Causes and Consequences of Crisis in Financial Markets - Example

INTERNATIONAL FINANCE Table of Contents A. Brief Explanations 4 A Financial Products 4 Equity 4 Commercial Bonds 4 Bank Loans 5 A.2. Financial Markets and Institutions 5 Retail and Investment Banks 5 Stock Market 6 Bond Market 6 B. Causes and Consequences of Crisis in Financial Markets 7 B.1. Credit Crunch 7 B.2. Eurozone Crisis 12 C. The Political Economy of Financial Markets 14 References 17 A. Brief Explanations A.1. Financial Products Equity The financial instruments can be broadly classified into equity based and debt based products. The equity shares represent the paid up capital of any company divided into small unit of equal value called shares. The products which are associated with equity gives the investor ownership rights. The equity shareholders are the ultimate risk takers because only after all other financial liabilities are paid off, the equity owners get to share the residual profit proportionately with their shareholding ratio. From the financers’ point of view, equity financing involves dilution of ownership stakes, investors have voting rights and tax advantage. From the point of view of the investor, he or she is the ultimate risk taker because only after paying off all senior and subordinated liabilities, the investor gets to share profit, if left any. Thus, if there is no residual profit left for the investor, he has to forego dividends (Baker & Wurgler, 2000, p.2221). Commercial Bonds A commercial bond is an instrument of debt that gives the holder of the bond the right to receive interest or coupon at regular time intervals till maturity. It is a financial instrument with limited risk because the right of an investor to receive coupon payments from the holder of bond must be honoured even if the company does not make any profits. The bond holder is also known as the creditor and the bond borrower is called the debtor. Form the point of view of the financer, a company may issue debt instruments when it wants to leverage its capital structure. Leveraging of capital structure means the inclusion of debt capital n the capital structure of the company to magnify the effect of higher Earnings per share to the shareholders. At the same time, the burden of tax is passed on to investor who receives regular coupon payments from the issuer. The issuer also does not have to worry about dilution of controlling stake and sharing voting rights. This is because the creditors are not the owners of the company and hence they are not the ultimate risk-takers. Their terms of coupon payment are negotiated in advance and they also receive it regularly even if the company makes loss in a particular year (Hakansson, 1999, pp.2-5). Thus, from the investors’ point of view, it is one of the safest modes of investment where there is certainty of cash flows. Bank Loans A bank loan is debt that involves the repayment of principal by the borrower along with interest on outstanding principal on or before maturity. In a bank loan the borrower initially receives the principal from a bank on which he has to pay regular interest unless the principal is repaid to bank. Thus, from the financiers’ point of view, it earns regular interest from the borrower and makes profit. From the borrowers’ point of view, he enjoys the loan principal at low cost and the option to pay it back after maturity (Packer & Zhu, 2012, pp.1-4). A.2. Financial Markets and Institutions Retail and Investment Banks In retail banking, the customers interact directly with the bank for transaction. The banks offers services such as opening current and savings account, time deposits, loans, credit card and debit card facilities, etc. Some of the multinational retail banks of UK are Royal Bank of Scotland, HSBC, Barclays, Standard Chartered and Lloyds Banking group. The investment banks are the financial institutions that helps individual, Corporate, and the government to issue securities. They are generally the merchant bankers that help the issuer of securities to underwrite assets. An underwriter promises to subscribe shares of the issuer in case there is under-subscription by public. There are 13 major investments in UK. Some of them are Deutsche Bank, Credit Suisse, Citigroup, Goldman Sachs, JPMorgan Chase, BNP Paribas and Barclays Capital (Schröder, 2011, pp.11-26). Stock Market It is a place where the securities are traded between the buyer and seller. The stock market may be traded in stock exchange or Over the Counter. The stock market may be primary (securities are issued for first time) or secondary (where securities are traded after they are issued in primary market). There are over 75 stock exchanges in UK that trades securities in the stock market. Bond Market It is analogous to the stock market with only difference is that only fixed income securities and debt instrument are traded here. It is further divided into the primary and the secondary markets that have similar concepts as in stock markets. Most importantly, the bond market also trades government securities. It can be classified into Corporate, Government, Municipal, collaterals, and funding. The major participants are institutional investors, individuals, government, and traders. B. Causes and Consequences of Crisis in Financial Markets B.1. Credit Crunch The global financial crisis is often considered by many economists as one of the worst financial crisis in history. The impact of the financial crisis of was so large that it led to the fall down of many large Financial Institutions around the world. It also resulted in the bailouts of commercial banks by the central banks of the countries. The stock markets around the world also tumbled from its impact. The realty sector was mostly impacted that led to a long-lasting unemployment and many mortgaged possessions were taken away because of inability to redeem mortgage by concerned party. The global crisis is often blamed as one of the major causes that triggered the global recession of 2008 and also contributing European Sovereign Debt Crisis. It is believed by many economists that the bursting of U.S. real estates and housing that peaked from the Clinton era, causes the value of U.S. securities to fall down rapidly that damaged global financial institutions. Thus, the origin of the financial crisis was the set of government policies that encouraged ownerships for new homes, easy access to sub-prime lending, faulty trading practices on behalf of buyer as well as sellers, prioritization of short term lending over long term lending, and most importantly the lack of adequate capital base in banks that made their solvency vulnerable. The reduced availability of credit reduced the investor confidence that affected the global stock markets in a complex manner. As a result of this crisis the large world economies slowed down during the period of global crisis and ultimately leading to reduced international trades (Brunnermeier, 2009, pp.78-81). The immediate cause for the trigger of financial crisis was the bursting of U.S. housing bubble that peaked from 2005. (Source: U.S. Census Bureau, 2008). There were already reports of rising default on subprime mortgages that further fuelled quickly thereafter. Such mortgages are usually given to borrowers with below average credit ratings which are mainly due to their higher average risk of evasion in loan repayment. The financial institutions often charge higher interest on subprime mortgages in order to compensate for the risk taken. Thus, as the banks began clearout more loans to home owners, the housing prices rose. Thus, the easy accessibility of credit in U.S. in addition to large foreign inflows led to the boom in construction and increased consumer spending that was mostly financed by debt. The falling prices of houses resulted in more homes less worthy than mortgaged loans which provided a financial incentive to financial institution to take possession of mortgaged property when the mortgagor failed redeem loans. As the housing market expended to other parts of economy, the defaults and losses on other types of loans increased significantly. Easy credit conditions facilitated higher subprime lending during pre-crisis years that increased from 9% in 2004 to over 20% in 2005-06. The low rates encouraged more borrowings and it was further pushed down due to rising current account deficit. (Source: U.S. Bureau of Economic Analysis, 2008). The U.S. Current Account Deficit was mostly externally financed from other economies which were running on trade surplus, like exporting nations. The U.S. experienced growth in foreign investments that created demands for many new financial assets that raised the assets prices and lowered interest rates. Among the developing economies, China was the largest foreign investor in U.S. The abundance of such funds reached the U.S. financial markets mostly into mortgage-backed securities. During the period of credit crunch many innovative financial products were developed. Such products were customised according to the need of customer. For instance, the risk taking propensity of an individual varies from another. The example of such financial products which led to crisis includes bundling of subprime mortgages into Mortgage backed securities, CDO (collateralized debt obligation), CDS (Credit default swap), etc. Increased use of these innovative financial products along with other complex instruments led to crisis. It multiplied the number of parties connected to single mortgage including brokerages, securitised originators, agents, insurances, etc. As the investors relied more on indirect information, they kept away from underlying asset. So instead of diversifying risk of investors it led to misrepresentations and fraudulent trade practices. The financial instruments lost investors confidence all around the world due to lack of transparency about the banks’ true risk exposure. It misled the market from correctly pricing the asset before the crisis. It enabled the mortgage market to grow more than it was truly worthy of. The investors’ expectation increased from mortgaged securities and that increased the demand for such securities which inflated the price. But when the time of redemption came, these securities defaulted leading to bad asset management and investors lost billions and billions of dollars which caused the crisis. As the financial products became more and more complex, their valuation process got harder. The investors relied on the credit rating of international bond markets, bank regulators and agencies. Their complex mathematical model proved to yield inflated results that increased the investors’ expectations and hence in reality the return from those stocks were much lower than expected (Mizen, 2008, pp.534-541). (Source: Mizen, 2008, p.537). This crisis was not confined into the U.S. markets only. Very soon it spread into global economic blow leading to failure of many international banks, plunging down of stock markets, and large reduction in the market value of assets. Since a significant part of MBS and CDO was held by European banks, the U.K. was mostly affected from the contagion. Complex derivative instruments like the CDS also accelerated risk and led to the European sovereign debt crisis since both were purchased by corporate and financial institutions. So, the credit and realty sector booms in U.S., number of innovative financial products like CDS, CDO, MBS, etc. that derives its value from mortgage payments and housing sector indices ultimately triggered the financial crisis. Such financial innovative products helped institutions around the world to invest in U.S. housing and construction sector in expectation of higher returns that was inflated. Consequently, when the banks started failing to repay lender, major financial institutions invested profoundly in subprime lending instruments, reported major losses. B.2. Eurozone Crisis The European sovereign debt crisis is also popularly known as the Eurozone crisis that was the outcome of global financial crisis of 2007. It is classified as a situation that made it difficult for some European countries, like Greece, Spain, etc., to repay government debt. These countries were in such a bad position that they needed third party assistance, bailouts, and quantitative easing, to help them out of the crisis. The origin of Eurozone crisis can be traced back to early 2007-08 when the credit crunch began in the U.S. due to easing credit availability, aggressive investment in housing sector, mortgaged based lending whose assets were overvalued. The sovereign debt of a country is always concerned with the government bonds. Thus, the Eurozone crisis is the result of failure of bonds of European governments. From the second half of 2009, the investors started fearing the sovereign debt crisis as a result of increased debt in the balance of payment of the government due to high debt between the European Central Banks, International Monetary Fund and the 17 member European countries collectively called Eurozone. Some of these countries defaulted on their sovereign debts which lead to their downgrade in the credit ratings. As a result, even after many meeting, debt restructuring and significant bailouts, these countries were not able to refinance their government. The failure in the European bond market cautioned the IMF and ECB because many other economies, directly or indirectly depended on them. The failure in the bond market negatively impacted the stock markets and developed a prolonged negative investor sentiment or a bearish market. It was soon felt that the Eurozone crisis may fall into double dip recession in which the normal cycle of bear phase continues for over double the above normal period. But this was a generalised version from many economists around the world while in reality, the extent of impact and its causes varied country to country (Lapavitsas, 2010, pp.31-47). In many countries even the private debts arising from the housing bubble of U.S. turned into sovereign debt crisis due to government bailouts to slow down the impact from spreading into the private sector. For example, in Greece, one of the countries in Eurozone, the government’s pension commitments and voluntary wage compensation fuelled the debt crisis. The structure of Eurozone is that the member countries of Eurozone share a common currency which is also called the monetary union. However, there is no fiscal union between these countries. It means that even though these countries shared common currencies, their fiscal policies, tax structure, pension schemes, public expenditures by governments, etc., were all different. This reason mostly contributed to the Eurozone crisis and the failure of sovereign bonds. Since these European member countries only shared the common currency, they had no intention to have a consensus regarding a common set of policies that might lead to a meaningful solution. So, when one country defaulted the other which did not, decided to stay out of the defaulting country’s contagion. This was mostly due to fact that no government of the member countries accepted suggestions from other governments positively due to many political reasons (Anand, Gupta, & Dash, 2012, pp.5-20). Thus, the European sovereign debt crisis was the result of several complex factors like the failure of bond markets that mostly depended on mortgages and aggressive lending of financial institutions leading to international trade imbalances. C. The Political Economy of Financial Markets The World Trade Organisation argues strongly in favour the economic benefits of free trade agreements between countries because sharing the economic resources between two or more countries that specialises in producing goods and services, leads to mutual benefit for all. Alternatively, liberal trade policies which allows the countries to share each other’s resources freely tends to increase competition, encourage innovation and better quality to consumers at the best price. In the past, statistical data have proven the fact that there is a direct link between economic growth and FTA (Free-Trade Agreement). The theory of comparative advantage also supports the view of WTO. According to it, any country would prosper if it concentrates and specialises in producing goods or services which no other country can produces better , in terms of cost efficiency, quality, innovation, or availability of raw material. Then such goods or services when exchanged with another country that specialises in producing some other goods or services, then unrestricted flow of each other’s goods will ultimately benefit both the nations. The free-trades and economic conditions may be multilateral agreements based on the requirement and commercial benefits of both countries. Tariffs are considered as barriers to free trades as they increase the cost of import for domestic country. Many poor economies put high tariffs on the imported goods to protect their domestic markets from strong global competition. It is believed that many developing countries follow this strategy to promote the country’s manufacturing sector. This is because, in a poor or developing economy, the cheap imports from global competitors will discourage consumption of domestic products and services. There will be a slowdown in growth and employment of labour in the country due to lower consumption of domestic goods and services (Laird & Crawford, 2000, pp.3-4). Then again another school of thought suggest that if a country shares each other’s resources, not only the goods and services along with other inputs are shared, but technological innovation is also shared. Thus, even though a country may have competitive advantage in terms of manpower, availability of raw materials, etc., it can still benefit by diversifying into another market where potential future demand may be even higher than producing country. When the comparative advantage theory interpreted, it can be said that countries prosper first by taking advantage of producing those goods and services at which they have competitive advantage and then trade these assets for the products and services of other countries at which it does not specialise but other countries does. Hence, both the countries benefit from free trades between them because they separately specialises in producing items which are exclusive without free trade but mutually beneficial when shared. Sometimes the competitiveness may also shift between the countries. The success in trades can shift from one company to another when there is change in technology for the production of large scale production of goods at cheaper rates. Thus, a country may have an advantage because of low manpower cost or abundant supply of raw materials, but the balance of power may shift from one country to another due to free trades. Liberal trade policies lead to better price discovery, innovation, economies of scale, etc. due to increased competition (Crawford, & Fiorentino, 2005, pp.15-19). Protection of economy from foreign competition might lead to inflated prices of goods and services, inefficient production, outdated and unattractive products, etc. that makes limited choice available to consumers. To illustrate comparative advantage theory of classical economist David Ricardo, consider country X is better than country Y in making automobiles while Y is better than X in producing rubber. In this case both the country would benefit if they trade each other’s products. This is also known as the case of absolute advantage. According to Ricardo’s principle of comparative advantage a country does not have to specialise in producing any item to benefit from trade. References Baker, M. & Wurgler, J. 2000. The Equity Share in New Issues and Aggregate Stock Returns. [Pdf]. Available at: http://people.stern.nyu.edu/jwurgler/papers/equityshare.pdf. [Accessed on February 13, 2013]. Hakansson, N. 1999. The Role of a Corporate Bond Market in an Economy – and in Avoiding Crises. [Pdf]. Available at: http://www.haas.berkeley.edu/groups/finance/WP/rpf287.pdf. [Accessed on February 13, 2013]. Packer, F. & Zhu, H. 2012. Loan loss provisioning practices of Asian banks. [Pdf]. Available at: http://www.bis.org/publ/work375.pdf. [Accessed on February 13, 2013]. Schröder, M. & et.al. 2011. The Role of Investment Banking for the German Economy. [Pdf]. 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