M2 Magazine May 2009

A BLUFFERS GUIDE TO THE GLOBAL FINANCIAL CRISIS

There has been much debate and proposed theory offered as to the cause of the 2008 global financial crisis. It just didn’t suddenly happen the signs were there a number of years ago. Unfortunately no-one wanted to listen. It was simply a matter of when it would happen.

The rate at which property prices soared throughout the western world fuelled by property developers and shady lenders pushing through bad loans for the sake of their own commissions wasn’t sustainable. When interest rates began to rise, the bubble burst and many finance companies became insolvent leaving a long line of carnage behind them, not only in the U.S. but all around the world.

Subsequently the N.Z. & Australian economies experienced a similar set of outcomes. The prices of houses were increasing on a monthly basis and the debt level in these economies was like an inflated air balloon that kept growing with nothing of real value to sustain it but hype. NZ overseas borrowing was climbing and generally for the purposes of consumption rather than projects that would develop wealth in our country. The economic crisis is not a new event in history it’s happened before and it will no doubt happen again.

The crisis began in the United States when the default rates climbed on ‘subprime’ and adjustable rate mortgages provided to persons with in the housing sector beginning in 2005–2006. (These types of mortgages are provided to persons with little or no equity in their properties and unable to get funds through the normal banking channels).

Government policies and competitive pressures for several years prior to the crises encouraged higher risk lending practices. Further to this, an increase in loan incentives such as easy initial terms and a long-term trend of rising house prices had encouraged borrowers to assume difficult mortgages in the belief that they would be able to quickly refinance at more favourable terms. However, due to a ‘tightening up’ in the money supply banks raised their interest rates to attract more funds into their banking system from local and overseas investors. The shortage of money soon caused a lower demand on housing and prices started to fall moderately in 2006 – 2007 in many parts of the U.S. Refinancing became more difficult. Defaults and fore-closure activity increased dramatically as easy initial terms expired, home prices failed to rise as anticipated and interest rates were set higher. Fore-closers accelerated in the United States in late 2006. By this time confidence had been lost in the U.S economy and so the global financial crisis through 2007 and 2008 was the result. During 2007 nearly 1.3 million U.S. housing properties were subject to fore-closer activity, up 79% from 2006.

In a nutshell for some cases as prices fell the equity that these homeowners thought they had was eroded into a negative position. They were then faced with having borrowed more than their properties were worth and they were saddled with higher repayments.

Financial products called mortgage-backed securities (MBS), which derive their value from mortgage payments and housing prices, had enabled financial institutions from around the world to invest in the U.S. housing market. Major Banks and financial institutions had borrowed and invested heavily in MBS and reported losses of approximately US$435 billion as at 17th July 2008. The liquidity and solvency concerns regarding key financial institutions drove central banks to take action to provide funds to banks to encourage lending to worthy borrowers and to restore faith in the commercial papers markets, which are integral to funding business operations.

Governments in the U.S and in Europe also bailed out key financial institutions assuming significant additional financial commitments. The risks to the broader economy created by the housing market downturn and subsequent financial market crisis were primary factors in several decisions by central banks around the world to cut interest rates and governments to implement economic stimulus packages. These actions were designed to stimulate economic growth and inspire confidence in the financial markets. Effects on global stock markets from the crisis have been dramatic.

Between 1st January and 11th October 2008 owners of stocks in U.S. corporations had suffered about $8 trillion in losses as their holdings declined in value from $20 trillion to $12 trillion. Losses in other countries averaged about 40%. Losses in the stock markets and value declines place further downward pressure on consumer spending, a key economic engine. Leaders of the larger developed and emerging nations met in November 2008 to formulate strategies for addressing the crisis.
Factors contributing to the crisis were a culture of consumerism and immediate gratification, spending all of an individual’s disposable income on consumption or interest payments is a major force in the U.S. economy and other western capitalist countries.

Fractional-reserved banking was another major factor that impacted on the US financial meltdown and the crash of so many NZ Finance company’s which followed. It is the practice whereby the finance companies keep only a fraction of their deposits in reserve (as cash and other liquid assets) and lend out the remainder. Under this practice the banks and finance companies maintain the simultaneous obligation to redeem all deposits immediately upon demand. In other words if a deposit is made into a bank of $100.00 the bank is allowed to lend out $80.00 and in some cases more. This practice of fractional-reserve banking is universal in modern banking and usually works well. At any one time relatively few ‘at call’ depositors will make cash withdraws simultaneously (a bank run) compared with the total deposits, and cash reserves can be maintained as a ‘buffer’ to deal with normal cash demands from depositors seeking withdrawals.

New Zealand banks do not practice fractional reserve banking. In accordance with Reserve Bank regulations all Trading Banks must hold the equivalent value of all their lending in both cash or Government stocks and bonds. Unlike finance companies who may participate in fractional reserve lending.

Speculation in residential real estate has been another contributing factor. While homes had not been traditionally treated as investments this behaviour changed during the housing boom.

During 2006, Wall Street executives took home bonuses totalling $23.9 billion. The New York State Controller’s Office stated that “Wall Street traders were thinking of the bonus at the end of the year, not long-term health of their firm”. The whole system – from mortgage brokers to Wall Street risk managers – seemed to lean toward taking short-term risks while ignoring long-term obligations. The fact that the crisis occurred without intervention at any stage from senior banking executives is 2.
evidence that most of them weren’t fully aware of what was happening in the market and certainly not cognisant of the serious implications of the warning signs.

Also critics allege that the credit rating agencies suffered from conflict of interest as they were paid by investment banks and other firms that organised and sold structured securities to investors; in many cases lending long term on short-term borrowing while expecting that these monies would be easily rolled over for another term.

The failures of the financial markets were not caused by complex financial instruments. They resulted from failures in leadership. Heads of the failed firms forgot two basic principles of business that ensure firms maintain financial stability and protect their customers.

Although there is a long list of obstacles that could cause a hiccup in the US government’s ongoing economic turnaround efforts, its single biggest challenge may come from its largest biggest creditor and that is China. China has cause to be concerned, as of the latest figures show, China holds $727.4 billion in US Treasuries – about 26% more than the $578 billion in US government securities the Asian giant held at the end of 2007. Ref: Money Morning Publication Baltimore USA 26th March 2009.
On the positive side though, tough times encourage innovation and create other opportunities. It’s just a matter of taking time out, thinking laterally and finding them. Let’s face it, the world keeps on turning and as William Wycherly wrote in 1671,"Necessity is the mother of invention" .is very much relevant in today’s world.

Fred Stewart – Business Doctor.