Securitisation, Boom and Collapse of Shadow Banking - Essay Example

?a) The financial crisis of 2007 was it simply the result of lax regulation, or were a range of factors at play? (50 marks). Lack of strict regulation was the core of 2007-2010 financial crises. However, there are a host of other factors that equally played a key role in the crises, though all the factors are somewhat intertwined and result in one issue to hold responsible – lax regulation. To explain the origin of these crises, I will start by explaining different phases of ‘The Great Bubble Transfer’, which led to speculative bubble in the home mortgage market. Under each of these phases, it will be explained how lax of regulation and other factors led to this crises. The first phase, as explained below, is Novel Offering. Finally, I will discuss the link between the crises and the factors such as Crises of Financialisation and contradiction. The crises will also be explained from an economic theory pint of view (Peretz and Schroedel 2009). Novel Offerings Novel offerings are sources of revenue used by banks and other financial institutions by trading in different financial products. For the last few decades, the context of deregulation has greatly contributed towards development of these financial products. For example, since 1970s, different regulations controlling the actions of financial institutions in the UK and USA have been loosening up. This includes Glass Steagall, which had been instituted to disjoin the people’s savings from the riskier operations of investment banks. The banks resulted in creation of shadow baking system, which allowed them to circumvent the rule that required them to balance the risk on their books with some level of capital. Securitisation, Boom and collapse of shadow banking The shadow banking system is believed to have traded the worst performing and the riskiest mortgages. These systems put extensive pressure upon the traditional institutions hence forcing them to soften their underwriting standards and start dealing with riskier loans. These banks were later criticised for underpinning the financial system, though they were not accountable to the same regulatory controls. What’s more, these banks were susceptible because of maturity mismatch, implying that they borrowed short-term loans from liquid markets and bought illiquid, long-term, but risky assets. The uncontrolled practices of such banks are the core of the 2007 financial crises – the situation could have been better if regulation was imposed on all activities related with banking. In the spring of 2007, the securitization markets were helped by shadow banking systems, leading to a more or less shut-down in the fall of 2008. What ensued was disappearance from market of more than a third of the private credit market (Thompson 2005). Figure 1 shows how securitization market came near shut-down during the crises. Figure 1: Decline of securitization market Securitisation is the process by which a certain assets’ cash-flows are separated from the balance sheet of the primary entity and transformed into marketable securities (Thompson 1995). The purpose of securitisation is to convert illiquid assets into marketable securities. It is used by insures as a form of risk management, which is achieved through transferring, commoditising and reallocating of different types of risks such as interest rate risk, credit risk, and pricing risk. Securitisation of the US subprime mortgage, according to Ingham (2008), fuelled the global crises during the summer of 2007 by increasing the extent of lending to subprime borrowers, which was happening at a very high default rate. Between 2004 and 2006, the market for subprime loans expanded significantly as shown in figure 2. As a result, the European and the US banks were writing off a massive amount of financial assets as the securitised mortgages became illiquid. The public money was used by many governments to bail out the financial institutions that were entangled into crises. Although it is usually a regulatory requirement to undertake credit rating on securitised assets, credit rating agencies contributed towards the subprime saga by offering undeservingly higher ratings on debt parcels (Brummer 2005). Figure 2: US Subprime lending expansion between 2004 and 2006. Credit expansion Following novel offering was a massive expansion of credit. These are key indicators of banking and currency crises in upcoming markets. Both firm and household credit have played some role in financial crises. When the amount of credit that the private sector can obtain from bank is significantly increased, the banks tend to experience crises (Demirguc-Kunt and Enrica 2002). Nationally, credit expansions are stimulated by highly optimistic future expectations in reference to asset prices and income, and sometimes by capital inflows and liberalizations. All these factors played some role, in different degrees, during run-up of 2007 credit crises. What followed this credit expansion is that firms and households accumulated significant amounts of debts, though income did not increase in an equal measure. An increase in non-performing loans and defaults culminated from the decline in asset prices or income, fueling the global financial crises. As shown in figure 2, subprime mortgage grew from $173 billion in 2001 to a sky-rocketing high of $665 billion in 2005 – this was a record 300% increase, in just four years (Lucas and Souleles 2008). Figure 2: the growth of subprime mortgage between 1994 and 2006. Speculative Mania The 2007 financial crises, is also attributable to a boom in the housing-market, which occurred in the US. This situation is similar to a historian bubble, which was referred to as ‘Tulip mania’ – it was a period in the history of Dutch when the prices for tulip bulbs increased fundamentally and then declined all of a sudden (Mackay 1841). In both UK and US, there is a market of mortgage called Sub-prime, which is given to poor customers with poor credit ratings. Just before the 2007 financial crises, many financial institutions had allocated a large amount of such loans to their customers. The probability of defaulting on such loans was obviously very high. An obsession for home ownership developed as a result of the rising house prices – this led to a housing bubble. At the same time, speculations of instruments such as CDOs significantly developed in the financial sector. A lot of money was being circulated in the market due to the speculation of making profits from CDO among other instruments. Figure 3 below shows the worsening status of mortgage in the UK from 2001 to 2007 (Mackay 1841). Figure 3: mortgage in the UK from 2001 to 2007. Distress Following the dramatic rise in US interest rates, the prices of houses particularly in strongholds of CDSs knocked down. This was meant to safeguard the investors. An external event struck the financial market, marking a sudden change on the direction of the economy. The housing bubble was first triggered in 2006 following surging interest rates that reverted the direction of housing prices in the subprime strongholds. The borrowers that took advantage of significant increases in home prices and extremely low interest rates to sell or refinance homes were abruptly met with crumbling housing prices and looming upsurge of mortgage payments. Following these happenings, the investors started to get concerned that the settling down of the housing market in some places would extend to the entire mortgage market and perhaps infect the entire economy. As a sign of such distress, CDSs meant to speculate on credit quality and to shield the investors increased worldwide by 49%, within the first half of 2007. Crash and Panic Crash and panic is the final phase that occurs during a financial bubble. It is characterized by swift selling of assets, hence flooding the economy with cash once again. The initial crash followed the explosion of mortgage-backed securities of Bear Steams hedge funds that occurred in July 2007. One of the securities lost 90% of its value while the other one dissipated entirely. A couple of banks in Asia, United States and Europe were compelled to accept their exposure to toxic subprime mortgage when it became clear that these risk management funds could not make out the definite value of their holdings. As panic intensified among financial institutions, as stern credit crunch resulted – each institutions was uncertain of the extent of financial toxic waste the other was embracing (Financial Crisis Inquiry Commission 2011). The spread of credit crunch into the commercial paper market brought to an end the key source of finance for structured investment vehicle (SIVs) that were sponsored by banks. This exposed some of the big banks to hefty risk, resulting from credit default swaps. One of the most memorable events that occurred is the failure and successive nationalization and assistance the Northern Rock – a British mortgage lender. Consequently, the US bond insurers started to experience the pressure – their problems particularly originated from their underwriting of credit-default swaps on mortgage-backed securities. Since even the international investors were strongly participating in speculation on US mortgage-backed securities, the financial panic swiftly infected the whole world. Actually, there was fear that the global economic growth would drop to less than 2.5 percent, hence paving a way for a global recession. Much of the fear that was going around the world was surrounded by a complex and obscure scenario that it was not very clear where the financial toxic was really originating - this occasioned a mad rush into U.S. Treasury bills and a radical fall in lending. SIV structured investment vehicle A structured investment vehicle (SIV) was an operating finance company, which operated like a traditional bank by generating a spread between its liabilities and assets. It achieved this by borrowing money by issuing of short-term securities at low interest rates and invests that money in long-term securities that generate high interest rates. The investors earn the differences between the interest rates. Given that SIVs depend on short-term commercial paper to finance long-term assets, their refinancing operates just like the ordinary banks. They, however, do not have liquidity facilities to cover 100 percent of their outstanding commercial paper. In August 2007, commercial paper yield spreads extended to as high as 100 basic points, and a few days later the market was totally illiquid. This was an indication that commercial papers investors had become so risk-averse. Crises of Financialisation and contradiction The theories that support financialisation put forward that society, economy and individuals are progressively more controlled by the financial sector. For individuals, this is concerned with their daily consumption and expenditures, including getting more loans for mortgage; while in regards to economics it is more about concentration of industrial production into smaller entities followed by a robust growth in financial sector. If the events that took place during the crises can be analyzed from a long-term historical perspective, then they can be preserved as indicative of general crises of financialization, which is a precursor for economic stagnation. By analyzing the primary issues that are concerned with class production, it can be easier to understand the significance of the foregoing events of capital accumulation (Froud et al. 2008). The US was highly castigated for its horrible bubble of cheap credit, which infected several segments of the economy. As a result, the debt of financial corporate was skyrocketing while household debts increased to 133 percent of disposable personal income, as illustrated in figure. The debt of the non-financial corporations and the government was also rising drastically. This huge outburst in debt in comparison with the underlying economy reached a peak in 2005, hence lifting the economy and fueling economic instability. This experience is explained in figure 4, revealing the dramatic increase of private debt in comparison with national income for the past couple of decades (Froud et al. 2008). Figure 4: Private debt as percentage of GDP Figure 5: US household debt versus disposable income (DI) and GDP By the summer of 2008, many analysts were compelled to accept that huge devaluation of the system could have become inevitable considering the pressure of the events. Henceforth, Jim Reid, the head of credit research from Deutshe Bank issued an analysis called ““A Trillion-Dollar Mean Reversion?,” – this was to examine the kind of relationship between GDP and financial profits as shown in Figure 6. In his analysis, he maintained that the US profits had departed from the average over a decade. In this sense, the theory that states that the returns in financial markets returns to a long-run average forecast would imply that $1.2 trillion of profits needed to be withdrawn before U.S. financial sector can recover from the mess that had been experienced for a decade. Figure 6. Growth of financial and nonfinancial profits compared with GDP (1970 = 100) Sources: Calculated from Table B–91—Corporate profits by industry, 1959–2007. Economic theory and the financial crisis Ideally, people used different instruments to speculate including money, pension funds, CDSs, CDOs, and many others. All these instruments were extremely risky from the very beginning, especially because they encouraged people to borrow money they could not afford to pay back. To counteract this effect, the spreads were used to reduce risk, which also resulted in “long chains of risk passing so that no one knew who was ultimately holding the risk” (Erturk et al. 2005). However, when confidence abated, people could not tell who was holding risky subprime assets - credit crunch resulted when the financial institutions hesitated from lending to each other. In effect, the financial system stopped working, exposing financial institutions into enormous difficulties – they could only depend on loan swapping merry go rounds, most of which effectively disintegrated. What followed was a replication of a similar situation across the economy. For example, General Motors was entangled into this bizarre when it came to depend on banks that, out of the blue, were reluctant on lending. Prior to Global Financial Crises (GFC) years, the economic theorists have used ‘efficient markets theory’ to give good reasons for deregulations of the financial sector. This theory supports that the pricing of assets is always correct and that the markets will always move towards the equilibrium (Cooper 2010). This position was evidently proved wrong following the collapse of the market for mortgage. Instead, the ‘Financial Instability Thesis’ is more compelling in such a situation. This theory postulates that markets can run from human behaviors or like a Ponzi scheme. In such a system, the investors increase at a higher rate as possible because they are motivated by the past payouts, rather than acknowledging that these payouts can only be sustainable if people continue to increase in the future. Financial instability theory also supports that prices movements are not arbitrary, but influenced by both human opinions and the past behaviors. The risk models that the designers of CDSs and CDOs, who purported that they were not abnormally risky, could only work with the exclusion of consideration of possible financial crises. In other words, these designers disregarded the history of financial crises, which is a very common scenario. Conclusion As discussed, the factors that contributed to 2007 financial crises are numerous and somewhat structurally interrelated. Some theorists mostly influenced by the work of Marx argue that financialisation and the consequent financial crisis is a product of the inconsistency of capitalism as a system (Bellamy and Magdoff 2009). However, it would be reasonable to argue that the core of the crises was lax regulation because all that happened could have been avoided if the activities of banks and other related institutions were properly regulated. b) In light of your discussion in part a), answer the following question: Could Lehman Brothers collapse have been avoided if it had followed a different business model? The principal cause of Lehman’s collapse was the subprime crisis and the macroeconomic control policies that affected the company during that time. When the government invokes macroeconomic policy to decrease the inflation in the economy through increase in the interest rate, the potential borrowers of bank loans find it extremely hard to afford such loans. This, therefore, means that the default on housing loans is very high while the value of derivative products that are associated with housing loans starts to crumble down. As such, the institutions such as Lehman, which invested heavily on derivative products of the housing loans, had to undergo a very difficult experience due to financial crises (Sender 2010; Jeffrey 2008). The board of Lehman continued to deal with subprime, particularly Alt-A/Alt – B mortgage loans, hence carrying on with its countercyclical model, which worsened its residential mortgage losses. The model adopted by Lehman was not distinctive – other banks that operated during that time maintained some balance between high-risk, high leverage model that was kept going by the confidence of the counterparties. Lehman’s asset stood at about $700 billion, while the liabilities were about $25. However, the assets were mainly long-term, while the liabilities were predominantly short-term. Lehman unfortunately funded its operations through the repo short-term markets, which means that the companies borrowed a colossal amount of capital form those markets. What Lehman missed in its strategies is to realize that confidence was essential. That is why Lehman was unable to fund itself when repo counterparties lost confidence and refused to lend their money. From the corporate perspective, Lehman made a number of mistakes that could have been avoided by adopting an alternative business model. In 2006, Lehman made decided to undertake an aggressive growth strategy, which would see it take on hefty risk, by substantially increasing leverage on its capital. Unfortunately, in 2007, the sub-prime residential mortgage business developed from problem to crises. Most importantly, the high leverage coefficient could have made it difficult for the corporate competency to disallow the risk. By August 31st, 2008, Lehman’s leverage coefficient had reached as high as 30, which exposed the company to the brinks of bankruptcy. As a matter of fact, it is prudent for a company to borrow money during the good times, and invest in assets that are booming – this way a company can boost its returns. What’s more, this enables the company to leverage its returns, which is really advantageous when the interest rates are low. However, Lehman should have put into consideration the fact that leverage cuts both ways, since it also leverages an entity’s losses when the prices of the assets decline. As a rational bank, Lehman should have maintained a leverage of about 12 times, which means that for every ?1 of ready capital and cash, ?12 can be loaned. Unfortunately, by 2004, Lehman had a leverage of as high as 20. Again by 2007, this figure had risen to an incredibly high of 44. This means that Lehman was leveraged 44 times by the time the prices of assets started to crumble down. It is also worth noting that the U.S. interest rates had plunged after 11 September 2001 terrorist attack, a factor that occasioned a boom in the commercial and domestic property prices for the subsequent five years, lasting up to 2006. Henceforth, the prices of houses declined year after another. Lehman made a grave mistake by heavily investing in the US real-estate market, considering its volatile state. In fact, Lehman was the largest underwriter of property loans by 2007, a situation that was extremely risky. By the end of 2007, Lehman had over $60 billion in housing property, a big proportion of which was invested in subprime mortgages - these are the loans that were extended to risky homebuyers (Jan 2008). To make the matter worse, the company had massively invested in credit default swaps (CDS) and collateralized debt obligations (CDO), both of which were highly entangled in the 2007 financial crises. Collateralised Debt Obligation is a type of investment, which originates from a portfolio of fixed-income investments such as corporate bonds, mortgages, or municipal bonds among many others. During the run-up to financial crises, Lehman Brothers borrowed a lot of money to invest in CDOs. All together, the investors that were getting used to CDOs began to accept lower quality assets, which were being stimulated by the housing boom, given that the economy was doing well and there was a lot of money. However, when the prices of housing went down, the economy started to cripple down, and people could no longer afford to meet their expenses. When the credit crunch started, Lehman experienced difficulties and was forced to sell its poorly performing CDOs at very low prices (Tony 2007). Banks are required to maintain a particular ratio of equity to the amount of loans they lend, which resulted in massive write-offs that reduced the amount of money for lending. As a result, a negative feedback loop started to build up, and eventually other banks refused to lend money to Lehman. This explains why this line of investment was extremely misinformed – it made the situation very bad for Lehman and it would have been better if a less aggressive business model had been adopted (Crowley 2009). Lehman also made a mistake through its heavy investment in Credit default swaps (CDS). CDS are financial derivatives aimed at facilitating risk-sharing among investors. During the run-up to 2007 crises, the investors and the financial institutions increased their demand on CDS, hence leading to the expansion of the market. In addition, the CDS contracts evolved and become more complicated. As expected, CDS should play the role of transferring the risk, but the unthinkable happened during this crisis because the contracts exposed Lehman into an unexpected risk. This is particularly because the contracts were used to speculate the performance of particular secularities, and not for hedging investment alone. As the sales and repossessions sky-rocked and property prices plummeted, Lehman was squarely entangled in the trouble. This was evident in its ? results, which reported a 2.5 billion loss as a result of its real estate exposure. In 2008, its total losses amounted to $6.5 billion, not accounting for more toxic waste that was yet to be brought to light. This, certainly, is a trouble that could have been escaped by avoiding over exposure into the risky real estate business. Figure 7 shows how Lehman kept increasing its leverage till 2007, when it reached the peak before its fall down (Gerardi 2008). Figure 7: Lehman Brothers’ increase in leverage. The other problem to blame for the collapse of Lehman was the diversified operations and investment strategies, which the company used in order to increase its profits. These include different fields that the company entered into such as housing investment, capital management, insurance, and commercial banks. Essentially, it is understandable that Lehman could have used diversified operations and investment model to reduce the financial and operational risk. However, the fields that Lehman specialized in were closely linked the housing market – this was as a result of the specialization in housing products. Lehman’s management deliberated on going beyond its risk limits in terms of its principal investments such as the concentration limits on its leverage loan and commercial real estate engagement. These limits were aimed at ensuring that the company’s investment were suitably limited and diversified by counterparty and business line. However, Lehman adopted a highly concentrated risks in the its two business lines, coupled with the market conditions - which eventually led to surpassing of risk limits by 70% margins in relation to commercial real estate and by 100% in relation to leverage loans. Lehman Brother’s failed miserably for practicing ineffective risk management, which also had its fare share in the factors that led to its collapse. Crowley (2009) suggests that financial products are unsafe if the control of corporate risk management is not followed. Crowley also adds that the kind of ineffective risk management that was practiced by Lehman may have originated from the diversified operation model, the dependent risk management entities and the ineffective measuring instruments concerning risk management. Furthermore, Lehman adopted tools that could not measure the liquidity risk and trust risk. In any case, the tool would have encouraged the management to invest in the housing products albeit the high risk. Therefore, had the management used an effective risk management model, Lehman could have been rescued from collapse (Ricardo and Krishnamurthy 2008). At some point, when the U.S. government was weighing options of bailing out Lehman, its failure was technically inevitable as the damage had already permeated so deep into its operations. Had the company adopted a better model to mitigate its problems, it could have been possible to rescue it from collapse, but unfortunately the efforts that were made during the run up to its collapse were a little bit too late. A financial analysis on Lehman conducted by Maux and Morin (2011) for the years 2005 to 2007 attempted to find out if the collapse of Lehman could have been foreseen and perhaps averted. This study applied Altman (1968) financial distress prediction model and found that Lehman’s coefficient was below the verge of 1.81, implying that the company was headed for collapse. One of the biggest problems that Lehman experienced was incessant lack of the ability to raise cash from the operating activities following its constant weakening of cash position. Then the other problem was the company’s tendencies to continuously over rely on external debt and massive systematic investments in financial instruments and working capital items. These are the most critical areas of its business model that Lehman could have rectified to avoid its fall down. Furthermore, the failure by Lehman to retain confidence of its numerous counterparties and lenders coupled with the fact that it did not have adequate liquidity to meet its short-term obligations was not good for the company either. The series of business decisions that Lehman made, exposed it to the risk of holding too much illiquid assets with weakening values, such as commercial and residential real estate – this also weakened the level of confidence of its lenders. This level of risk is illustrated in figure 8. With these facts, it is clear that Lehman’s problems could have been predicted and perhaps an alternative model adopted to prevent the company from collapsing. Figure 8: Lehman’s exposure risk Lehman, like many other businesses failed not because it was not making profits, but because it experienced serious cash-flow problems. Lehman was operating at extremely small amount of cash, albeit having a massive asset base as well as liabilities. Its total assets relative to shareholders equity is as illustrated in figure 9, which evidently shows an excessive holding of assets at the expense of shareholders equity. This, in other words, means that Lehman did not have sufficient liquidity as its cash and other assets that are easily converted into cash were inadequate. Lehman’s trembling finances started to agonize other banks when the markets came crumbling down, hence they were forced to protect their own interests at the expense of Lehman. By then, Lehman was drastically losing liquidity, a very dangerous scenario for a bank. Figure 9: Lehman’s Total Assets versus shareholders equity: 1999 – 2007. The famous subprime crises left Lehman entangled in myriads of problems. This was because its new business model exacerbated its business risk since its venture into long-term assets such as private equity, commercial real estate, and leverage loans had an extremely unpredictable future and were more illiquid than the traditional investment (Dutta, Caplan and Lawson, 2010). Therefore, it would have been better if Lehman had halted from its aggressive strategy to avoid being entangled into crises of such a magnitude (Briskler 2008). Furthermore, it would have been a better situation if Lehman exercised strict compliance to safe accounting practices. Lehman collapsed due to its obscene leverage ratios, inadequate liquidities buffers, and inadequate capital bases. In addition, if the company had used stronger accounting standards, then the managers could have found it hard to manipulate their activities for their unwarranted self-interests (Duchin and Soysura 2012). Therefore, Lehman should have monitored its accounting standards to hinder the wicked practices that contributed to damages in the company’s investment. A shown in figure 10, Lehman’s leverage ratios increased drastically between 2005 and 2007, following the aggressive strategy of borrowing massive funds to invest in the commercial and domestic real estate market (Hatzius 2008). Figure 10: Leverage ratios for major investment banks, including Lehman The factors that led to the collapse of Lehman have many lessons to be learned. It points out the importance of establishing effective and efficient departments of risk management to leverage the company from succumbing to risks of different kinds. In any case, Lehman ought to have put into consideration the risk factors when important decisions were being made or when operation and investment strategies were being implemented. What’s more, the collapse of Lehman shows that the corporate managers had made a grave mistake by assuming that long-term benefits can be foregone in order to gain short-term profits (Hatzius 2008). Like the old adage goes, “do not put all of your eggs in the same basket”, Lehman committed a big mistake by investing so highly in housing market, just because it was booming, and failed to consider what would happen if things turned out as unexpected. Noticing the booming housing market, Lehman borrowed terribly and invested all the profits in the risky mortgage market. Following the process of securitization as discussed earlier, the mortgage houses that Lehman had acquired granted the NINJA or subprime loans. Lehman, following its reckless and greed, became a leader in the subprime-mortgage-backed securities (Karl 2008). Also, learning from the lessons of what happened, it would be reasonable to argue that Lehman could have shunned from venturing into business opportunities with very high risks. In regards to this, Dutta et al. (2010) maintained that Lehman made a lot of mistakes by venturing into a higher-growth business model, which was characterized by shifting from a low-risk brokerage model to a capital demanding banking model and purchasing of high levels of assets. Dutta et al. (2010) added that the difference between long-term, illiquid investment and short-term debt required Lehman to endless turn over its debt, hence exposing it to high business risk. In that effect, Lehman borrowed huge amount of funds every day. Considering the fact that market confidence and the ability to service debt could have been extremely important for Lehman to access funds that matches this level, maintenance of good credit ratings was so essential for the company (Carl 2009). 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