began to realize that the crisis was not just limited to the financial industry, but also affected the real economy. The fifth instability arose due to the skyrocketing margin calls of non subprime mortgage-re- 14

4 lated fixed income securities. For example, Carlyle Capital, the investment fund of the private equity giant the Carlyle Group, received substantial margin calls and additional default notices from lenders in March Although Carlyle Capital invested mainly in triple-a rated mortgage securities, lenders started questioning Carlyle Capital s solvency and raised margin calls and collateral requirements. The sixth instability was due to the liquidity problem of government sponsored enterprises such as Fannie Mae and Freddie Mac. Fannie and Freddie suffered combined losses of nearly US$14 billion in the year following the start of the subprime mortgage crisis. As Fannie and Freddie guaranteed almost half of the country's mortgages, their significant losses threatened the entire mortgage and credit industry. Consequently, the US federal government decided to take over Fannie and Freddie with over US$200 billion in public funds. The seventh instability came about after September 2008 when Lehman Brothers and other investment banks went bankrupt or were merged by other institutions. This was a real turning point of the financial crisis. The eighth instability, which is still ongoing as of March 2009, resulted from the upward risk of nationalization of US commercial banks. The main focus was on Citigroup, which already reported five consecutive quarterly losses. Although the US government decided to essentially nationalize Citigroup, share prices plummeted to less than US$1 at one point early this year. There is a good chance that more US commercial banks will be de facto nationalized. Among all the instabilities outlined above, the seventh is the most significant, as the contours of the current crisis changed completely when Lehman Brothers filed for Chapter 11 in the New York court. Capital markets were thrown Figure 2 Development of Global Financial Crunch 1st Instability: Feb.-Mar nd Instability: Aug.2007 Borrower Mortgage Cash Mortgage Originator Loan Obligation Cash SPC (Special Purpose Company) MBS Cash Underwriter Investment Bank Broker Dealer 3rd Instability: Nov.2007 SIV (Structured Investment Vehicles) Loan Obligation Cash Investors (Hedge Funds, Insurance Firms,Banks, etc) Cash CDO 4th Instability: Jan.2008 Bond Insurer Note: Kwon, Soon-Woo (2008). Ever Rising Global Financial Instability and its Impact on the Global and Korean Ecoonomy KET 13 (11), Samsung Economic Research Institute April 2009 SERI Quarterly 15

5 Global Financial Crisis Overview into a panic, and people began to realize that the crisis was not just limited to the financial industry, but also affected the real economy including household incomes and job security. Consequently, the crisis can be divided into the two of phases of before Lehman Brothers filed for bankruptcy and after, as this marked the point where Wall Street volatility moved to main street instability, and the global financial crisis turned into global economic crisis. After Lehman Brothers filed for bankruptcy, the values of all assets depreciated except for safe-haven assets such as gold. As the problem began affecting the real economy, safe-haven currencies such as the Japanese yen and the US dollar appreciated. The appreciation of the US dollar led to a steep decline of commodity prices including those of crude oil. Governments around the world announced economic stimulus plans to ease the rapid economic downturn. The G20 summit marked the beginning of global mutual aid and major governments agreed to increase financial stability and economic stimulus packages. The US government unveiled a plan to help troubled financial institutions and auto companies through the US$700 billion TARP (Troubled Asset Relief Program). In addition, European countries, Japan, and China also announced massive financial stability and economic stimulus plans. However, the credit crunch continued to deepen and losses of financial companies continued to mount, so that US commercial banks could not survive without additional capital injection of the government. Both the US House and Senate compromised on a US$782 billion economic stimulus act, and the US Treasury Secretary, Tim Geithner, introduced a US$2 trillion financial stability plan in February In spite of those aggressive plans, the US Dow Jones industrial index fell to below 7000 points in early 2009, a 12-year low, while the Japanese NIKKEI 225 index recorded the lowest point in 26 years. As investors outlook becomes dimmer, the world economy has moved into a highly uncertain phase. Figure 3 US Home Price Index and Sales Jan.2000= Sales (right) Price (left) Thousand Jan-01 May-01 Sep-01 Jan-02 May-02 Sep-02 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Note: US S&P/Case-Shiller home price index 20 city composite US, existing home sales Source: Datastream 16

6 Most economists now attribute the financial crisis to financial innovation, including new financial products and risk management techniques. The Root Cause of the Crisis The root of the global financial crisis was the US housing bubble, which developed for three reasons: 1) long lasting low interest rates since the early 2000s, 2) loose mortgage loan evaluations due to high competition among mortgage companies, and 3) lack of government supervision on innovative financial products, especially mortgage-related derivatives. Since 2002, the US Federal Reserve maintained a negative real interest rate for about three years to ease the financial shock post IT bubble. With low interest rates, the competition between mortgage companies increased and companies applied loose credit standards to low credit rated borrowers. Borrowers loan payment burdens became heavy as the federal interest rate gradually went up to 5.25% in July 2006 from 1% in July 2003, and the US housing bubble started to burst as housing prices declined and the delinquency rate went up. Most economists now attribute the financial crisis to financial innovation, including new financial products and risk management techniques (Hull, 2008). Although global financial markets have benefited substantially from the productivity of financial innovations, the misuse and abuse of such innovations can cause regulatory vacuums, as authorities are usually slow to respond with new and appropriate regulatory measures. In fact, such regulatory arbitrage is often the main motivation behind innovations, including securitization (Longstaff, 2008). Securitization allowed mortgage loans to be traded in financial markets, and its complexity has made it difficult to detect the incidence of losses. About 55% of total mortgage loans, amounting to about US$6.3 trillion, was securitized as of Park (2008) claimed that the root cause the current international financial crisis is the abuse of various financial techniques in an environment of excessive greed and recklessness. Figure 4 shows how a mortgage loan can be securitized. In the first securitization stage, mortgage loans are converted into MBS and securitized to CDOs, which are then expanded into CDO squared in the third stage, the size of losses of which are uncertain. These complicated securitization processes allowed subprime mortgage delinquency to spread to all financial industries around the world. Because these derivatives were sold globally, these problems arose not only in the US but also in other countries. In August 2007, BNP Paribas SA, France's biggest bank, halted withdrawals from three investment funds because it could not fairly value their holdings after US subprime mortgage losses agitated credit markets. Thus, criticism regarding the lack of government monitoring and regulation is difficult to April 2009 SERI Quarterly 17

7 Global Financial Crisis Overview Figure 4 The Securitization Process and its Losses Individual Mortgage 1st Securitization 2nd Securitization 3rd Securitization RMBS CDO AAA AA Low Risk Senior Tranche (80%) Issuance US$354 bil. Losses 0(0%) A Mortgage Pool BBB BB B Unrated Medium Risk High Risk Mezzanine Tranche (10%) Equity Tranche (10%) Issuance US$75 bil. Losses 350 (46.7%) Issuance US$21 bil. Losses 170 (81%) CDO 2 (CDO-Squared) Tracking accurate losses unavailable yet Note: Yu, Jung-Suk (2008). US Subprime Mortgage Problems and Their Ever-Enlarging Impacts on the Global Financial Market KET 13 (5), Samsung Economic Research Institute. avoid (Restoy, 2008). The US regulatory structure is complicated the Fed and Office of the Comptroller of the Currency(OCC) for commercial banks, Securities and Exchange Commission(SEC) for investment banks, and Commodity Futures Trading Commission (CFTC) for derivative markets. This complicated nature caused the financial regulatory system to be inefficient in catching up with various abusive practices. Due to their slow learning curve, regulators were slow to recognize the real cause of the crisis. Consequently, ineffective prudential regulation failed to control the excessive risk-taking by investment banks, and allowed the latter to create various distortions. Finally, credit rating companies such as Moody s, S&P, and Fitch should also share the blame, as they downgraded troubled assets and companies long after the subprime crisis arose, and should have acted well in advance before the crisis took hold. Ineffective prudential regulation failed to control the excessive risktaking by investment banks, and allowed the latter to create various distortions. 18

8 Impact on Emerging Countries Including East Asia Although the crisis began in the financial sector in the US, the global financial crisis and the subsequent credit crunch have affected emerging countries more severely than developed ones (Reinhart and Rogoff, 2008). Several emerging countries have been hit by the rapid withdrawal of foreign capital and are struggling to fund current account deficits. When foreign currency financing dried up in these counties, domestic banks stumbled and currencies came under pressure. East European countries were particularly vulnerable because their economies are highly dependent on financing from West European countries, whose banks have also suffered from liquidity problems and continuation of losses. East Asian economies, especially those of Korea, China, and Japan 1, seem to have a relatively brighter outlook than others because they have large foreign reserves (Lee and Park, 2008). However, East Asian countries have not been able to avoid the global recession: Korea s GDP declined by 5.6% in the fourth quarter of 2008 from the previous quarter, and Japan s GDP fell by 3.2%. China s GDP growth slowed significantly to 6.8% from the previous year. Because all East Asian countries have exportdependent economic structures, their recent trade figures have been getting much worse. Foreign demand for major goods such as IT products and automobiles produced by East Asian countries has continued to fall. Korea s exports fell a record 33.8% in January and 18.3% Figure 5 CDS Premiums in East Asian Countries Basis Point (KOREA) 800 KOREA Basis Point (CHINA & JAPAN) CHINA JAPAN Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 Note: The premium on the country's five-year credit default swap Source: Datastream 1 Of course, Japan is not an emerging country but has similar structure with Korea and China. April 2009 SERI Quarterly 19

9 Global Financial Crisis Overview in February of 2009 year-on-year. Japan s exports declined 45.7% and posted its first currentaccount deficit (172.8 billion yen) in 13 years in January. China s exports plummeted by a record 25.7% and its trade surplus declined sharply to US$ 4.8 billion in February. Regarding currency values, the Korean won went in a different direction from the Japanese yen and Chinese yuan against other major currencies until the end of While the won depreciated against the dollar by 34.0%, the yen and yuan appreciated by 18.8% and by 6.9% in 2008, respectively, due to the increased likelihood of the yen and yuan being regarded as safe-haven currencies in Asia. However, risk facing all East Asian countries increased sharply in The premium on Korean five-year credit default swap (CDS) 2 stood at 4.22 percentage points as of March 12, Other East Asian countries' CDS premiums have also been soaring recently, indicating that the default risk is also on the rise. Japan s premium, which was around 0.44 percentage point at the end of 2008, rose to 1.15 percentage points in March 2009 while China s premium has gone up to 2.24 percentage points. Reflecting increasing risk arising from shrinking export volumes and consumption, the currency values in East Asian countries fell against the dollar. As Korea was exposed to overblown rumors about a second currency crisis triggered by foreigners withdrawing foreign capital from Korea in September 2008 and March 2009, the won soared to 1,570 against the dollar in March 2009 from 1,260 in the end of Even the yen depreciated from 88 in January 2009 to close to 100 against the dollar in March 2009, while the yuan also depreciated slightly. However, the silver lining for East Asian countries is that their manufacturing sectors remain highly competitive. Consequently, as external volatility subsides in the second half of 2009, economic conditions will stabilize and they will be ready to rebound faster than other nations. World and East Asia s Economy in 2009 The financial crisis is expected to become less intense in Central banks around the world will maintain low interest rates and unorthodox monetary policies will be pursued to provide liquidity for stabilizing financial markets, while governments around the world will implement bailouts and economic stimulus plans to boost their economies. As such efforts begin to take effect from the second quarter of 2009, the global financial crisis is likely to begin subsiding. However, as the financial crisis has already Table 1 Real Economic Growth Rate Forecast of East Asian Countries (%, YoY) Q1 Q2 Q3 Q4 Annual First Half Second Half Annual KOREA CHINA JAPAN Note : The numbers are based on February 2009 forecasts. Source: Samsung Economic Research Institute 2 In the CDS, the buyer that wants to evade risk pays a premium to the seller, in exchange for the right to payout in the case of a default. Hence, the premium goes up if the likelihood of a bond default increases. 20

10 spread to the real economy, the global economy is expected to show an overall contraction in Samsung Economic Research Institute (SERI) predicts that world economic growth rate would be minus 0.3% in SERI also forecasts that Korea s economy contracts by 2.4% and Japan s real GDP by 2.7% in China s real growth rate is also predicted to slow down to 8.1% in SERI s prediction for China s real growth rate is higher than that of other forecasting institutions because we expect that the Chinese government s enormous stimulus packages will take effect relatively quickly within The economic growth trend of East Asian countries will be in better shape in the second quarter of The aggressive efforts of East Asian countries to boost their economies will readily help this region s economic recovery. In addition, intergovernmental policy collaboration is being strengthened to prevent the spread of financial turmoil and to ease the severity of the economic downturn. East Asia should try to lead the new global financial order so as to prevent the reoccurrence of global financial crises in the future especially as Asia did not engage in the practices that became the causes of the current crisis. This is a good opportunity to strengthen collaboration between the three East Asian countries, and if cooperative work between East Asian countries progresses during the current financial crisis, it is likely that East Asian countries will become more powerful players on the global economic and financial stage. References Hull, John C. (2008). The Credit Crunch of 2007: What Went Wrong? Why? What Lessons Can Be Learned? Working Paper. Joseph L. Rotman School of Management, University of Toronto. Kwon, Soon-Woo (2008). Ever Rising Global Financial Instability and Its Impact on the Global and Korean Economy. KET 13 (14). Samsung Economic Research Institute. Lee, Jong-Hwa and Park, Cyn-Young (2008). Global Financial Turmoil: Impact and Challeges for Asia s Financial Systems. Working Paper Series on Regional Economic Integration No. 18. Asian Development Bank (ADB). Longstaff, Francis (2008). The Subprime Credit Crisis and Contagion in Financial Markets. Working Paper. Anderson School of Management, UCLA. Park, Yoon Shik (2008). Global Financial Innovations and the Subprime Mortgage Crisis. Working Paper. International Finance School of Business, George Washington University. Reinhart, Carmen M. and Rogoff, Kenneth S. (2008). Is The 2007 U.S. Sub-Prime Financial Crisis So Different? An International Historical Comparison. NBER Working Paper Series National Bureau of Economic Research. Restoy, Fernando (2008). The Sub-prime Crisis: Some Lessons for Financial Supervisors. Monografia No. 31. Comision Nacional Del Mercado De Valores (CNMV). Yu, Jung-Suk (2008). US Subprime Mortgage Problems and Their Ever-Enlarging Impacts on the Global Financial Market. KET 13 (5). Samsung Economic Research Institute. KIM Kyeong-Won is a vice president of CJ Corporation. Before joining CJ, he headed the Department of Global Studies at SERI and the research center at Samsung Securities. He received his PhD in Finance from Columbia University. Contact: alexkkim@cj.net KIM Hwa-Nyeon is a research fellow at SERI. His research focuses on the US economy and the global commodity market. He is a member in the Korean government s advisory committee on the global grain market and received his Ph.D from Texas A&M University. Contact: hnkim@seri.org April 2009 SERI Quarterly 21