A re-examination of the credit crunch

The financial crisis of late 2008 and the global recession which has followed is a topic of great interest to researchers, businesspeople, policymakers and the public. The global financial crisis has its roots in the US, Europe and other advanced countries. Indeed, the crisis which had erased around US$25 trillion from the value of stock markets seems largely to have been unexpected. Partly this was because it came on the heels of a seven-year period of high growth and originated in the US; many had expected a global slowdown to start in the emerging markets.

Both the initial destruction of financial wealth as well as the psychological shock of seeing many elite Wall Street firms on their knees, prompted numerous commentators to initially raise the specters of the great depression. Although not the great depression, it is indeed true that the world is staggering from financial to economic crisis as the US, EU, Japan and other high-income economies entered the recession at the end of 2008. Having decimated Wall Street and then crippled Main Street, the financial crisis seems like a hurricane about to sweep across the developing world.

Causes of the crisis

Its proximate causes include sub-prime lending, unsustainable financial engineering, derivatives usage, and faulty credit rating by agencies, a lax regulation and large global imbalances in those countries. But the fundamental cause of the crisis was the loose and excessively accommodative monetary policy followed by the US and other advanced economies from 2002-04.

Sub-prime lending

The sub-prime crisis which broken out in 2007 had resulted in the bankruptcy of Lehman Brothers, the acquisition of Merrill Lynch and the nationalization of the major banks in Europe such as RBS, which is the magnate of the commercial banks. It generated a huge crisis of the liquidity of the major banking market all over the world; banking industry had also appeared in a wide range of large-scale losses.

To put it very simply the subprime crisis was caused because the lending norms in the US were very lax. The value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007, with over 7.5 million first-lien subprime mortgages outstanding. In addition to easy credit conditions, there is evidence that both government and competitive pressures contributed to an increase in the amount of subprime lending during the years preceding the crisis. Major U.S. investment banks and government sponsored enterprises played an important role in the expansion of higher-risk lending.

Some, like American Enterprise Institute fellow Peter J. Wallison, believe the roots of the crisis can be traced directly to sub-prime lending by Fannie Mae and Freddie Mac that are government sponsored entities. Subprime mortgages remained below 10% of all mortgage originations until 2004, when they spiked to nearly 20% and remained there through the 2005-2006 peak of the United States housing bubble. A proximate event to this increase was the April 2004 decision by the U.S. Securities and Exchange Commission (SEC) to relax the net capital rule, which permitted the largest five investment banks to dramatically increase their debt to capital ratio (from 12:1 to 30:1 or higher), financial leverage and aggressively expand their issuance of mortgage-backed securities.

The history behind the asset bubble can be found in the desire of the US government to increase home ownership in the US. Though the intention is good, the methods it took to achieve the cause, was quite disastrous. Unfortunately, the way it chose was by distorting the lending decisions of banks and other mortgage market participants, which is evident in the rationale behind the Community Reinvestment Act (CRA) on insured banks in 1977 and an "affordable housing" mission on Fannie Mae and Freddie Mac in 1992. “The government--through CRA--required banks to lower their lending standards. Down payments, steady jobs, good credit histories, and income levels commensurate with mortgage obligations were abandoned in favor of "flexible" lending requirements” (Wallison, 2008). This resulted in many sub-prime mortgages being approved, which otherwise, wouldn’t have been so.

This applied additional competitive pressure to Fannie Mae and Freddie Mac, which further expanded their riskier lending. Subprime mortgage payment delinquency rates remained in the 10-15% range from 1998 to 2006, then began to increase rapidly, rising to 25% by early 2008.

Though the politicians were quick to jump and accuse private investors in Wall Street for the crisis, it would be unfair to leave the legislators out of the blame game. Government policies ensured that when the bubble began to deflate, there would be little equity left in the assets, mainly due to “cash-out refinancing”, which allowed homeowners to draw out their equity through refinancing when their asset prices rose in value.

Accompanying rises in house prices further fuelled credit growth, especially through mortgage lending. In the US, subprime market mortgage lending, to households without the essential means to repay loans, took on huge proportions; according to Lin (2008) about US$1.3 trillion was lent in subprime mortgages. US mortgage lenders securitized these subprime loans, which were then sold throughout the financial system as assets. They were able to issue and securitize these bad loans due to a combination of inadequate regulation and financial innovation. The latter made it difficult for other institutions to assess the risks of these securitized mortgages and led to increased subprime mortgages (Bicksler 2008). Thus in spite of their underlying risk, they were taken up by financial institutions. As put by Krugman (2007),

The innovations of recent years—the alphabet soup of C.D.O.’s and S.I.V.’s, R.M.B.S. and A.B.C.P. — were sold on false pretences. They were promoted as ways to spread risk, making investment safer. What they did instead—aside from making their creators a lot of money, which they didn’t have to repay when it all went bust—was to spread confusion, luring investors into taking on more risk than they realized.

Deregulation

Critics have argued that the regulatory framework did not keep pace with financial innovation, such as the increasing importance of the shadow banking system, derivatives and off-balance sheet financing. In other cases, laws were changed or enforcement weakened in parts of the financial system.

There were high levels of financial innovation on Wall Street, driven by a search for higher yields in a low-interest-rate environment. Much of this innovation was carried out by firms whose activities were not regulated, and other new instruments were too complex to be effectively regulated. As a result, policies tended to advocate for deregulation of financial markets and were sometimes accompanied by additional lax supervision.

The great rush for Mortgage Based Securities, was mainly due to the fact that regulators demanded lower capital requirements for residential mortgages than for other assets. For commercial loans, banks were supposed to back it up by 8% capital, while mortgages required just 4%. Further, converting this into a Mortgage based security, the capital requirement reduced drastically to 1.6%. The high preference for these securities can be clearly understood in this light.

The deregulation ideologues got their biggest triumph in November 1999, with the repealing of the Glass-Steagall Act, established after the Great Depression, with much lobbying efforts. The act, in short, separated the investment banks from commercial banks, which implies that the commercial banks were confined to taking deposits and making loans and investing in low risk bonds and securities, as they were primarily representing the interests of a risk-averse population, in stark contrast with the investment banks who played on behalf of wealthy people, who could afford to take big risks, in exchange for higher returns. With the repealing of this Act, commercial banks began to indulge in high risk – high returns mortgage securities, which spelled doom from the beginning.

Financial innovation and complexity

The term financial innovation refers to the ongoing development of financial products designed to achieve particular client objectives, such as offsetting a particular risk exposure (such as the default of a borrower) or to assist with obtaining financing. Examples pertinent to this crisis included: the adjustable-rate mortgage; the bundling of subprime mortgages into mortgage-backed securities (MBS) and slicing them into tranches based on their riskiness called collateralized debt obligations (CDO) for sale to investors, a type of securitization; and a form of credit insurance called credit default swaps (CDS). The usage of these products expanded dramatically in the years leading up to the crisis. These products vary in complexity and the ease with which they can be valued on the books of financial institutions.

Certain financial innovation may also have the effect of circumventing regulations, such as off-balance sheet financing that affects the leverage or capital cushion reported by major banks. For example, Martin Wolf wrote in June 2009: "...an enormous part of what banks did in the early part of this decade – the off-balance-sheet vehicles, the derivatives and the 'shadow banking system' itself – was to find a way round regulation."

Ultimately, this aided in not only spreading the risk around the financial sector, but also in successfully masking it. Neither the borrowers nor the lenders truly understood the risk involved in the securities that they were investing in.

Low interest rates

Lower interest rates encourage borrowing. From 2000 to 2003, the Federal Reserve lowered the federal funds rate target from 6.5% to 1.0%. This was done to soften the effects of the collapse of the dot-com bubble and of the September 2001 terrorist attacks, and to combat the perceived risk of deflation.

Then, along came Bush’s administration’s tax cuts in 2001, which was the answer to the perceived slump due to the dot com bubble bursting. This played a pivotal role in shaping the background for the current crisis, as it led to huge fiscal deficits, which meant that the current expansionary fiscal policy will only aggravate the situation (Stiglitz, 2009). However, the tax cuts could hardly achieve its target of stimulating the economy in 2001, and the real stimulation was left to the Fed. Thus, there was a sharp decline in the real interest rates in the US, UK, and other countries.

“The difference between the nominal long-term Treasury yield and the trailing twelve-month rate of consumer price inflation, another measure of the U.S. real interest rate, falling from about 3.5 percent in 1996 to about 1.5 percent in 2004. In the United Kingdom, the real yields on inflation-indexed government bonds fell from an average of 3.6 percent in 1996 to just below 2 percent in 2004; in Canada, the analogous figures were 4.6 percent in 1996 and 2.3 percent in 2004 ” (Bernanke, 2007).

Revenge of the glut

Bernanke, as the Fed chief, in his two brilliant speeches in 2005 and 2007 speaks of the low interest rate as the third component of the Savings glut or Global imbalances phenomenon, the other two being Current account surpluses and deficits in the world and discrepancies in the savings rate across the world. Krugman (2009) is invariably right when he comments that: “…subprime lending was only a small fraction of the problem. Even bad home loans in general were only part of what went wrong.” Any analysis of the present recession without tracing its historic roots and the underlying problem of global imbalances is bound to be incomplete.

The irony of the problem is that it is the emerging economies that are fuelling and sponsoring the growth in the United States and other developed economies. This has to be understood in a historical perspective. The decade of the 1990’s was a particularly rocky and painful period for the developing countries. First, it was the Mexican crisis in 94, followed by the East Asian crisis in 97-98, crisis in Russia in 98, in Brazil in 99 and finally Argentina in 2002. Though these crises were of different natures and magnitudes, they had one thing in common: horrible mismanagement of the crises by the IMF and the US Treasury, which further worsened the situation in these countries. Left with a bitter aftertaste and a general distrust, these countries began to accumulate huge foreign exchange reserves for such a contingency.

Source: Are Developing Asia’s Foreign Exchange: Reserves Excessive? An Empirical Examination (Park & Estrada, 2009)

Table 1: Showing Asia's top 10 reserve holders

Source: Are Developing Asia’s Foreign Exchange: Reserves Excessive? An Empirical Examination (Park & Estrada, 2009)

As can be seen from Figure 1, emerging Asia’s Forex reserves have been steadily swelling since the 90’s. China seems to stand out in Table 1, with $ reserves well exceeding 2 trillion. This was possible by having savings rate close to 45% of GDP during the same period. The undervalued Yuan also significantly contributes to this, as this makes exports cheaper and imports more expensive, which results in curbing domestic aggregate demand and maintaining a high priority for exports. It all adds up when we look at the mirror image of the US savings rate, which has been steadily declining, falling almost below the ominous 0%.

Table 2: Current account balances (Billions of US$)

Country or region	1996	2000	2004	2005	2006
Industrial	31.1	-304.7	-296.5	-502.5	-607.3
United States	-124.8	-417.4	-640.2	-754.8	-811.5
Japan	65.7	119.6	172.1	165.7	170.4
Euro area	77.3	-37.0	115.0	22.2	-11.1
Other	12.9	30.0	56.6	64.4	45.0
Developing	-82.8	124.7	296.5	507.9	643.2
Asia	-40.2	77.0	172.4	245.1	352.1
China	7.2	20.5	68.7	160.8	249.9
Hong Kong	-4.0	7.0	15.7	20.3	20.6
Korea	-23.1	12.3	28.2	15.0	6.1
Taiwan	10.9	8.9	18.5	16.0	24.7
Thailand	-14.4	9.3	2.8	-7.9	3.2
Latin America	-39.1	-48.1	20.4	34.6	48.7
Middle East	15.1	72.1	99.2	189.0	212.4
Africa	-5.2	7.2	0.6	14.6	19.9
Eastern Europe	-18.5	-31.8	-58.6	-63.2	-88.9
Former Soviet Union	5.2	48.3	62.6	87.7	99.0
Statistical discrepancy	-51.6	-180.0	0.0	5.4	35.9

Source: Ben Bernanke (2007)

Taking a balance of trade approach, which is a logical extension of the savings glut phenomenon, it is imperative to look at the current account deficits in some countries and the surpluses in others. In accounting terms, allowing for statistical discrepancies, the world trade balance sheet has to be equal. So the United States’ $ 812 billion current account deficit has to be matched by surpluses elsewhere. As table 2 shows, that elsewhere happened to be emerging Asia. With rapid growth and a devalued exchange rate that ensured low domestic consumption, China’s current account surplus has been increasing at a tremendous rate. Also, the current account surplus of the oil exporting Middle East with the Iraq war particularly aggravating the soaring oil prices and countries such as Russia, Nigeria and Venezuela have surged significantly. “In 2008, according to forecasts from the International Monetary Fund, the aggregate excess of savings over investment in surplus countries will be just over $2,000bn” (Wolf, 2008). With the deregulatory zeal, uninhibited financial sophistication and innovation, rising stock prices at first and low real interest later, strong dollar, etc the American economy attracted much of the savings glut of the emerging economies and equally led the American population to spend (on imports as well) more than their incomes allow, leaving no room for savings.

Though the lessons from the crisis are plenty and the solutions as myriad as the problems itself, it would be instructive to learn from how certain countries coped with the recession. While China’s strategy has been discussed at varying lengths, the question remains whether it is replicable in other countries. It is worthwhile to discuss India’s position before the crisis which enabled it to get away lightly.

India, by itself, provides an instructive tale and the advanced economies can take a leaf out of its book. While the west was struggling with negative growth rates, India was still achieving admirable growth rates of 6%, and while there was a complete breakdown of the financial sector in US and EU with the biggest banks falling and falling hard, none of the Indian banks even came close to liquidity crisis. The credit crunch has definitely affected India, but to a much lesser extent than most other countries and there are many factors that softened the damage.

As certain economists have put it, the resilience to a global meltdown depends largely on how “decoupled” a country is from the international financial markets. India’s exports account for only 13% of its GDP, which means that the 8%+ growth rates achieved since the 2000s have been largely driven by domestic demand. This can be accounted by the fact that India has, perhaps, the highest middle class population in the world. The burgeoning middle class is able to absorb the industrial supply and drive India’s economic growth.

India had a chairman of the central bank, the RBI, a man who can be considered the anti-thesis of Alan Greenspan. Y.V Reddy, in his prudent manner, ensured that there was enough liquidity in banks, even before the crisis by having tough regulations that would have appalled the banking sector in the West. Lending was done solely on the basis of income and capital ratios were as high as 12-15%, which is why when the bubble burst, Indian banks had less than 2% of NPAs on its balance sheets (Nocera, 2008). The CDOs and other mortgage based securities were an insignificant part of the financial market.

The RBI made sure that Indian banks did not get caught up in the frenzy of the bubble, by almost banning SPVs and other off-balance sheet vehicles. Commercial properties had excessive reserve requirements, which made sure that banks had enough liquidity during the crisis. During the bubble, Reddy saw a threat of inflation and soaring housing prices and raised interest rates considerably to deflate it. Thus, the main difference was that while the American regulators stood by, nay, even encouraged the bubble, the Indian regulators took an active role and made sure things didn’t go out of hand.

Works Cited

Bernanke, B. S. (2007). Global Imbalances: Recent Developments and Prospects. Federal Reserve Bank. Berlin.

Krugman, P. (2009, March 1). Revenge of the Glut. New York Times .

Nocera, J. (2008, December 20). How India avoided a crisis. New York Times .

Park, D., & Estrada, G. B. (2009). Are Developing Asia’s Foreign Exchange Reserves Excessive? ADB Economic Working paper Series , 2-5.

Stiglitz, J. E. (2009). Capitalist Fools. Vanity Fair .

Wolf, M. (2008, December 2). Global imbalances threaten the survival of liberal trade. Financial Times .