Who Is Responsible For The Global Downturn
Introduction: Global downturn
The present Economic crisis has gained prominence and rapidly spreading across the globe, it is been popularly known as “global financial crisis”. It has made its mark in all leading nations of the world which were known for their enormous growth in the field of technology and banking. Countries which ruled the global economies for decades have now lost their significance in international markets and there has been a drastic change in their financial positions. News stories started concentrating on financial market giants and banks collapsed which were very successful, unbeatable and highly legitimate businesses in international markets. How can the businesses which are very successful collapse suddenly? How could leading investment banks lose their value and legitimacy overnight, what could be the reasons and situations which made the bankers lose their popularity and strength? All these questions can be answered after analysing the operational abilities and capabilities of the financial organisations and their way of executing the strategies. The present global crisis can be understood only when various aspects are studied carefully, various disciplines and theoretical views need to be considered for better understanding of situation. According to new institutional theory proposed by (DeMaggio and Powell 1983; Meyer and Rowan, 1977) gives the better understanding of present crisis by explaining the crucial aspects of institutional-organisational interrelationship. In some ways it can be considered that the present crisis is not completely new, but this situation is bit similar to the previous crisis situations and bubble bursts. The general phenomenon of the previous crisis situations gives us an opportunity of understanding the present crisis scenario. Theoretical findings of the present study about the current global financial crisis give the general and fundamental understanding of the crisis situation instead of relating the aspects to particular crisis situation. Present global financial crisis not only provides opportunity to analyse the situations which drove the organisations towards downturn, it also gives clear understanding of interrelationship and working coordination of the informal organisations and financial industry organisations. For better analysis and understanding of the present crisis it is necessary to bring various theoretical arguments in to limelight and also the interplay between global financial organisation and formal or informal organisations has to be understood. International dimensions have to be considered in order to understand the current global downturn.
Here in the present case financial services organisations and investment banks are considered and their relationships with formal and informal organisations are evaluated to give better shape to the situation and analysis. Within in the span of one year US mortgage crisis has turned in to global financial crisis and influenced the major economies worldwide. The recession started in third quarter of the financial year of 2008 and it has been rated as most intensive crisis for the first time since 1974-75 situations. Unlike the previous recessions this crisis has engulfed the entire financial system of the world making the situation unfavourable to world economies. International trade interdependence and globalisation have already majorly influenced by the crisis and the growth rate has declined drastically in the recent years particularly in case of developing countries. Rapid developing and emerging economies across the world such as China, Russia, India and many other countries have started concentrating autonomous growth as they have strong domestic base and properly segmented diversifications. Though the 40% drop in gross domestic product (GDP) is not anticipated as in case of US in 1930’s, the developing nations which are involved in inter business activities will get exposed to real threat and account huge loss in international crisis. The situation would have been such worst if the financial industry organisations have stabilised, it is necessary that world nations need to head towards building more stabilised financial system in order to avoid such situation in future. Financial is interrelated system which greatly influences the economies which are linked to the system. Governing bodies of the countries plays crucial role in avoiding the recession and they need to be effective and efficient in handling the recession situations as the crisis create uncertainties and disturbances in whole financial and economic systems of the country.
Aims and Objectives:
From the U.S. mortgage crisis to the undermining of trust in the world:
World economy was on continuous growth and it has recorded the most significant and fastest growth rate in the recent years. The current global economic crisis was preceded by the drastic development and growth among different areas across the world. Except transition economies most of the highly populated countries have shown tremendous growth rates and evolved as emerging economies in the world. In the span of five years 2003-2005 the international GDP has grown more than 33% whereas it was achieved in eight years during 1990’s. Despite of rapid growth in population among leading countries they had not suffered with unemployment in the last 20 years, during 1990’s countries across the world have started addressing the major challenges and global objectives such as protection of environment, climatic changes prevention, information revolution, fighting against poverty (goals of millennium development), mass middle class creation among developing countries. Despite of conducting wide ranging experiments on major aspects such as financial services, liberalization of international trade, integration process of European regions, capital and labour flows, the international GDP has doubled in two decades. Unlike the growth scenarios of the previous two decades, major aspects such as over accumulation during intensive boom, rapidly growing imbalances across the major sectors and increased inflation fuelled situation to get much deeper than expected. For the first time in August 2007, the rapidly growing world economy has lost its stability and started downturn. When crisis across U.S housing construction started within very less time it has influenced the mortgage system which directly related to the U.S financial organisations, that was the exact pint where the prices of food, metal and oil grew up tremendously and had contributed considerably to the current recession. Russia being the first to face the liquidity crisis and gradually it has worsened the situation across many developing and developed countries of the world.
With the origin of the global economic crisis, the estimates of the international economic growth have become more pessimistic and majority of the nations across the world have been directly affected by the crisis. Most of the developing which are involved in international trade had bitter experiences, continuously growing economies have seen faster downfall with the origin of crisis as they were not sufficiently prepared for such economic calamities. The situation has become worst in the next twelve months from its origin which is September 2008 the American assets were further worsened and the loss was estimated to be several hundred millions of dollars. Unfortunately there were signs of global economic stabilisation after few bankruptcies and mergers which took place during the first two quarters of the financial year 2008. The major economic and financial regulators of U.S such as International Monetary Fund (IMF), Federal Reserve (Fed) and U.S. Treasury Department have found evidence of economic stabilisation which were not reflected. Despite of extensive work of analysts, forecasters, regulators and auditors, the crisis broke out suddenly and it has been considered to be the most severe keeping the world’s entire economic history of four centuries.
There were no evidences that any of the American financial industry organisations have suffered such extensive intensified crisis which evolved as dangerous threat to their sustenance and existence earlier in the history of international economy. All the monitory authorities of U.S have experienced sudden surprise with such intensive crisis, it can be noted that organisation for economic cooperation and development (OECD) did not monitor the international economic problems and also private financial sectors failed to assess and monitor the activities of the international economies which made the situation uncontrollable. Though the IMF has had information about inflation processes and other crucial financial policy and macroeconomic problems it has not included this information in the list of major challenging objectives of the nation. IMF has always criticised the government functioning towards tackling the financial imbalances existing in the system. IMF almost worked ‘within system’ which made the U.S unaware of the objectives of scrutinizing the probable systematic risks involved in financial system of the country. The final stage of the economic boom was included gradual increase of raw material price and energy resources and later it was not these sectors which were affected by the crisis but the entire private financial sectors belonging to rapid developing countries were tremendously disturbed by the crisis. Despite of lessons learned from 1997-98 Asian crisis situations which enhanced the regulation, improved transparency of financial organisations reporting activities and increased attention to supervision it was surprising to face such uncertainties resulted due to crisis. Though the governments of the various countries face challenges in handling the immediate threats to the nation’s stability, most influencing situations such as recession and accumulation issues related to budget system will create uncertainties and discrepancies which lead to slow down of resolving the social and other problems of the country. “An extremely dangerous period for the world socio-political condition lies ahead (the longer it lasts, the more dangerous it will be)”. The development and growth took place in the previous two decades have changed the world enormously, but now the situation arise to judge such drastic changes and tremendous growth, now it is necessary to test the durability of such growth to identify its sustenance and longevity. The situation has arrived to implement the strategies required to address the immediate issues related to the crisis, governments and the public has significant role in developing and implementing the plans to overcome the challenges of current recession. During last two decades it is found that present generations have lead their lives comfortably stable without facing any issues related to unemployment in many developing countries across the globe. There was no cold war and people lived their life in broad budget opportunities until the current crisis. Keeping the evidences and consequences of the current global financial crisis countries need to adopt the strategic plans which takes the world out of recession without major losses to the nations and also it necessary to keep the stability and sustainability undisturbed. Limiting the scale of crisis and safeguarding the economic stability are the prerequisites and any plans implemented by the governments should ensure fulfilment of these requirements. The financial estimates and forecasts have gradually changed during the last quarter of the financial year 2008; forecasters have absorbed the pessimistic results and bad news and they changed their view on future growth and development. For the first time in November 2008, the forecasts identified the negative growth for the financial year 2009 and predictions for modern recessions across the developing nations have been observed.
The global story: macro trends meet financial innovation:
The main aspect of current global crisis was the interplay between the macro-imbalances in the financial system which grown rapidly with the changing business scenarios, though the financial innovations and developments occurred during last three decades have been very supportive and advantageous, but especially the developments which took place in the last 10-15 years have grown under macro-imbalances and uncertainties.
In the history financial system, there was sudden explosion of macro-imbalances in the last decade. The east Asian rapid developing nations and some oil exporting countries such as china and Japan has enormous amounts as their current balances, where as in case of developed countries such as USA, UK, Ireland and Spain had high deficits in large current accounts. High saving rates policies adopted by China and other developing countries has worked as a key driver of macro- imbalances in the financial system. These countries have has higher savings when compared to their domestic investments which created surplus savings and can considered to be most significant management of exchange rates. China and surplus countries have implemented risk-free policies risk-free government which are bonds or government guaranteed bonds unlike investments such as equity and property or fixed income assets.
Figure: Global current account balances:
Figure: Foreign-ownership of marketable US Treasury bonds as percentage of total amounts outstanding
The interest rates policies followed by the financial institutions reached to historically low levels due to the surplus current accounts maintained by the developing countries. During the financial year 1990 the investments were only concentrating on U.S or UK as they were risk-free index-linked government bonds which were giving the maturity over 3% real, but during last five years it observed that the maturity has decreased to less than 2% and even 1% at some times. The very low and medium interest rate and long term policies adopted by the financial institution have in turn driven two effects.
Many of the developed countries such as UK and U.S have experienced rapid growth of credit extension, where as it was more specific to residential mortgages. This rapid growth was associated with degradation of credit standards in the financial market and fuelled the price of properties to boom which was perceived that lower credit standards are costless and suitable factors for extensive growth.
Figure: UK real interest rates (20 year bonds yield at May 25 or nearest week day)
Figure: Household debt as proportion of the GDP
The low or medium and long term interest policies also have triggered thoughts of investors towards high yielding investments involved with less or risk-free government bonds. Insurance or pension fund companies which were involved in selling annuities could invest at 3.5% real yield to maturity as it was completely risk-free scenario, where as it has decreased to 1.5% in the current situation. In the history of investment plans investors have always shown interest in driving their funds towards risk-free sources and in the present case the main reason behind investing such large amounts in to residential mortgages can be considered that they were perceived as risk-free investments.
Financial market innovation:
The macro-imbalances have stimulated the demand of yield uplift has been met by the most influencing aspects of the financial system such as financial innovation, packaging, trading, securitised credit instrument distribution and trading. Corporate bonds and securitised credit forms are as old as modern banking practices in the history of financial system. Securitised credit system was a creation of Fannie Mae in the 1930s and it has acquired a prominent position the global financial system as well as in American financial system. It has played a vital role in mortgage lending in U.S and recorded a stable and consistent growth since its creation in the year 1930. Securitised credit has shown the consistent growth for fifteen years till its explosion in mid 1990’s. Both scale and complexity of securitised credit have experienced explosion growth in mid 1990’s.
Value of total stocks of credit securities has experienced sudden explosive growth which in turn driven the securitised credit to become complex.
The explosive growth of alphabet soup of structured credit and increased complexity of securities sold.
The volume of credit derivatives have experienced sudden explosion making the traders and investors unaware of underlying credit exposures or to create synthetic credit exposures (fig 7).
The responsibility of uplifting the demand for yield was associated with the financial innovation. It was anticipated that value creation, liquidity, offering investors combinations of risk and return which looked more attractive when compared to the underlying credit exposures which are directly available by structuring, slicing and hedging practices. The nature of securitised credit model was changed drastically associated with extensive growth in importance of securitised credit.
The growth of securitised credit:
Source: Oliver Wyman
Causes of the international financial crisis:
Recently a conference held at Reserve bank of Australia on current financial turmoil, Adrian Blundell-Wignall and Paul Atkinson explained that present financial downturn has caused mainly due to two reasons, one happens to be the liquidity was badly affected by macro global policies which were implemented by the major market players and the other was very poor regulatory framework though it maintains far relation and acts as defence line, but contributed considerably to the present crisis situation. The liquidity was badly affected by the policies and the situation resembles dam overfilled with flooding water. Very less interest rates across countries such as one percent in U.S and when it comes to other developed country Japan has zero interest rate, and fixed exchange rates policy adopted by china lead to over accumulation of sovereign wealth funds all these factors caused liquidity overflow. Excess leverage and asset bubbles were formed to the liquidity overflow, the main faults started in regulatory system which forcefully directed huge amount of funds in to specific areas such as mortgage securitisation and activities of off-balance sheet which was started in the financial year 2004. The pressure has grown rapidly and the regulatory system was completely disturbed and it outbursts causing enormous damage [Adrian Blundell-Wignall, Paul Atkinson and Se Hoon Lee, The Current Financial Crisis: Causes and Policy Issues, Financial market trends – ISSN 1995-2864 – © OECD 2008].
In the present report the reserve bank findings are considered for better understanding and analysis of the crisis situation. Report also brings various aspects which intensified the situation leading to huge loss and economic downturn in to lime light. Though the crisis has originated in the financial year 2008, it is important to consider various aspects since the financial year 2004 in which actually system went disturbed. The present global crisis which damaged the world’s financial system is not an independent completely, but it was created by the incentives of policy actions which were adopted earlier and distortions which diverted the regulatory system from the track and it lead to uncertainties and discrepancies in the whole global financial system [Adrian Blundell-Wignall, Paul Atkinson and Se Hoon Lee, OECD, 2008].
Figure 1: Source: OECD, Datastream (The Current Financial Crisis: Causes and Policy Issues)
From the above figure 1, it can be observed that there was sudden rise of residential mortgage backed securities (RMBS) after the financial year 2004, which was instant, it is necessary that any research done on global financial crisis should explain the situation. What are main reasons behind sudden explosion of RMBS and how such instant change influenced other dependent financial system, many of the earlier reforms focussed on lapses involved with corporate governance, securitisation, under writing practices, agencies which depend on credit ratings, and poor risk modelling financial aspects, and these were the few aspects which played vital role in developing new banking business models by which they achieved enormous success in the previous years. The RMBS accelerated rapidly in the year 2004, due to the liberalisation of credit rating agencies, they became more independent and the policies turned more inferior which triggered the amount of funds invested in mortgage loans. These agencies drove banks towards making higher profits by adopting the inferior policies. During the financial year 2004, the political scenario has changed in U.S, and four major crucial factors came in to play which considerably influenced the activities of the entire financial system. Being the first initiative the Bush government encouraged the zero equity mortgage proposals (American Dream) which facilitated the low income groups of American families with mortgages. The second crucial aspects was regulator of Fannie Mae and Freddie Mac, the Office of Federal Housing Enterprise Oversight (OFHEO), imposed the large amount of capital requirements and the banks played significant role in providing low income mortgage loans. The Basel II accord on international bank regulation was published and opened an arbitrage opportunity for banks that caused them to accelerate off-balance-sheet activity and the final factor was investment banks were allowed to take part in the low income mortgage loan process which provide security to the money which banks investment in the scheme. “Prior to 2004 broker dealers were supervised by stringent rules allowing a 15:1 debt to net equity ratio. Under the new scheme investment banks could agree voluntarily to SEC consolidated oversight (not just broker dealer activities), but with less stringent rules that allowed them to increase their leverage ratio towards 40:1 in some cases”. These were the four major significant factors which occurred in the financial year 2004 and caused the banks to speed up with the securitisation of off-balance sheet mortgage to invest the huge amount of capitals and share the banks price. The conference held at Reserve Bank did not oppose the idea of living low income mortgage loans (American Dream) nor the multilayered U.S regulatory system and the higher leverage in investment banks, but it was the situation which made the whole financial system diverted from the track headed towards origin of current global crisis [Adrian Blundell-Wignall, Paul Atkinson and Se Hoon Lee, OECD, 2008].
When OFHEO demanded the huge amount of funds for low income mortgage loans and Fannie and Freddie controls of balance sheets, banks faced an interruption in their earnings and even revenue gaps with unexpected requirements of OFHEO. In order to handle the situation banks planned to create the look-alikes of Fannie and Freddie which were structured investment vehicles (SIVs) and collateralised debt obligation (CDOs). Banks responded a bit late to these sudden federal mortgage pools which made banks react slow to Fannie- Freddie regulatory system. Major issue originated due to the improper understanding of designed business model and corporate culture, this situation is clearly explained in the below figure 2.
Why was mortgage securitisation in subprime more pronounced in the USA?
The conference held at Reserve bank raised a unique question about the overall scenario of present global crisis which was how the Basel global bank regulation alone became the reason of this crisis and why has it affected only U.S., there were many reasons which were mostly related to the policies adopted. In an attempt of understanding the overall situation, the major reason was Bush administration, ‘American Dream’ policy which tried to facilitate the home loan mortgage to the lower income groups through zero percent equity which in turn generated mortgage raw materials. Secondly considered reason was the deductable mortgage interest rate policies adopted, thirdly 1986 tax reform act included the Real Estate Mortgage Investment Conduit (REMIC) rules, entity level tax was exempted in issuing multiple-class pass through securities. Mortgage securitisation was highly attracted by this tax exemption policy. The greater dominance of investment banks in U.S played in developing a new business model which was considered to be key aspect of current global financial crisis. The 1997 tax change policies which exempted the homes from paying capital gains tax unlike stock (financial assets) also contributed in overall situation which lead to global downturn. The capital restrictions implemented by Fannie and Freddie also included in set of reasons for global crisis. Overall incentives created by these aspects tempted the banks in involving over investments on low income home mortgages which gradually turned to be disaster in the later years. During the initial stages of this current crisis investment banks involvement was greater for many disasters, investments banks contributed to crisis directly and also indirectly as a part of diversified financial institution. Major investment banking giants in global market such as Lehmans, UBS, Lynch, Bear Stearns and AIG (via its investment bank subsidiary AIG Financial Products that had CDS losses on a massive scale played a prominent role during the initial stages of financial crisis of 2008. Most of the investments banks were concentrating the fee income generated through securitisation of home mortgages, the situation continued and reached were low quality mortgages are facilitated to low income group customers which was based on RMBS policy adopted by the Bush administration increased the toxic levels in leveraged vehicles and disturbed the bank balance sheets leading towards enormous damage to the whole financial system.
In case of other European countries such as Germany, Switzerland and United Kingdom adopted similar strategies which were implemented in U.S financial market to keep the lucrative market share. Banks from these European countries were strong and had enough confidence and faith on the policies adopted by the financial institutions of United States of America. Including other major financial market giants from different countries would have concentrated on the policies of investing in RMBS to keep the major market share. Majority of the investment banks competed in investing huge amounts in mortgage expecting high returns under low income mortgage plans.
Contribution of British banks in Global downturn:
Northern Rock scenario:
Northern Rock is a United Kingdom based financial organisation which is involved in activities such as holding and servicing the some pre existing mortgage and savings accounts, it is a new savings and mortgage bank. Northern Rock is an authorised bank under Financial Services Authority (FSA) for taking deposits and it deals with new savings products. In the recent years prior to the current global crisis Northern Rock recorded 25% of growth every year and it grew assets by investments extensively in mortgage plans which were borrowed heavily from whole sale markets. It invested more than 75% of their assets in mortgage products anticipating higher returns which make their share bigger in the financial market. According to Basel II concept the capital requirements of the financial institutions were relatively low after implementing the newly designed strategies. The combination of credit culture and equity culture attracted the financial institution which facilitates more expanded businesses leading more profitable mortgage products enhancing their share price and business expansion. Companies anticipated giving excess capital to shareholders with an equally beneficial impact on the share price.
Here is the response of the Northern Rock CEO in the UK Treasury Committee Evidence:8
“Mr Fallon: Mr Applegarth, why was it decided a month after the first profit warning, as late as the end of July, to increase the dividend at the expense of the balance sheet? Mr Applegarth: Because we had just completed our Basel II two and a half year process and under that, and in consultation with the FSA, it meant that we had surplus capital and therefore that could be repatriated to shareholders through increasing the dividend”.
Northern Rock had total assets of GBP 113bn along with GBP 2.2bn of share holder’s equity by June 2007, just before the crisis origin and when liquidity was about to dry up. It had 16.7% of their total assets as RWA under Basel II which was nearly GBP 19bn. Despite of their enormous growth and stability, they were the first British bank to suffer since 1866 and their regulatory capital reached less than 10% of GBP 23 billion which was nearly equal to the amount supported by authorities.
High economic growth rates worldwide since the beginning of the 2000s, against the background of serious savings imbalances:
In the current economic scenarios the systematic problems in financial systems across the world have been rapidly growing, it can be understood from empirical studies conducted on major countries that the negative balance of payments have been accumulated especially in U.S since 2006, and on the other hand the developing such as India and china have surplus growing amounting to trillions of dollars, or about 1.2 percent of world GDP (Figure 2). When flow of savings are considered the developed countries have enormous amount when compared to developing countries, such great difference in savings between developed and developing countries created the imbalances the whole financial system of the world, which lead to the origin of current financial crisis.
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