Financial Crisis explained

As Gordon Gekko puts it in the movie "Wall Street" - "Greed is the Mothers milk that will keep the malfunctioning corporation of USA alive". This was 1987 and exactly 20 yrs down the line capitalists have proved why greed isnt good all the time. There was immense greed to make money, whatever be the means, amongst all factions of the capitalist set up right from companies to investment bankers to shareholders. Corporate governance and shareholder activism to question what is right and wrong went badly amiss. The primary cause for the subprime crisis to have manifested itself as a global systemic disease leading to the collapse of economies, countries and banking behemoths world over was because of a simple instrument designed to hedge risks in the 19th century commonly known as "Derivatives". These instruments derive their value from another instrument that they are intended to represent. For example : Crude Oil futures derive their value from the prices of crude oil. This proved to be a blessing to commodity traders and businessmen who could protect themselves from the vagaries of price fluctuations for physical commodities like Oil, Gold, Metals etc If X had to import 500 barrels of Oil from dubai, on the date of entering into a transaction with his dubai supplier he would also buy oil futures of equal value to hedge his price risk on Oil. So lets assume when on the date of transaction where he agrees to import oil (3 months later), oil prices in the real/spot market are at $50 per barrel. So he would pass an accounting entry for $25000 (500*50) in his books as oil purchases. Simultaneously he buys oil futures for the same 500 barrels from the derivatives market at $50 for a 3m future delivery. Now 3 m down the line, lets say a barrel of crude oil quotes at $ 55, what would X do and how does he benefit by having entered into two transactions 3 m earlier. This is how it works : X will pay $55 per barrel to the dubai supplier thereby having an outgo of $27500 (in place of $25000 for which the transaction was booked ) . In effect he would suffer a loss of $2500 die to oil price increase. But this loss gets nullified with the help of the derivative contract he has entered in the oil futures market. Since oil quotes at $55, in the futures market X would make a gain of $ 2500 by selling the futures contract . This is how derivatives had helped in the past by mitigating and hedging risk effectively. Enter the financial shenanigans of Wall street who spot an opportunity in derivatives and extrapolate the same process to the currency markets first and later on to the entire financial universe. Derivatives as hedging instruments would work only when they have a physical asset backing them and that too only when the structure of a transaction is designed as a two way hedging tool (especially in financial markets) i.e a transaction in the spot market complimented by an opposing transaction in the futures market..For eg.. X buys 1000 shares of Reliance at Rs.1200 per share and simultaneously sells Reliance futures contracts in the derivatives market for equal value to protect his cash position. So even if Reliance share prices fall, he doesnt not lose money net net because of the profits he makes in the futures market. Given this background, Wall street brokers and investment banks saw immense lending by commercial banks and financial institutions in the housing market. These banks were guided by the policy of "housing for all" and the aspiration of the common man to "own a house". Alan greenspan, the then fed governor lowered interest rates to an all time low from 2001 onwards to fund the iraq and afghan wars of USA. This led to huge increase in money supply as government borrowing also stepped up pulp priming the economy. Fed's printing machine at Fort Knox worked overtime printing the US dollar(ofcourse with the face of george wahsington inscribed on it) and banks with excess money had to lend given the burgeoning demand from the american public buttressed by lower interest rates and tax rebates for home owners. Banks gleefully began to lend to every tom, dick and harry and increased their balance sheet size to abysmal levels. There was no regard whatsoever as to what was the borrower's ability to repay. All bankers believed in the theory that real estate prices had only way to go..that is Up. Land and property prices were expected to appreciate continuosly into the future. As legendary investor benjamin graham's old adage goes " History repeats itself but Wall street people learn nothing and forget everything" . Everyone forgot what happened in 1997 to South East Asia and Japan's lost decade of 1990-2000. They were all real estate bubbles fuelled by excessive credit that ruined these economies for years and decades to come. So a significant segment of the US population almost to the tune of 7% were subprime borrowers. These were borrowers with no income or proper credit standing as already explained above who became owners of house properties (imagine a day when slums wont exist in india..will it ever happen?? It happened in US because of the benevolence displayed by Bush n Co). Now what did these people do to meet their EMI obligations since every dollar borrowed has to be repaid. The banks again helped them here. These innocent souls did not realise what they were getting into. As housing prices kept hitting the roof, banks told them they could borrow even more using their houses again as secondary collateral. So came in the concept of refinance..With this arrangement they could borrow more to repay their existing interest and principal committments. It became a vicious circle based on a simple one way bet on housing prices appreciating continuosly. Enter the Wall street brokers, they too wanted to make money from this superb real estate financing juggernaut. They had the weapon and ammunition which normal banks did not have. They had super achievers and Ivy league grads in their workforce to boost their reputation. The weapon and ammunition these lads brought in on the garb of financial innovation and obscure statistical models were the same derivatives reinvented in a different format. A wall street position was such a coveted job for many and was until last year the essential "American dream" for every sophomore. How did this turn out to be a pipe dream? How did these derivatives become weapons of mass destruction? Read on Wall street guys got in touch with all the banks across USA and Europe and explained their business model as to how banks need not wait to recover the money from their borrowers, rather they could use these derivatives modelled through them to get immediate realisation of the loans granted. The methodology given to them by our friendly wall street people for a hefty commission was called "Asset Backed Securitisation". The loans granted by banks were secured by house property as a physical asset. These loans which were receivables / debtors in the bank balance sheets could be shifted out of the balance sheet by converting them into a Special purpose vehicle. So all these advances or loans granted were taken out of the balance sheet and converted into AAA rated bonds which would be issued to investors worldwide. The basic premise or assumption was that subprime borrowers would never default because housing prices will keep increasing in the future. Even if they do, their properties could be repossessed and disposed off at high prices and thereby loans could be recovered. The possibilities of default were considered negligible and this was the achilles heel of this whole mechanism. This was how the investment banks pooled all the receivables of various banks in US and UK and converted them into bonds which were sold to investors worldwide in US,UK, China, Japan to name a few. These investors typically comprised of investment banks, financial institutions, pension funds, government agencies, high networth individuals etc. As housing prices never seemed to be falling or depreciating, these investors lured by high returns from these bonds or derivative instruments( known by different jargons like ABS- Asset backed securities or CDO- collateralised debt obligations) started investing huge sums of money. Investments banks were buoyed by the fee based commission they were earning from this business of securitisation and started inventing newer financial models to make money. All these investors forgot the simple fact that what they were investing into was a derivative instrument whose value was dependant on the performance of the asset pools or in other words continuos repayments from the original subprime borrowers. Another aspect which made these investors blindly invest in these instruments were their reliance on the AAA ratings issued by global credit rating agencies like S&P and Moody. Even rating agencies known for their sophisticated risk assessment models failed in their role and duty as watchdogs. All investors who had faith in ratings ended up becoming slumdogs. As sub prime borrowers kept making their interest payments, these payments were used by banks in turn to meet the interest committments on bonds issued to investors globally. All these models were working fine as long as housing prices were stable. The banking regulators failed to predict the magnitude of crisis that would engulf them in the event of property prices collapsing in the US. They failed to lift the smokescreen and see that subprime borrowers were meeting their loan committments only through refinancing of their properties and not out of their monthly incomes (which in either case was negligible or non existent). Turn to 2006-07, America was hugely saddled with debt. Leverage was enormously high. Banks balance sheets were leveraged 30-40 times their networth/equity. A large portion of the debts picked up by banks were amounts owed to investors abroad on these subprime bonds that they had issued. US being a largely consumer oriented economy and being the worlds largest consumer ran a huge fiscal deficit. Countries like China, Japan and India were funding US consumption. Savings was just 0.9% of their GDP(Gross Domestic Product). Private sector Debt to GDP had balooned to 300%.The total debt US owed reached $50 trillion for a country whose GDP was $13 trillion. US debt exceeded the world GDP. The last time the debt balooned beyond 150% in US was prior to the great depression of 1929 and we all know the dangerous consequences of the same. A similar story was scripted again by relentless credit creation and fiscal profligacy arising out of greed. When government borrows at such a large scale, there would be obvious pressure on interest rates to start rising. Greenspan was forced to cut down the excessive money supply in the economy which was fuelling inflation to record levels. FED began to raise interest rates in the economy. The trouble started for subprime borrowers. The days of low interest rates were over and monetary policy action had swung in to curb excessive spending and provide for fiscal consolidation. A few set of borrowers started to default on their loan obligations towards end of 2006 and these banks promptly repossessed their houses, disposed them at the prevailing high prices and repaid the bonds too . What goes up can come down. As the mess started getting bigger in 2007 with more loan defaults, greater number of houses were repossessed (otherwised called foreclosures) and resulted in a huge supply of houses waiting to be sold at bankruptcy courts all over US. Subprime borrowers went to the streets with all their posessions. With interest rates at such a high, obviously there would be few takers for housing loans as consumers would postpone their decisions to purchase a house. This led to the massive collapse in the housing market due to over supply and lack of demand. The supply glut meant housing prices began their downward spiral into a bottomless pit. Existing subprime borrowers became ineligible for further loans as banks refused to refinance them due to falling property prices. Consequent to the drop in market values of property, banks also started demanding additional collateral from subprime borrowers on the loans issued to them. With no means to make even a semblance of repayment they had no other option but to foreclose and surrender their houses. As 7-8% of the population got their act together to foreclose one can envisage the magnitude of the crisis that had befallen the richest country on earth. Almost $1 trillion, the size of Indian GDP was swallowed by subprime borrowers alone and it meant wiping out 7-8% of the US GDP. Add to this the credit creation process of global investment banks through the securitisation process of issuing bonds and other derivatives. The derivatives market world over reached a size of a mammoth $600 trillion by 2007 (12 times World GDP) through excessive credit creation. Moreover add to this another innovative instrument invented by wall street pundits called the "Credit default swaps" (CDS). These instruments offered protection from default on any loan or advance made for the cost of a hefty premium called protection fee. Most banks and insurers had purchased these Credit default swaps from investment banks like Lehman Brothers, Bear Sterns and Citigroup etc. In the event of a default on their receivables, these investment banks would take over those receivables from these banks who had lent in the first place. Investment banks were having a free ride on the premium income for more than 7-8 years as instances of defaults were quite low when the US economy was in an upswing. As the saying goes, the chickens had finally come home to roost and these CDS instruments became an albatross around the neck of investment banks. The world economy was caught in a systemic crisis with the fall in property prices refusing to die down. Banks had to write off their receivables and loans which meant wiping out their net worth to a large extent especially in case of banks which had huge debt- equity ratios. They could not meet their committments to holders of these subprime bonds/derivative instruments and started defaulting on the same. They approached these investment banks for help seeking to redeem the CDS instruments they were holding. But these investment banks had a similar story to tell. With housing crisis having a brutal impact on financial markets, the stock markets too went into a tailspin. Investment banks were sitting on huge portfolio losses on their stock market operations. IPO's had dried up completely and the debt market was caught in a state of shock. They could hardly underwrite any deals in such a situation and this impaired their operations and profitability severely. Add to this the situation where apart from underwriting several securitisation deals for hefty commissions, these firms had also invested billions in them. Many firms like lehman and bear sterns reported dismal numbers towards the end of 2007 and needed emergency capital from US federal reserve to survive. As newsflow from the financial world kept getting worse day by day, there was a severe crisis of confidence in the global financial markets. The cost of protection for credit default swaps swelled indicating high probabilities of defaults and this resulted in the widening of credit spreads for even AAA rated instruments ( AAA rating is the highest rating of safety and security of a debt instrument as to its timely repayment of debt obligations). The difference between interest rates of a AAA instrument and US treasury bond ( which is considered risk free as it comes from the government) widened to as much as 17-18%. Major rating agencies like S&P and moody's started downgrading the ratings of major financial institutions and investment banks. Quarter after Quarter into 2008, the write off's continued all across the financial world. US FED now run by Ben bernanke cut interest rates to levels below 1% to stimulate the economy and kick up inter bank lending to restore confidence in the system. They also opened up separate windows of credit to shore up the capital and equity base of major banks in the US. But these steps were just not enough when the size of the mess was so unprecedented. On one hand banks found their assets to be worth nothing as all the amount lent vapourized into thin air but the liabilities and debts kept inreasing due to the nature of contracts and excessive leverage they had assumed on their balance sheets. Each banking company had an asset liability mismatch of gargantuan proportions. Many of the bank's chieftains were in self denial mode for months altogether promising stakeholders that they are positive about recovering from the hole they had fallen into. Most of these banks were also not willing to take help from FED which meant government interference and control. Beggars cant be chosers in this world and fine words butter no parsnips. Little did they know that the black swan event was around the corner. Saddled with toxic assets, debt obligations rising by the day and revenue streams literally closed out and capital not forthcoming from friendly quarters, Bear Sterns decided to file for bankruptcy followed within 6 m by lehman brothers. These 150 year old institutions had a major role to play in the world financial markets. Majority of trades and transactions in the US capital makets happened through them being counterparties to various classes of investors. A lot of investor/institutional/hedge fund money was locked up with them and these were no more recoverable. These events sent the credit markets into deep freeze mode. Inter bank lending completely stopped due to deep mistrust about the financial position of each other. There was immense hoarding of cash and risk aversion was at its peak. In times of crisis, there is always hectic deleveraging and money always goes to US treasury bonds which is considered a safe haven. Its pretty ironical that money went back to the same place where the crisis had originated, but the dollar being the world's reserve currency this was very much on the cards. All sorts of financial assets that were considered risky faced a severe unwinding. Equity markets globally suffered the most. All roads led to the US treasury. Emerging markets like India also faced the brunt with the indices falling more than 68% from its peak. India has seen investor wealth erosion of more than Rs.40 trillion over the last one year due to an external event we were not even responsible for in the first place. But thats the price one pays for the adverse effects of globalisation. As i write this article, the effects of this financial crisis of the 21st century has engulfed the real world big time. The sins committed by wall street have affected main street too. The crisis has spread into the real economy sending the world into recession with massive layoffs and job losses across industries and sectors. The lack of credit and working capital for running the day to day operations of businessmen across the globe has had a massive impact on industry dynamics. With banks not doing their primary activity of lending, investments have slowed down in the real economy. The manufacturing sector is facing a huge demand destruction and order book cancellation . Slowdown in industrial demand has also led to a massive sell off in the commodities market with most of them quoting at multi year lows. Lay offs and downsizing have become oft recited terms with unemployment expected to reach 10% in US alone. Bush followed by Obama now have been doling out stimulus packages dime a dozen to kickstart the credit markets and revive the economy. But things still seem to be stagnant and confidence is yet to be restored in the financial markets. The S&P and Dow index have broken 12 year lows and these are indications of worse things to come. More banks might even fail. US seems to be doing the same mistake that Japan did in early 90's. The world faces the risk of going into prolonged recession followed by deflation for many years unless some important measures like the following are taken at the earliest : 1. The size of this crisis is so huge that no one is certain as to the magnitude of losses sufferred by banks and financial institutions. Therefore to restore confidence all banks need to be nationalised in the US and Europe with a blanket guarantee on all deposits by the respective governments to prevent bank runs from happening. This will restart lending activities from conservative banks like JP morgan which has not got itself into the subprime mess to a large extent. Banks from China may also be willing to lend once they regain confidence in US banks. 2. The carnage and deadlock in the housing markets needs to be stopped. The objective should be more of keeping people in their homes rather than putting people into new homes. Therefore foreclosures must be stopped which would mean the government would have to waive all the borrowings and liabilties of homeowners/subprime borrowers who do not have the ability to pay up. 3. Toxic assets arising out of derivatives which are still finding a place in bank balance sheets must be taken over by the government at a fair valuation. Right now there are even proposals to create a bad bank which will take over all the toxic assets from US banks and help them clean up their balance sheets. Once housing market improves, these assets can be offloaded as government bonds at reasonable prices 4. Inject liquidity into deserving banks to shore up their capital base and reduce their leverage ratios to reasonable levels. The government gets a stake in all these banks as its hardearned taxpayers money that goes into revitalising these broken and busted institutions. No more instances of privatising profits and socialising losses if capitalism has to survive. 5. A new world financial order is required on the lines of the Bretton Wood Conference of 1944. Basel II norms for banks must be made much more stringent with regulators insisting on high capital adequacy norms and regulatory oversight. Reforming the role of IMF (which was sleeping at the wheel along with financial regulators) to preempt and prevent a future financial crises is also a need of the hour. Warning signals and risk monitoring systems must be set in place for preventing asset bubbles and intense speculation in financial markets. 6. Rating agencies also have to take equal share of the blame and be made accountable for being lackadaisical in their approach towards rating highly leveraged institutions. Their mandate is to foresee an impending risk and express an opinion on the same to ward off investors at the right time. God knows how AAA ratings were issued to institutions that were leveraged 30-40 times over their equity base. An overhaul of the entire ratings process may be timely. Amidst all this global gloom and doom scenario, India has been relatively insulated to a limited extent from the financial crisis. No doubt, capital flow has dried up and our exports have been hit badly, but the latter constitutes only 20% of our GDP. Our growth story emanates from within and despite a slowdown we will continue to chug along at 5% growth rates for the next couple of years, given that our internals continue to remain strong. RBI is sitting on huge forex reserves and our external debt situation is also reasonable at 25% of GDP. We have been inflation coming down to sub 5% with fall in global commodity prices and interest rates will also follow suit soon. Once deposit rates start falling we will see the benefit of lower interest rates percolating down to the economy. At present India has also caught cold due to relentless sneezing by US. It is under these circumstances that the government of a country needs to be proactive. The banking system is safe and sound and we have no problems with capital adequacy. This gives enough license for the government to start spending on infrastructure projects all across the country. This is a once in a lifetime opportunity and with commodity prices at such low levels, the cost of execution of projects will also end up on the lower side. Since our fiscal deficit is already at high levels of 10-11% of GDP, we must use our forex reserves to fund major projects. Government spending as a counter cyclical measure always restores confidence and equilibrium in the economy and foreign funds will automatically flow in to the country restoring our double digit growth rates in a few years time. Political will, vision and thought leadership is the need of the hour if India has to be another China. As for the financial crisis which continues to have ramifications globally, it may take years for US and Europe to come out of disarray. The G20 and other forums of the world must join together to ensure that deflation is avoided at all costs. This definitely is not the last financial crisis of the world. We have had many in the past and we will continue to have many in future. But whats important is how strong the world emerges from each of them and what are the learnings that we take forward into the next generation. History does repeat itself!!