Global Financial Stability - Assignment Example

Finance Table of Contents Part I- Extent of credit deterioration in United s 3 Part II- Rise of systemic risks 4 Part IV-Impact of credit deterioration on availing finance 7 Part V- Reforms suggested by Partnoy and Skeel 7 Part VI- Justification for the recommendations 9 Part I- Extent of credit deterioration in United States The Global Financial Stability Report (GFSR) of April 2007 stated that the deterioration in the U.S. subprime market initially was due to poor underwriting standards, adverse employment and income trends in certain regions of the country. The nonprime or subprime borrowers are individuals with a bad credit history including delinquencies and a poor repayment capacity. The delinquency rates of the nonprime mortgages originating in the years 2005-06 have consistently moved up. Mortgages for the year 2007 are expected to fare even more poorly based on the current records. The decline in the housing prices in the U.S. has further aggravated the chances of delinquencies and dismal recovery in the event of foreclosure. Given the rising interest rate scenario, the rates of non-payments are likely to rise further. The weak economic fundamentals are responsible for the delinquencies in the prime mortgage market. However they will be protected from the interest rate re-sets because of their equity cushion. The outstanding amount on mortgage equity is at 40 to 50 percent of the value of the home on adjustable-rate-mortgages (ARM) advanced to prime borrowers. The crisis has spilled to the real estate commercial sector worth $3.3 trillion. There has been a fall in the debt service coverage ratio accompanied with a rise in the loan to value ratio. The pessimistic economic outlook together with the strict lending standards can result in rising losses especially on the recently disbursed loans. The spreads on the Commercial mortgage-backed securities (CMBS) have widened in the anticipation of default and worse loss rates ever in the commercial property sector of U.S. However, the impact on the commercial property sector is much less compared to the residential mortgage property as only one-quarter of the former is securitized in comparison to the 80 to 90 percent of the securitization in the subprime residential property market. Despite the weakness in the mortgage market the quality of credit in the consumer debt market has remained immune. But there are chances of deterioration in the consumer credit markets with the rise in personal bankruptcies and rising unemployment levels. Owing to the weak economic outlook, the spreads on consumer-related-asset-backed-securities (ABS) have reached record levels. The default rate in the corporate debt market in the month of January 2008 was roughly equal to the defaults for the full year of 2007 (International Monetary Fund, 2008). The GFSR of October 2009 give a positive picture with anticipation of lowered corporate default rates. With the increase in the capital cushions and support of the government the stability risk of the banks have receded. Part II- Rise of systemic risks The weak economy and deterioration of credit quality impacted the capital of major financial institutions. The aggregate losses and write-downs were estimated to be approximately $945 billion as on March 2008 comprising of $240 billion by the commercial real estate securities, $120 billion of losses being accounted for corporate loans, $565 billion for U.S. prime and non-prime loans and the remaining $20 billion by the consumer loans. The banks being exposed to structured products are most vulnerable to losses arising from them. Their market capitalization has declined worldwide by nearly $720 billion in March 2008. A similar situation is being faced by the insurance companies as they have also witnessed a decline in their market value with an estimated loss of $105 to $130 billion. The IMF staff estimated losses of $60 to $90 billion to the banks as a result of the downgrade of the financial guarantors. Corporate and Financial Indicators An examination of the corporate profits, S & P 500’s implied volatility and the debt-earnings ratio of companies with a high yield also helps in projecting the default rates. The figure below suggested flat corporate profits in 2008. The implied volatility in the equity market went to 25 percent in the month of February 2008. The debt to earnings ratio was predicted to rise even higher in 2008. Source: (International Monetary Fund, 2008). Despite the huge capital injections in the financial institutions the investors felt that some of the banks needed additional capital. The funding constraints are an indicator of systemic stress. As a result of the current crisis some large hedge funds were closed down. The systemic risks subsidized as per the GFSR report of October 2009 as a result of the policy action taken for financial stability. The earnings of the banks rebound in the first six months of this year but the core earnings are expected to be low. The monetary and financial condition has improved and the credit risk has declined as per the current report. The interventions of the policymakers reduced the bank’s credit risk premium. Despite the government’s initiatives the bank spreads rose in March 2009, but the risk premium descended afterwards as a result of the fiscal measures. Part III- Fragilities in Balance sheet and weak capital base The financial crisis revealed the presence of huge amount of Off Balance Sheet entities (OBSEs). The OBSEs enable the financial institutions to shift the risk off the Balance Sheet thus making it undisclosed to the investors and the regulators. Such entities granted credit beyond their limit. The securitization further provided a surplus capital to the banks. These OBSEs are structured in away as to avoid its appearance in the Balance Sheet. The financial institutions managed to avoid the consolidation thus making the detection of such activities difficult for the investors. Also, under the regulatory capital requirements of Basel I the securitized products in the form of OBSEs did not attract capital adequacy risk weight. The impact of the crisis was expected to have been less severe with the adoption of Basel II in the countries. Under the Basel II norms banks are required to assess the capital charges for any OBSE exposure. As per the Pillar 3 of Basel II, a bank has to disclose the securitization activities. The gap between the total assets and the risk weighted assets signify the large share of assets that carried a low risk weight. Under the Basel I norms, the banks were able to maintain a low or no risk weight for certain assets. The risk weights on the instruments related to hedging and other asset-backed securities were much less due to their high credit rating. The increased reliance of the banks on the money market and securitized funding exposed them to interest rate risk. Part IV-Impact of credit deterioration on availing finance The losses incurred by the banks might squeeze the credit growth substantially. It is expected that the banks will reduce their lending in order to offset some part of the worsening key ratios. The shortage of supply can lead to a credit crunch. In a gloomy market scenario, the banks try to hold more capital to support their Balance Sheet resulting in a fall in their profits and other fee based incomes. The banks tighten their lending standards resulting in a slow credit growth. The rising losses on loans increased the credit risk. Even though the risk-free rates declined with the liberal monetary policy, the illiquidity prevailing in the markets increased the cost of funding. The GFSR 2009 states that trade finance dropped sharply and the reason for this fall can be attributed to the banks’ unwillingness to lend as they attempt to delever their Balance Sheet. Also, as a result of the rising credit risk the banks have become overcautious of lending. The falling confidence levels are likely to raise the costs of procuring credit. The dysfunctional interbank markets together with the hoarding of liquidity by the banks call for a government intermediation in the financial transactions. The same can be seen in the issue of bank debt where all the newly issued debt comes with a government guarantee. Part V- Reforms suggested by Partnoy and Skeel Partnoy and Skeel opine that the disclosure of credit default swaps and Collateralized debt Obligation (CDOs) should improve. Generally the credit derivatives are largely unregulated and are also exempted from the securities law. It is important for the private parties to make voluntary additional disclosures. The public disclosure must include: Firstly, the International Swaps and Derivatives Association (ISDA) must make all the documents related to credit derivatives freely accessible on the net. Currently the ISDA charges fees from the market participants for such documentation. Secondly, the market participants must register their credit derivative transactions by publishing the relevant documents through the Edgar service of SEC. Thirdly, even though there is transparency in the credit default swap market, it is recommended to have a centralized pricing service in the case of credit derivatives. Fourthly, the companies must describe the impact of the credit derivatives not just in the footnote but also in narrative manner in their results analysis, in the financial filings operations sections and also in the management’s discussion. The companies must disclose the impact of such transactions on their risk profile. For instance a bank must disclose the use of credit default swap to hedge its exposure in lending. With regard to the credit derivatives, the opening up of competition in the credit ratings can resolve some problems. The Credit Ranging Agency Duopoly Relief Act of 2005 will increase the competition by removing the SEC in the recognition of credit rating agencies. Other than this, the companies can explain their investment policies with reference to the credit ratings. The institutional investors must disclose their reliance on such ratings in matters of investment decision making. They must also make a disclosure of the relevance of such ratings on the use of CDOs or credit default swaps. In addition, they must disclose if their internal ratings of the risk and credit quality of the tranches of CDO conform to the publicly released credit ratings of such instruments (Partnoy, Skeel, n.d.). Part VI- Justification for the recommendations The recommendations of Partnoy and Skeel emphasize the need for the disclosure of transactions relating to the credit derivatives. If all the information is easily accessible on the net then the investors can choose an avenue for investing depending on their risk appetite. Further the description of such transactions in the financial statements increases the transparency of these financial activities. If the investors can learn about the hedging strategies adopted by the institutions they will feel confident about the safety of their investment. The hedging strategies act as safeguard in the case of any unfavorable movements. In short, it can be summed up that the recommendations of Partnoy and Skeel increase the level of transparency and hence are acceptable. References International Monetary Fund. 2008. Global Financial Stability Report. Available at: http://www.imf.org/external/pubs/ft/gfsr/2008/01/pdf/text.pdf [Accessed on November 5, 2009]. Partnoy, F. Skeel, D. No Date. The Promise and Perils of Credit Derivatives. Available at: http://homepages.ulb.ac.be/~plegros/documents/classes/finance/Themes/Innovations%20financieres/Partnoy-Skeel.pdf [Accessed on November 5, 2009]. Read More