The Financial Crisis from 2007 to 2009 - Essay Example

I. Introduction This paper aims to explore the financial crisis from 2007 to 2009, with a specific focus on the role of asset securitisation in the crisis. In order to provide a comparative analysis of this role, the paper starts by providing a benchmark picture of the asset markets prior to the financial crisis, under the efficient market theory. An overview of the global financial crisis, with focus on the asset securitisation as the starting point of the crisis. In order to understand the concept of asset securitisation and its role in the financial crisis, the concept of value and fair value accounting is assessed; these concepts are also needed in order to propose recommendations for regulators. Cases in point are explored through some major financial institutions to show the financial statements unreliability to measure asset values. The role of financial intermediaries and imperfect information are then delved into, as to how they propelled the crisis. In order to provide a conclusive view of the global financial crisis, the paper ends with a discussion about how asset securitisation has ended up in speculations, market manias, and eventually a financial crash in the global financial system. With all these, certain regulations are proposed II. Body A. Financial markets and the efficient market theory The invisible hand view of the economy, as explored in the book “Economics” by Samuelson and Nordhaus, will fail to exist under two conditions: when there is imperfect competition and imperfect information, and when there are market externalities. The failure in major financial markets exists because of either of these conditions. Prior to the financial crisis, the financial markets such as stocks, bonds and mutual funds markets are considered markets where the invisible hand operates. The stock market has always been referred to as an efficient market by economists. According to Brealey, Myers and Marcus, “the competition [in this market] to find misvalued stocks is intense. So when new information comes out, investors rush to take advantage of it and thereby eliminate any profit opportunities (2004, 165).” An efficient market, according to Samuelson and Nordhaus in their book “Economics” is defined as “one where all new information is quickly understood by market participants and becomes immediately incorporated into the market prices (2004, 534).” This characteristic of the stock market as an efficient market is attributed to the availability of timely information which is incorporated in the prices of the stocks. The stock market indeed needs investors who believe that the market is inefficient in order to make the market efficient. As investors think that there is a certain degree of inefficiency in the market, these investors’ notion of the stock prices are that they are underpriced, and there is a chance to profit from this situation (Segerstorm 2009, 39). Therefore, as investors believe in this inefficiency, and the possible reward of profiting from these undervalued stocks, they are driven to action. When investors are driven to action, they look for more sources of information, analyze the information and push the prices up or down depending on the value of the information as regards the certain stock. When investors are prompted to take action either by driving the prices of the stocks up or down depending on the information, the direction of the prices tend to be that which incorporates the value of the information—thus, eliminating the possible profits from buying and selling the stocks; hence, making the market operate under the invisible hand theory of Adam Smith. B. Asset securitisation and the financial crisis The current global financial crisis can be traced back to the housing bubble that has started in the United States way back in the 2000s (Hanney 2008). During that period, borrowing rates have declined which has given enough incentives for consumers to borrow from the banks (Ryan 2008). With the existence of a sub-prime market, banks have extended their credit even to credit unworthy customers because those credits can also be pooled where the risks of defaults can be minimised (Van Deventer 2008). Banks are given the incentives even as underwriters of mortgages because they can sell these mortgages in the sub-prime market, where the selling banks will be able to minimise the risks because it is passed on the buying bank, and the buying bank can profit from these mortgages through a monthly guarantee fee (Ryan 2008). The buying bank, in the form of mortgage-backed securities will sell these assets to other investors (Ryan 2008). This is how the sub-prime mortgage market in the United States work. When these customers prove to be unable to pay their mortgages, financial institutions in the United States are left with mortgage-backed securities that have stopped trading in the market and the markets have become illiquid (Ryan 2008). To the buying banks, because these mortgages happen to be bad debts, chances of being paid by the issuing company become narrow. As housing prices have reached a peak and have fallen, the value of the real estates from which the value of the mortgages are based have fallen as well (Van Deventer 2008). The negative equity arising from the situation where the home value is less than the mortgage is an enough reason for a buyer to default—if the buyer lacks savings, or got a job cut and the lack of home equity will not enable her to refinance to pay for the mortgage (Van Demeter 2008). A lot of big companies in the United States have fallen because of this, and the chain effect and inter-linkages has resulted in the global financial crisis (Landy 2009). The worst has not yet ended with this. Even with the efforts for financial markets to recover, some asset markets become stagnant where investors are reluctant to trade, and the markets become illiquid (Hitz 2007). Because of the fair value method of accounting, the assets of companies are reported according to the prices of the market (Practical Accountant 2009). Since there are very little trading activities in some capital markets, the prices do not go upward and remain low (CPA Journal 2009). This has resulted in huge losses that in the companys financial statements. C. Measuring asset values: the value concept and fair value accounting Accounting regulatory boards have find it hard to define the concept of fair value. According to McCollum, “obtaining information relevant to fair value is one of the biggest challenges organisations and auditors face in the current market (2008, 14).” While regulatory boards such as the Financial Accounting Standards Board and International Accounting Standards Board try to define a concrete definition of the fair value, the closes that they can get is a specific hypothetical market price under idealised conditions (Hitz 2007, 326). Fair value has been defined by the FASB in SFAS 157 as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (Trussel & Rose 2009). In basic finance, value, or more specifically the value of an asset in economic terms is best defined as the sum of the future benefits, or cash flows to the company which is discounted to the present (Wallace 2008). This is more commonly referred to as the fundamental or shareholder value (Hanney 2008). This link between value and the price in the underlying assumption behind the concept of fair value is held by the efficient market theory, where the price includes all the available information in the market and is a good predictor of value (OKelly 2008). Capital markets are considered efficient markets where investors are assumed to be sophisticated, rational individuals who maximise their wealth and utility, and thus only accept prices that reflect the true value of the commodity (Campbell, Owens-Jackson & Robinson 2008). This provides the link between the definition of fundamental value and the perceived value. D. Real value of assets, asset securities and the unreliability of financial statements: Cases in point Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac are some of the buying banks in the mortgage-backed securities industry supply chain. Fannie Mae and Freddie Mac buy whole mortgages from institutions through their swap programs (Mortgage Servicing News 2007). These mortgages are exchanged are then exchanged for mortgage-backed securities. Fannie Mae and Freddie Mac will pay principal and interest for these MBS in exchange for a guarantee fee (Credit Management 2008). In June 30, 2008 the two companies have held together $1.8 trillion in assets which are comprised entirely of MBS and whole mortgages, and $3.7 trillion in net credit guarantees outstanding (Frame 2008) . Under the fair value accounting method, the companys assets, liabilities and derivatives are marked to market value (Pozen 2009). This requires the companies to write off the decline in asset prices and recognise them as losses. Although Fannie Maes book value of equity is $41.2 billion, and $12.9 billion for Freddie Mac, their respective fair values of equity are $12.5 billion and -$5.6 billion respectively (Frame 2008). Lehman Brothers and Bear Stearns. Lehman Brothers and Bear Stearns are two of the largest investment banks in the United States. In the industry supply chain, these investment banks are the banks which have bought MBS (mortgage-backed securities). MBS are a very liquid investment, and because they are backed by real estate which is considered safe, these banks have used leverage in order to buy more securities (Woolf 2008). The fall in the housing prices has resulted in the burst of the housing bubble. When investors found out about the credit unworthiness of some of these mortgages, the market for MBS becomes illiquid as investors stop trading (Van Deventer 2008). Prices of MBS fall and firms are required to write down some significant decrease in their asset amounts, with an equivalent write down in their equity amounts under the fair value method of accounting (Scannell 2008). For Lehman, however, the huge amount of interest amounting to $5.4 billion in the second quarter of 2008 that arises from a very high leverage, $613 billion in debt has made Lehman Brothers file for bankruptcy (Economist 2008). Bear Stearns has $30.7 billion of MBS in its portfolio as of November 2007 (MarketWatch 2008). Prior to this, fair value accounting has allowed these companies to overstate the asset values as these values are in line with the bubbles, and not with true and fair value, which is determined by the future stream of cash flows (Woolf 2008). American International Group (AIG). AIGs role in the financial crisis can be considered different from those of Fannie Mae and Freddie Mac, and Lehman Brothers and Bear Stearns. When mortgage-backed securities are issued by selling banks, the risk of failure of this kind of derivative has been hedged through an insurance-like product called the CDS or credit-default swap (Van Deventer 2008). The credit-default swaps protect the buyers from the risk of default from mortgages in the mortgage-backed securities (Van Deventer 2008). Since the number of defaults has increased due to the sub-prime mortgage crisis, AIG is required to provide for the claims its CDS buyers (Crump 2008). The burden has been transferred from the buyers of MBS to AIG. AIG, being one of the largest CDS providers has an exposure to credit derivatives of up to $600 billion, including $80 billion in sub-prime mortgages (Crump 2008). Due to the sub-prime mortgage crisis, the companys net losses has reached almost $18.5 billion in June 2008 (Crump 2008). The companys credit swap portfolio, under the fair value accounting the amount of this has to be adjusted. This results in a loss in value of super senior credit swap portfolio amounting to $5.96 billion (Crump 2008). Although the company as a whole has a strong asset base and profitable operations all over the world (Crump 2008), the losses partly due to the losses incurred by the financial institutions due to the sub-prime mortgage crisis and the losses from market valuation reflects financial statements that does not show the true value of the company, which comes from the future cash flow streams from its other profitable operations. E. The financial intermediaries and their role in the crisis The whole global financial system is comprised of users of financial capital, sources of financial capital, and the financial intermediaries. The distortion of information in the market, from the point of view of the sources of financial capital has come from the financial intermediaries. As two global investment banks—Bear Stearns and Lehman Brothers have collapsed, along with the bankruptcy of AIG, the worlds largest insurer, the distortion in the information that investors perceive prior to this collapse started to unfold (Jameson 2009, 499). After these distortions have started to unfold, it caused a capital flight from the major financial markets. The sources of capital have panicked (Financial Management 2009, 20-21). One of the reasons for the global financial crisis have been the low-quality loans without enough collateral offered by banks to consumers with very high credit risks (Acharya & Richardson 2009, 38). This is associated with the housing bubble, where the housing sector in the US, with the availability of credit even to those who could not afford it (Kozol 2009, 12). This is a major fault of the financial intermediaries when they have not done enough credit check to ensure that the borrowers can qualify for a loan. This is due to the lax regulations over the US financial markets by the Fed (Duska 2009, 19). As the financial systems of major industrial countries are entangled due to convenience to global investors with the technology, those which are more entangled with the US financial system can be more affected by this crisis (World Bank 2008). F. The role of imperfect information The financial crisis has started out due to the exposure of the imperfect information in the market. For a long time, the market operates efficiently as investors have trusted the information that is available for the public. When the inefficiency of the US financial system has been exposed to the public, the imperfect information has led to inefficiencies in the financial systems (Pagano and Rossi 2009, 667). This led to the collapse of many financial markets as capital flight from risk has set in, in order for many investors to minimize the potential loss they will experience from the inefficiencies of the countries’ financial systems. G. Other light concerning the financial crisis The global credit crunch has been traced by economists and media pundits to be caused by the sub prime mortgage crisis which has disrupted the US financial system, which effect has impacted many of the advanced economies of the world. According to the article by Foster and Magdoff (2008), the ‘financialisation’ of the US economy by speculative activities in order to hoard capital is the major reason for the global crisis—where the economy has overcapacity of capital but no increase in production in order to back it up. In order to understand it better, according to Foster and Magdoff (2008) they have linked first the global financial crisis to the subsequent events that has appeared which may have been the trigger, but not the sole cause of it. While according to the article, this financialisation process which is caused by speculation of capital increased the supply of capital in the economy, and not because of faster growth of production may have taken place a couple of decades ago, the trigger has occurred when asset bubbles appeared and the Fed has started ‘to make preemptive attacks.’ The trigger starts back after the 2000 stock market crash. There are several policies which aimed to prevent “economic catastrophes” from happening (Foster and Magdoff, 2008). When the housing bubble occurred in 2006 at the same time interest rates are increased by Fed in order to regulate inflation, the housing sector as well as mortgage-backed securities faced a meltdown. This has been the start of the chain of events that lead to the global financial crisis. However, according to the authors, Fed’s efforts in order to address the crisis by bailing out several financial institutions will result in the effect that it aims to promote because the problem lies in a much deeper issue (Foster and Magdoff 2008). If we look at history of finance and the events that lead to a situation similar to the global financial crisis, the situation can always be traced back to market manias, as is the housing bubble in the United States. When there is a certain bubble, the invisible hand in the market fails to function in order to regulate efficiency (Perez 2009, 781). When manias occur, the vast speculation on a certain traded commodity creates an illusory wealth in the market. As the prices continue to increase due to the bubble, the government is forced to push more currency into the money supply. The bubble continues and wealth begins to increase due to speculation, which is merely due to ‘financialisation’ or profiting from financial capital (Blackenburg and Palma 2009, 531). As more currency flows into the money supply, the economy feels something is wrong. There is so much money in the economy which is only backed by increase in currency and money supply, not by production (Foster and Magdoff 2009). According to Foster and Magdoff (2008), this financial crisis has its roots so much deeper than the perceived roots—that is, it is rooted in overcapacity which is not supported by growth in production. As more and more currency flows into the money supply due to the illusory wealth that speculation brings, monetary inflation becomes a threat associated with it (Carfang & Togni 2009, 58). Some people see through this, and begins hoarding money and wealth in order to hedge their currency from the inflation that is about to happen. This creates panic in the market, capital flights, and then crashes follow. And this calls for more regulation. III. Conclusion and recommendations Although other lights have been shed as to the real cause of the global financial crisis such as overproduction of money supply where growth only comes from profits in financial markets without real growth in the economy, the role of asset securitisation plays a huge role in the crisis. Asset securitisation has blurred the link between the value of the assets as determined by their fundamental value and the value of the assets which are linked by their market values. As with the above examples, financial statements do not always capture the fair market value of its assets as well as its liabilities. Because fair value accounting is based on the assumptions that asset prices are the closest to reflect the fair value, prices are subject to factors other than the ones that regulate the efficient capital markets. A companys fundamental value is assumed to be reflected to the assets prices, which is aligned with the investors perceived value of it. However, distortions happen especially in times of mania and bubbles. The bubble that had preceded the global financial crisis made investors to act irrationally, which has resulted in changes in price dynamics, not necessarily a change in fundamentals. As illustrated in the examples, fair value accounting has allowed companies to overstate their assets and understate their liabilities, especially in times of mania. While the mortgage-backed securities have negative values because of the risk of default, prices due to bubbles have distorted this. While the insolvency of the credit unworthy mortgage customers must have predicted a negative stream of cash flow, which signifies negative values, the valuations show the response of the market in line with manias and bubbles instead. For companies with future profitable operations through its other products and divisions such as the AIG, this value is not incorporated. Fair value accounting has distorted the balance sheet items during the financial crisis, and not reflecting the true or fair value of the company and its activities. All of these arguments point back to a single thing – information. In order to maintain an efficient market, there should be perfect, or at least near-perfect information. The use of accounting methods in order to provide investors with information about the securities becomes of the primary targets of reform, such as in cases of manias and bubbles. From an accounting regulation point of view, this calls for tighter regulations and reforms such as enforcement of higher disclosure to investors and to the public-at-large. The less regulated non-traditional banking sectors, including investment banks and other non-traditional financial intermediaries, should also be regulated the way commercial banks are regulated. Because the financial crisis is linked with excessive use of leverage, a limit on the level of leverage should also be proposed for certain industries, especially financial institutions in order to ensure solvency and liquidity stability. This proposal goes hand in hand with a proposed minimum level of capital, especially for the financial institutions in order to adequately absorb losses from insolvency of its clients. There should also be a system-wide regulation for credit application and minimum credit requirement that banks should follow when assessing their clients ability to pay them. Works Cited __________. "Bear Stearns: latest victim of the sub-prime crisis." MarketWatch: Financial Services 7, no. 5 (2008): 4. Business Source Premier. EBSCO. 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