The Recent Credit Crunch from an International Finance Perspective - Essay Example

?Topic: Discuss and analyse the recent credit crunch within an international finance perspective: include the events leading up to the crisis, economic and financial consequences, government responses and lessons to be learnt. The sub-prime mortgage sector in America can be seen as one of the leading causes of the financial crisis that spread globally in the last decade, through the practice of collecting large numbers of mortgage contracts into derivative bonds that were sold internationally across the financial sector to banks, pension funds, sovereign wealth funds, and other groups as secure investment opportunities. (Krishnamurthy, 2008) Analysts recognize a weakness of lending standards particularly in the sub-prime mortgage market that led to a wider level of default than previously anticipated by risk management and securities ratings groups. (Roubini, 2008) Along with this came an increase in property values in both residential and commercial real estate that can be described retrospectively as a “bubble”. When this real estate bubble popped, and property prices plunged, many mortgage owners found themselves “underwater,” essentially owing more to the bank for the mortgage than the resale value of the property was worth. This increased the incentive to default on loans, perpetuating or worsening the cycle of losses in the banking sector. Yet, there were critical legislative changes related to the financial operation of investment banks that can be seen as a more fundamental root of the financial meltdown that occurred in 2008-9 with the passage of emergency Wall St. bailout bills in Congress. The repeal of the Glass-Steagall regulations that separated the speculative functions of stock, bond, and derivative trading from traditional banking led to the operation of large Wall Street investment banks such as Goldman Sachs, J.P. Morgan, and the Lehman Brothers as hedge funds. (Barth et al, 2000) This would technically not be a problem except for the fact that these entities received preferential treatment from the Federal Reserve in billions of dollars as well as a TBTF backstop of trading activities from the government, as evidenced by the bailout, TARP, etc. (Kaufman, 2008) The highly leveraged investment activities of the Lehman Brothers and other groups such as Bear Stearns was also being undertaken by large, TBTF banks such as the Bank of America, CITI, and even insurance firms such as AIG. (Karnitshnig et al, 2008) The catalyst for the meltdown as mentioned was primarily the bonds related to sub-prime mortgages that lost value, causing liquidity problems and margin calls for institutions that forced collective selling and a further lowering of prices. Since these companies were also market makers, a major prequel to the financial meltdown was what is colloquially known as the “quant wipeout” of 2007, where numerous computer trading programs managed by large hedge funds and other investment banks imploded as their trading strategies spiraled into deep losses. (The Curious Capitalist, 2007) As margin calls hit more and more financial institutions operating with leveraged investments, forced selling was cast into an environment where the market makers themselves were increasingly unable to be support buyers for prices. (Roubini, 2008) From this cycle of margin calls and forced selling into a declining market, the Wall Street icon investment bank the Lehman Brothers was finally forced into bankruptcy, and was not backstopped by the government, allowed to fail. This set off not only a huge round of financial panic, but even more forced selling of assets as the Lehman Brothers controlled an enormous share of the international investment market for corporate securities. The declining market prices spread through contagion from real-estate and sub-prime mortgage securities to nearly every asset class in commodities, equities, bonds, and derivatives. Adding fuel to this fire was the short interest of hedge fund traders such as John Paulson, who bet billions of dollars against the market in shorting sub-prime securities. That he did this often with a form of insurance contract related to credit default had implications across the industry, as symbolized by the government’s need to bail-out AIG in order for it to meet its CDS commitments to Goldman Sachs, who created many of the securities “designed to fail” with Paulson as a client, and were later charged by the SEC for this activity. (Stempel and Eder, 2010) Thus, the portrait of the financial meltdown that defined the closing days of the Bush administration as well as the presidential election which elected Barrack Obama and that has been described as second to only the Great Depression in severity is a complex mix of factors that displays the interconnectedness of modern international finance. That banks are considered “Too Big To Fail” and have their trading activities back-stopped by the U.S. government is something critics have labeled “crony capitalism” or “socialism for the rich”. Following the repeal of the Glass-Steagall regulations, investment banks operated as if one hand knew not what the other was doing, but generated huge profits and losses on leveraged trading plays that ultimately had to be bailed-out by the government at great cost to the taxpayers. The “Bailout Clock” has this total currently listed at over $4.7 trillion dollars of taxpayer money spent on the bailout of these private companies, with as much as $13.7 trillion dollars committed. (SourceWatch, 2011) The Federal Reserve has subsequently pursued policies of quantitative easing to increase the money supply and further assist the investment banks in building profit, leading in some sense to inflation of asset classes such as equities, commodities, and bonds internationally, as well as through the support of their direct purchase of trillions of dollars in securities from private firms. (Bernanke, 2009) As this bailout of Wall Street is undertaken with the same public taxpayer funds that could be used to address global poverty issues, and billions of people live on only a few dollars a day internationally, it begs the question of social justice in the context of public assistance. To summarize, the sub-prime mortgage market in the U.S. led to billions of dollars in mortgage-backed securities being sold as equivalent to bonds as a secure investment with an attractive rate of return by investment banks to pension funds, sovereign wealth groups, hedge funds, REITs, and other investment banks around the world. As evidenced by the SEC case against Goldman Sachs relating to this activity, the investment banks may have prepared the securities with the knowledge that large clients like hedge fund manager John Paulson were going to short them, and in a sense, designed these securities to fail. (Stempel and Eder, 2010) That the investment groups such as pension funds trusted Goldman Sachs in these transactions led to huge losses for their interests, but the hedge fund managers who shorted these securities or purchased insurance contracts for credit defaults made billions in profits and are regarded as being prescient in predicting the market. Yet, the same groups have every interest to continue to discourage investigation to what degree they manufactured the crisis by playing both sides of the market, and the government, to their own interest. The Wall Street investment banks recovered quickly and remain the most profitable of corporations in the world. Nevertheless, many changes in the laws of financial regulation have occurred such as those implemented by the Obama administration and the Basel Accords which strengthens the reserve requirements for speculative activity on the part of investment banks, as well as increasing the division of interest between banking and investment activities. Yet, by most accounts, business continues as usual on Wall Street while the public has trillions of dollars in debt related to the bail-out. What is ironic is that the same investment banks also finance the public debt and earn interest payments off of Treasury notes as a regular part of their business model and as a means to fuel speculation in commodities, equities, and other securities. That other investors who are not back-stopped by the Federal Reserve and government have difficulty competing with these investment banks in a free market is considered a problem of modern capitalism. 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Retrieved from http://www.sourcewatch.org/index.php?title=Total_Wall_Street_Bailout_Cost Shirreff, David (2011), Lessons from the Collapse of Hedge Fund, Long-Term Capital Management, paper, Retrieved from http://www.edge-fund.com/Shir.pdf Stempel, Jonathan and Eder, Steve (2010), Goldman Sachs charged with fraud by SEC, Reuters, Apr 16, 2010. Retrieved from http://www.reuters.com/article/2010/04/16/us-goldman-idUSTRE63F3JX20100416 Read More