Role of securitization and structured finance products in the recent banking and financial crisis - Essay Example

? Role of "securitization" and "structured finance products" in the recent banking and financial crisis affecting developed economies Submit to: Submit by: Table of content Page 1. Introduction 3 2. What caused the crisis? 4 3. Mortgage loan crisis at US lending markets 5 4. CDS – Credit Default Swaps 6 5. Why economic models failed? 8 6. Case Reference – Perspective of HSBC Bank 8 7. Conclusion 9 8. References 11 1. Introduction Financial institutions cater to the needs of different types of customers by providing relevant financial services. Financial institutions worldwide have been affected by the adverse market environment created by the US sub prime fiasco. Trouble began when the financial companies started relying too much on the innovation in the blind faith that it will yield returns. As it is common knowledge that banking industry has suffered the most due to the current meltdown, the symptoms of the malaise started emerging in the US mortgage business first. The cracks appeared in the banking system. Housing prices, according to Financial World (2008) started falling in the year 2005. Initial symptom appeared in the market for sub prime residential mortgage-supported securities as investment demand shrank in 2006. In February 2007, auctions to finalise rates on ARS instruments failed because of decreasing investor demand. Cracks in financial market became wide open in June 2007 with the failure to meet the lenders’ call on Collateralised Debt Obligations (CDOs) by two Bear Stearns hedge funds for subprime loans. Let’s try to comprehend what happened. The recessionary trends as per BBC News (2007) that the banking industry is bearing appeared with the sub prime lending to home borrowers. The mortgage brokers were inspired to sell loans in the sub prime sector as hectic activity was taking place in the economy. The sub prime crisis started from Cleveland where loans in huge amount were cleared without verifying income and documents by the mortgage brokers. Refinancing was permitted with the condition that new sub prime mortgage would start after two years at double the prevailing interest rates. The crisis deepened when the whole of America came in its hold as property prices skyrocketed because of increase in demand for owning property through mortgage brokers and refinancing. After a reset period of two years, interest rates went higher as Fed interest rates also touched a high level, on which sub prime mortgage interests were based. Housing prices started declining sharply after the boom period. A wave of repossessions was behind this trend. Banks started taking precautionary measures, cutting back on credit to cover risks to their investments. Being forced to dry up the whole sale bond market and their balance sheets from the adverse affects, banks started shrinking their portfolio. The Pension Funds suffered the severe losses being the prime purchasers of sub prime mortgage bonds. As the banks have hidden their holdings of sub prime mortgages in off-balance sheet instruments such as “structured investment vehicles” or SIV’s, they were reluctant to bear the losses. 2. What caused the crisis? The US financial system was under observation, as reported for planning its restructuring and strengthening control but still there is no clarity on what regulatory policy change has been enforced even till June 2009. Limits on mixing of the investment with commercial banking within the financial market were put off by getting away with the Glass-Steagall Act. Investment banks were not regulated for levering up their conditions. Financial innovations promoted easy availability of credit. Loan s against mortgages were “securitised” and forwarded by associates of Lehman Brothers and other financial companies. The outcome was unhindered consumer spending and reducing household savings. (Schneider & Kirchgassner, 2009). In the US, internal policies and globalisation was responsible for the financial crisis, which was fuelled by innovative products like complex derivative securities, “conduits” and “structured investment vehicles”, not controlled at all. Commercial banks, investment banks and hedge funds advanced by the changing perspective of the financial market got leverage and their associate parties offered it under the impression of the mathematical models and means to measure and hedge risks thereupon. Depending on the new-born faith in the working of models through scientific ways, associate parties were sure that risks could be taken care of (Schneider & Kirchgassner, 2009) In this context, it is significant to evaluate the role played by the financial innovations such as mortgage-backed securities and other collateralised debt obligations. The institutional investors believing in the working of the mathematical models got approval from regulatory bodies that financial companies should be given freedom in deciding to put on hold the capital to cover risk but the financial crisis was not solely the outcome of these models; there were such factors responsible as depending on faith in the market powers to streamline the economy (Schneider & Kirchgassner, 2009). 3. Mortgage loan crisis at US lending markets. FRS was responsible for creating macroeconomic environment wherein banks were pro-inclined to take risks because of the low-interest rate policy. FRS used this policy for sustained economic growth to fight globalisation effects. The Federal Reserve reduced the base interest rate to 1.25%, which spurred domestic borrowing and mortgage activity. The policy did not realise in high inflation as was planned by the US. The Chinese cheap consumer products were flooded into the US market by China. China’s Central Bank purchased the US government securities to be used as reserves. The policy depended on Chinese consumers’ habit of saving. This policy could not succeed in the long run, as it was meant to serve short term motive. It led to inflation in those countries whose currency was pegged to the US dollar. Commodities such as oil, gas and metals saw the impact of inflation on global scale (Yugina, 2009). The impact of the US policy on global financial organisations was quite destabilising. Playing the role of financial intermediaries, they were bound to bear the price risks of assets whose instruments they purchased. The financial sector has created certain tools to minimise the impact of such risks onto the books for distributing them institutions for selling to investors. This innovative instrument of the financial institutions to cause increase in the cost of assets boomeranged (Yugina, 2009). Banks offered credit to defaulting borrowers to pay the increased cost on housing. Banks were sure to recover their losses in the case of non-payment by insolvent borrowers by selling their houses at increased prices. They had the option of reselling the mortgage risk to debt market investors through securitization instruments. To overspread their risks, banks created another debt instrument insulated by primary debt instruments with different risk levels, CDOs, or collateralised debt obligations. The cost of the new instrument was computed by the banks using a mathematical model. It was left to market forces to determine its price later in the trading process. This instrument not only functioned as a sort of dissemination of the risk but getting shifted to the third party (Yugina, 2009). 4. CDS – Credit Default Swaps Another instrument of shifting risk and risk spread was CDS, or credit default swaps, which is a way of providing cover to loans and other debt instruments against the risk of default (not carrying out credit or debt obligations). Off late, this instrument had been widely employed to boost CDOs. The nominal quantity of taking such obligations, according to some sources, is a product of the US GDP; they can be submitted for payment if all the mortgage borrowers are unable to pay their loans. The major outcome of the usage of these instruments was to disseminate risks in resale their merger, and loss of risk management ability of the banks in the traditional context of risk control systems. A number of instrument holders belonging to ungoverned market had no idea about the type of risks they had agreed to take (Yugina, 2009). With the raising of interest rates by the FRS, late payments on sub-prime mortgage loans and floating rate mortgage loans happened. Premium on houses started reducing, which caused loss of mortgage loan security. Liquidity of CDO was affected with the instruments “hanging” as deficit to banks. As per the regulations, these assets were supposed to be evaluated on prevailing market price, which was no more a possibility compelling banks to write them off by deciding their value by their own. The biggest banks had the alternative to either recreate capital or file their requests (Yugina, 2009). Because of the bankruptcies of underwriters mired in the insurance of credit and debt instruments, the financial crisis has entrenched deeply in the developed countries’ economies. The US banking suffered a huge set back because of not regulating financial derivatives market and also because of its lenient policy on hedge funds. Besides, the banking authorities put aside risky off-balance-sheet obligations; there was no management on limiting the short-term liabilities, not visible on the banks records by creating special-purpose companies to securitize their participating CDO writings. This SIV (structured investment vehicle) process was dynamically employed by some banks for short-term securitization of CDO packages (Yugina, 2009). 5. Why economic models failed? Mostly, economic models used are of representative-agent type. In financial markets, this agent was permitted to control risks, putting limitations on the agent’s profit earning potential and over foretelling future happenings. Theoretically, risk management models serve only the academic purpose of showing huge increase in business transactions and growth in “exotic” financial instruments. Such models are not based on historical data, as such researchers depend on simulations, making comparatively whimsical assumptions on correlations between taking chances on probabilities. Such theories can not be examined empirically (Schneider & Kirchgassner, 2009). 6. Case Reference – Perspective of HSBC Bank Causes of crisis, according to the HSBC Holdings plc (2008) were complex and inter-related. A number of reasons include global financial imbalance that was created by speeding transfer of global economy towards emerging markets. It was the macro economic triangle of consumer nations, producing nations and resource providers that opened the doors of high growth rate. It resulted in financial imbalance in consumer markets like America where deficit of liquidity was immensely felt. Second reason of the US economy taking a wrong turn was that the producing and resource providing countries had plenty of cheap credit, which they invested in US dollar. It created a boom in consumer market and fuelled the housing market. As mortgage market didn’t follow stringent rules while sanctioning home loan in America and in some of the emerging markets, it deepened the crisis further. Another reason was complex structure of securitisation. Behaviour of securities as financial instruments got beyond the comprehension of investors as well as senior bankers. Another cause of crisis was over dependence on wholesale funding, which the banks assumed that would be ever available. Their assumption proved wrong because with the collapse of securitisation market, assets’ market value came down sharply, creating losses on the balance sheet’s asset side and funding became a liability. As a result of financial market turbulence (HSBC 2008) it had become difficult to follow prices for structured credit risk as market lacked liquidity. Asset market further deteriorated as financial institutions’ reach to wholesale markets to fund such assets was constrained due to extra load on asset prices. It resulted in decrease in the fair values of asset-supported securities and transactions in sub prime mortgages as well as in other asset classes. 7. Conclusion Financial stability can not be guaranteed through strategies based on relevant policies. Such strategies can only be “customized” as per the particular traits of the banking and the financial aspects of the economy. Banking competition is not an ordinary trade-off, so guaranteed stability in banking sector is not socially beneficial. Banks’ depend on financial mechanism to produce results. Banking crises can result from the functioning of intermediaries and financial systems. Future research on comparison between different financial systems can guide on competition between the financial markets and the banking impacts on the performance of banks (Ruiz-Porras, 2008). References BBC News, 2007. The downturn in facts and figures: US sub-prime. [Online] 21 November. Available at: http://news.bbc.co.uk/2/hi/business/7073131.stm [Accessed 25 July April 2011]. Financial World, 2008. From bust to boom and back again, [Online] December 2008. Available at: https://www.financialworld.co.uk/Archive/2008/2008_12dec/Features/timeline/15705-print.cfm [Accessed 25 July April 2011]. HSBC Holdings Plc., 2008. Annual report and accounts ‘Strength, diversity and resilience’. [Internet]. HSBC Holdings plc Available at: http://www.hsbc.com/1/PA_1_1_S5/content/assets/investor_relations/hsbc2008ara0.pdf [Accessed 25 July April 2011]. Ruiz-Porras, Antonio. 2008. Banking Competition and Financial Fragility: Evidence from Panel-Data. Estudios Economicos, 23, (1), 49-87. Available at: http://www.jstor.org [Accessed 25 July April 2011]. Schneider, Friedrich., Kirchgassner, Gebhard., 2009. Financial and world economic crisis: what did economists contribute? Public Choice, 140, 319–327. Available at: http://www.springerlink.com [Accessed 25 July April 2011]. Yugina, V’, 2009. Some features of economic and financial crises in the course of global integration. Studies on Russian Economic Development, 20, (3), 292-296. Available at: http://www.springerlink.com [Accessed 25 July April 2011]. I. Read More