Guys, while doing Bubbles and crashes I did mention about the causes of the Subprime crisis and global financial melt down. Couple of days back I read this article of my favorite author Mr. Swaminathan Aiyar. He has explained the reasons very simplistically and effectively. So please go through this…
The Federal Reserve Board
Alan Greenspan, Fed Governor in 1987-2006, was once hailed as a genius for keeping the US booming, but is now called a serial bubble-maker. He presided over bubbles in housing, credit, and stock markets. He said it was difficult to identify asset bubbles in advance, so anti-bubble policies might be anti-growth. It was better to let bubbles build, and sweep up after they burst. Bernanke, like Greenspan, ignored the US housing bubble till it burst.
US politicians
Envisioning a home for every American, regardless of income, they provided excess implicit and explicit housing subsidies. One law forced banks to lend to subprime poor borrowers. Legislators created Fannie Mae and Freddie Mac, government-sponsored entities that bought or underwrote 80% of all US mortgages, and enjoyed exemption from normal regulations. Politicians ignored Greenspan’s warning that such a dominant role for two under-regulated giants posed a huge financial risk.
Fannie Mae and Freddie Mac
They resisted regulation, and spent over $2 million lobbying legislators against any tightening of rules. As mortgagers of last resort they should have been especially prudent. But they bought stacks of toxic mortgage paper — collateralised debt obligations (CDOs) — seeking short-term profits that ultimately led to bankruptcy.
Financial innovators
Their ideas provided cheap, easy credit, and helped stoke the global economic boom of 2003-08. Securitisation of mortgages provided an avalanche of capital for banks and mortgage companies to lend afresh. Unfortunately the new instruments were so complex that not even bankers realised their full risks.
CDOs smuggled BBB mortgages into AAA securities, leaving investors with huge quantities of down-rated paper when the housing bubble burst. Financial innovators created credit default swaps (CDSs), which insured bonds against default. CDS issues swelled to a mind-boggling $60 trillion. When markets fell and defaults widened, those holding CDSs faced disaster.
Regulators
All major countries had regulators for banking, insurance and financial/ stock markets. These were asleep at the wheel. No insurance regulator sought to check the runaway growth of the CDS market, or impose normal regulatory checks like capital adequacy. No financial regulator saw or checked the inherent risks in complex derivatives. Leftists today demand more regulations, but these will not thwart the next crisis if regulators stay asleep.
Banks and mortgage lenders
Instead of keeping mortgages on their own books, lenders packaged these into securities and sold them. So, they no longer had incentives to thoroughly check the creditworthiness of borrowers. Lending norms were constantly eased. Ultimately, banks were giving loans to people with no verification of income, jobs or assets. Some banks offered teaser loans — low starting interest rates, which reset at much higher levels in later years — to lure unsuspecting borrowers.
Investment banks
Once, these institutions provided financial services such as underwriting, wealth management, and assistance with IPOs and mergers and acquisition. But more recently they began using borrowed money — with leverage of up to 30 times — to trade on their own account. Deservedly, all five top investment banks have disappeared. Lehman Brothers is bust, Bear Stearns and Merrill Lynch have been acquired by banks, and Morgan Stanley and Goldman Sachs have been converted into regular banks.
Rating agencies
Moody’s and Standard and Poor’s were not tough or alert enough to spot the rise in risk as leverage skyrocketed. They allowed BBB mortgages to be laundered into AAA mortgages through CDOs.
The Basel rules for banks
These international negotiated norms provided harmonised regulatory checks on financial excesses across countries. The first set of norms, Basel-I, was widely criticised as too rigid and blunt. So countries agreed on Basel-II, which allowed banks to use credit ratings and models based on historical record to lower the risk-ratings of many securities. This dilution of norms led to excesses everywhere. Iceland’s banks went bust holding loans/securities totalling 10 times its GDP. The dilution of risk-rating in Basel-II helped inflate the financial bubble.
US consumers
Their savings used to be 6% of disposable income some time ago, but more recently has been zero or even negative. They have gone on a huge borrowing spree to spend far more than they earn. This excess is reflected in huge, unsustainable US trade deficits.
Asian and Opec countries
They undervalued their currencies to stimulate exports and create large trade surpluses with the US. They accumulated trillions in forex reserves, and put these mostly into dollar securities. This depressed US interest rates, and further fuelled borrowing there.
Everybody
Consumers, corporations, banks, politicians, the media — indeed everybody — was happy when housing prices boomed, stock markets boomed, and credit became cheap and easily available. Bubbles in all these areas grew in full public view. They were highlighted by analysts, but nobody wanted to stop the lovely party. Everybody liked easy money and rising asset prices. This trumped prudence across countries.
No comments:
Post a Comment