Credit Crunch Since Summer 2007 - Coursework Example

Extraordinary events have occurred in the financial markets since the summer of 2007. These events have unfolded in various sectors and are all interlinked. The US economy affects the entire world economy as they partner with individuals and businesses round the world. This can be explained by the Mitchell’s theory of the business cycle which emphasizes that the dynamic phases of the cycle in the economic activity can be explained by the augmentation and the squeeze of the profit margins which in turn affect many important variables.1 This is exactly how a chain reaction has taken place in the global financial markets which has been described as ‘multifaceted’ and ‘complex’.2 Excess liquidity, the ‘savings glut’ in global financial markets, inadequate asset/liability and risk management practices of financial institutions3, the un-orderly proliferation or the increase in the delinquency rates of the subprime mortgages in the United States, led to the failure of several banks including a classic bank run in the United Kingdom.4 As the events unfolded, it led to a run on one of the leading investment banks in the United States. Credit crunch has been referred in the past to explain the curtailment of the credit supply in response to a decline in the value of bank capital, and also conditions imposed by regulators, bank supervisors or banks themselves that require banks to hold more capital than they would have held. What took place in summer of 2007 was credit squeeze, according to Mizen.5 At that time the effect of credit was restricted to liquidity in the capital markets and the effective closure of certain capital markets that affected credit availability between banks. There was disorder in financial markets as banks wanted to determine the true values of assets that were no longer being traded in sufficient volumes to establish a true price. The financial institutions were aware of the need for liquidity but were not willing to offer it except under terms well above the risk-free rate. This credit crunch too will have global implications as international investors are involved. In fact this will be more complex than earlier crunches because financial innovation has allowed newer ways of packaging and reselling assets. It has been intertwined with the growth of the US subprime mortgage market. The problem started to appear in the lower quality US mortgage lenders. As defaults started to appear there was excitement in the market and soon a subprime specialist, New Century Financial, filed for Chapter 11 bankruptcy. This was followed by the Swiss owned investment bank UBS that closed the Dillon Reed hedge fund after incurring $125 million in subprime mortgage–related losses. A series of such closures and losses followed when even German and French banks close hedge funds in troubled circumstances. The credit crunch was the result of a credit boom of past five years. Following the dotcom bubble and the 9/11 attacks, the short-term interest rates were reduced. Even though the interest rates were not as low in the UK, but the credit grew there too. Another factor for credit growth was the global savings glut flowing from China, Japan, Germany and other oil exporters that kept the long-term interest rates down. Following the Asian crisis of 1997, there was a strong demand for US Treasuries and Binds that raised their prices and lowered the long-term interest rates. The deficits in the industrialized countries were funded for some time by the large savings flow from the emerging markets but this led to imbalances that could not be sustained indefinitely. Nevertheless, they encouraged the growth of credit. The following table demonstrates that the US savings ratio fell from 6 percent of disposable income to below 1 percent in little over a decade and the total debt– to–disposable income ratio rose from 75 percent to 120 percent: Source: Mizen (2008). In other countries too as the revolving debt in the form of credit card borrowings increased significantly, and as prices in housing markets across the globe increased faster than income, mortgages were offered at higher multiples, thereby raising the level of secured debt to income. The borrowers were made to believe that the housing prices would continue to rise and they were even offered in excess of 100 percent of the housing prices. The American residential mortgage market consists of some $10 trillion worth or mortgage loans.6 The subprime market grew rapidly as advanced credit scoring techniques were applied for assessing applications. Online investigation of borrowers’ credit ratings sharply reduced the processing costs, which in turn meant that the profitability of placing new mortgages soared. Automated underwriting reduced the average cost of lenders of closing a loan by $916. Before automated underwriting down payment was essential but this was subsequently abolished. This led to increased competition and as competition intensified, the mortgage brokers and the lenders relaxed the approval standards. The demand for subprime mortgage financing increased which led to a rapid growth of mortgage broking mortgage lending and institutional investors’ financing of mortgage pools. The entire system failed to recognize how the incentives changed the dynamics of the market and how it affected different participants. There was mismatch between loan quality and loan’s governance which could be measured by the risk control capabilities of lenders and investors. They used instruments like collateralized debt obligations (CDOs) and default insurance. Since it was covered by insurance neither the original lenders nor the institutional investors had any incentive to monitor the default risks. In fact some insurers even under-priced the insurance they sold, which further aggravated the situation. Borrowers were encouraged and even lured by attractive deals. The borrowers were unaware that what appeared to be teaser loans or carried low short-term interest rates led to the greater use of adjustable-rate mortgages (ARMs) which could substantially increase when the interest rates rose. Almost 80 percent of subprime loans in 2006 carried low “teaser” rates. The borrowers started facing increased payment obligations and even the repayment period was extended, it only meant larger interest payments. The probability of borrower default increased as the value of the borrower’s equity in the home was small. The investors were not aware of the risks involved in borrowing. The subprime borrowers were usually poorer than those who could obtain loan at much lower rates of interest. The subprime borrowers entered the market when the housing rates were already high which means the amounts borrowed was high compared to the income. As the interest rates increased, the borrowers started defaulting. The risk levels were not monitored by lenders even though US federal regulators were aware of the problems as the subprime industry evolved. Enhanced screening, monitoring and governance capabilities were not paid heed to. Eventually properties started being repossessed and sold in the market at a discount. Lenders become reluctant to commit additional funds and the loan standards were tightened leading to a classic credit crunch. HSBC has cut back on second mortgage loans and Credit Suisse the number of origination in the subprime market could fall by 50 percent. According to Blundell-Wignall7 there have been four forces at play. In housing and asset-base securities, excessive liquidity resulted in asset bubbles, which prompted the speculators to borrow while the rising asset vale of collateral comforted the lenders. Secondly, there were gaps in the regulator and accounting standards. Third was the role that rating agencies played in the securitization process. Normally banks assess the credit and retain it as private intimation but the investors too had to assess the risk return profiles of these assets. Instruments like CODs and asset-backed commercial paper (ABCP) conduits smoothened the way for a boom. Fourthly, there were failures in the corporate governance of financial intermediaries. While several banks stayed clear, others rushed ahead lured by fast profits and fees. To keep the markets functioning, the central banks had to step in with new liquidity operations. Insolvency was recognized as the core of the problem – insolvency of the home owners who took on home loan in the expectation of capital gains and the insolvency of the financial institutions that either managed their risks poorly or were satisfied with short-term wholesale funding of their balance sheets. Credit crunch is not very difficult since it does not take much to wipe off the bank’s capital. If the funding declines or if asset write-offs occur, in the absence of new capital injections, banks are forced to de-lever in order to meet capital rules or go into bankruptcy. The OECD estimates a loss of $420bn out of which about $90bn is associated with US banks that play a key role in the intermediation process. The European banks also have a substantial share of the subprime securities and they are less well capitalized than their US counterparts. The US mortgage delinquency rates started increasing as per the table below: Source: Mizen (2008). The problems further aggravated in the US, because in Europe there is a property register that can be used to identify and repossess the assets to sell them to recoup a fraction of the losses, which is not present in the US. Hence once the package was sold, it was difficult to identify who owned the property. Nevertheless, subprime crisis only triggered the problem but mispricing of risk was widespread. Therefore any of the high-yielding assets could have triggered off the credit crunch. Even after the credit crunch was experienced in august 2007, many banks spent months evaluating their losses. There was uncertainty and even inter bank lending was affected. The effect of this crisis was first seen in the capital markets. This was because previously the banks that granted mortgages and loans traditionally kept them in their books now they started transferring the credit risk to other financial institutions in innovative ways.8 This led to several new structured products, to the securitization of many risk categories, which led to the emergence of a shadow-banking system in the form of off-balance sheet vehicles. After making a loan, a bank could either sell it outright or insure itself by buying a credit default swap (CDS). While structured products include the CDOs and the asset-backed securities, the off-balance sheet vehicles include the ABCP. These products led to the current credit crunch by making credit extremely cheap and the credit spreads shrunk to historically low levels. The transfer of credit risk distances the borrowers from the lenders. First it makes it unclear who holds the risk. Then, the banks had no incentive to monitor and assess the applications seriously. Since the risk was held by other financial institutions, the banks held the risk only till such time that it was passed on to other financial institutions. The UK government recognized the need to protect the commercial bank depositors. Attempts to rescue Bear Stearns were to limit the damage of the crunch on settlement in the financial system. Bear Stearns hedge funds had invested heavily in structured finance products but Goldman Sachs gave indications to the hedge fund Hayman Capital that it would not take exposure to Bear Stearns.9 As this warning news spread, Bear Stearns found it difficult to finance its activities. They had to sell off their short-term ABCP assets and it soon became clear that Bear Stearns would not be able to roll over its assets. The Federal Reserve Bank of New York stepped in to support the institution with a 28-day loan via JP Morgan Chase. JP Morgan Chase had to finally take over Bear Stearns thereby averting a financial system crisis. The ratings of products reduced from AAA to A+ which was described as unexpected by the OECD.10 Banks like IKB Deutsche Industriebank AG could not roll over its ABCP and it has to be bailed out by its major shareholder, KfW Bankengruppe. Soon BNP Paribas and Sachsen LB, a German Bank too failed to provide enough liquidity to support its conduit. All these created pressure on banks’ liquidity and they had no incentive in interbank lending. Banks started hoarding liquidity to cover any losses they might experience in their own books which turned out to be substantial. Large investments banks like UBS, Merrill Lynch and Citigroup were involved. The table below demonstrates the top corporate writedowns: Source: Mizen (2008). The public community banks have taken the largest hit due to the credit crunch. The average net interest margins for banks with less than a billion in assets contracted by 30 basis points11. This contraction was due to intense pricing pressures that left some of the banks scrambling to secure stable funding sources. The bigger banks have the clout and scale to manage through the crisis but the smallest banks suffered the most. The following table gives the net interest margin based on assets: Source: McCune (2008). The subprime crisis led to repricing of risks which spread from opaque securitised products to other assets classes. The equity prices fell particularly for financial sector companies, corporate bonds registered steep increases in the premium paid by riskier borrowers and the bank credit default swap (CDS) rates widened.12 Following the Bear Stearns episode in March 2008, there were some signs of improvement but banks in the US and Europe has been severely affected as many have reported writedowns and credit losses. To ease the situation the dollar has depreciated which could boost exports and support growth in the United States. Governance and control are the only answers to avoid such mishaps in the future. According to the Basel Committee on Banking Supervision at the Bank for International Settlements, the board of directors is ultimately responsible for the operations and financial soundness of the company.13 The senior managers should hence be responsible for communicating messages about behavior through out the organization. There should be strong governance and control culture within the organization which could reduce the risks of control failure. The message should be clearly spread within the company that compliance risk is owned by the business and the staff is responsible for adhering to the desired compliance culture. Thus it was not just the subprime mortgage in the US that led to the credit crunch. It was a series of events that were interconnected that made the situation grave. Even though it has its roots in the Asian financial crisis of 1997, the market turmoil was mainly created as cheap loans were given without background verification as the concentration was on quantity rather than n quality. Secondly, as the loans were passed on to financial institutions, the banks did not carry risks. Thirdly, the risks were insured at very cheap rates thereby putting the insurance companies under pressure. As the housing bubble burst, the entire system was affected. Global liquidity crisis ensued as the structured investment products shifted the global liquidity into commodity futures. The global savings glut added to the problems. The financial market turmoil is at its extreme and threatens worldwide economic growth. Recession is likely in several countries and much depends on how the policy makers are able to soften the credit crunch, which is unfolding through the balance sheets of the financial institutions. Lessons have been learned in the current credit crunch that will alter future operations of the financial system. The weaknesses in the regulation process are expected to be eliminated but the incentives should be fully understood and communicated to the end-investors. Governance and control measures, regular monitoring of events and accounts are essential to recover from this credit crunch which started unfolding in the summer of 2007. Bibliography Blundell-Wignall, A 2008, Subprime crisis: A capital issue. Organisation for Economic Cooperation and Development, The OECD Observer no. 267 (May 1): 24-25. http://www.proquest.com/ (accessed November 3, 2008). Brunnermeier, M K 2008, Deciphering the 2007-08 Liquidity and Credit Crunch, Journal of Economic Perspectives, Reviwed online 31st October 2008, from Gentle, C 2008, Work in progress? How the credit crunch has its roots in the lack of integrated governance and control systems, The Journal of Risk Finance. vol. 9, no. 2, pp. 206-210 Guichard, S & Turner, D 2008, QUANTIFYING THE EFFECT OF FINANCIAL CONDITIONS ON US ACTIVITY, Reviewed online 03rd November 2008, from Johnson, L D & Neave, E H 2008, The subprime mortgage market: familiar lessons in a new context, Management Research News, vol. 31, no. 1, pp. 12-26 McCune, J 2008, Snapshot, American Bankers Association. ABA Banking Journal; Jun 2008; 100, 6; ABI/INFORM Global, pg. 8 Mijen, P 2008, The Credit Crunch of 2007-2008: A Discussion of the Background, Market Reactions, and Policy Responses, FEDERAL RESERVE BANK OF ST. LOUIS REVIEW, Reviewed online 02nd November 2008, from Mouhammed, A 2008, ‘Mitchells General Theory of the Business Cycle and the Recent Crisis in the U.S. Economy’, The Journal of Applied Business and Economics, vol. 8, no. 3, pp. 30-49. http://www.proquest.com/ (accessed November 3, 2008). Orlowski, L T 2008, Stages of the Ongoing Global Financial Crisis: Is There a Wandering Asset Bubble?, IWH-Discussion Papers, Reviewed online 31st October 2008, from Read More