The seeds of the global financial crisis which were triggered by the collapse of Lehman Brothers in the USA in 2008 had been sown during the last many decades. The basic reason for the emergence of the crisis is the manner in which the financial industry was allowed to grow with minimal regulation and engage in activities which have little to do with their basic function of acting as a bridge between those who have excess funds by accepting deposits and lending to those who invest in economic activities beneficial for the society in return for profit. In the last few decades, the finance industry, apart from the medical and the arms ammunition industry, has evolved to be one of the most powerful and influential industry around the globe.
The nature of this industry has evolved from one of being a support function to being the prime driver of growth around the world. The banks and financial institutions were not contented with the profits generated by the difference in the interest rates given to the depositors and that charged from the lenders. They effectively used money power and lobbyists to get people sympathetic to their cause elected to the key powerful positions in the government, the central banks of various countries and positions in global financial institutions. The result of this was that the finance industry became one of the least regulated industries around the world and was gradually given access to almost all the stock, currency and commodity exchanges around the world. They were also able to charge interest rates as high as 36% per annum to the borrowers of unsecured loans (credit cards) while giving depositors an interest of 1% - 4% per annum on deposits across different maturities. This led to supernormal profits for the financial institutions resulting in extremely vulgar salaries and bonus compared to rest of the population. The high profits also got them the money power to influence more and more government official and politicians who made rules to benefit these institutions.
The main focus of these institutions was to maximize their commissions and earnings by giving maximum loans and products to as many customers as possible. These institutions first exhausted the borrowers who were genuinely entitled to borrow loans depending on their present and expected incomes, the prime loans. Then they turned to the willing borrowers whose incomes did not justify the amount they wanted to borrow. They lend to customers to buy houses and cars without appropriately verifying their documents and relaxing their lending standards to accommodate as many people as possible.
The banks, now faced with increasing demand for loans, were pressurized to increase their lending capital. They bundled up the loans given to the consumers, shopped for the best rating from the credit rating agencies and sold them off to the agencies handling investments for the public funds like insurance companies and hedge funds. This enabled them to free more capital to lend and also earn fees in trading those securities. The income of banks was being generated by just trading paper, no productive activity was being done which would enhance the value of the services or be useful to the society at large.
Now the banks were armed with more capital to lend and most of the people who could qualify for loans and lots of people who could barely manage to pay the installments had already availed the loans. Keeping the commissions to be earned on giving loans in view, the banks enhanced their innovative lending practices and came up with interest only or teaser loans. These interest only were loans in which the consumers paid the interest only on loans for the first few years and then paid the full installment including the principal. The teaser loans were loans in which the consumers paid only part of the interest and the balance of the unpaid interest component was added back to their loans a few years down the line. This reduced the installment required to avail the loans substantially and hundreds of thousands of consumers qualified for the loans on the basis of their earnings. Another round of commissions/ bonuses earnings were generated for everyone involved in approving and disbursing these loans which are now classified as the sub-prime loans.
The result of these substandard loans being disbursed to a majority of the population unleashed an unprecedented artificial consumer demand for housing, cars, stocks etc. creating the biggest credit boom. Home prices rose sharply due to pent up demand created by the easy liquidity conditions and the profitabilities of the companies began to soar resulting in higher share prices. Leveraged products like derivatives encouraged speculation and all asset prices multiplied within a short span of time creating the biggest house, stock and commodity market bubble around the world. All this was happenning while the high paying jobs in the manufacturing and services sector in the developed countries were being shipped to the developing countries as the multinational enterprises took advantage of the sharply lower cost of labour and operations in the developing countries to boost their profits.
The most remarkable achievement of the financial industry was in November 1999 when they were able to use their money power and lobbyists to get the United States Congress to repeal the Glass Steagall Act 1933. This act was implemented after the stock market crash of 1929 whereby the investment and the commercial activities of the banks were split into two separate entities. The commercial activities of the banks were found to be too speculative in nature and using financial leverage the banks took huge risks to generate profits for themselves. This was perceived to be the prime reason of the creation of the credit bubble and the subsequent stock market crash in 1929 which sent the world economy into the great depression whereby millions of people lost their means of livelihood and it took decades for the world economy to recover. The Glass Steagall Act successfully kept the wolves away from hen house for 66 years and saved the world from another credit crisis as the savings of the majority of the population were kept away from speculation and leverage. This safeguard provision was repealed in 1999 and this gave the financial institutions the legal right to leverage the savings of the majority of the citizens to speculate in the currency, stock and commodity markets to earn maximum profits for themselves. The conditions which caused the credit bubble and the great depression in 1929 were being exactly replicated in the financial world.
The United States Congress, on the insistence of the financial industry, passed Bankruptcy Abuse Prevention and Consumer Protection Act in 2005 making bankruptcy for citizens and small businesses a more expensive and difficult task. This led the banks and credit card companies to increase the credit lines of the customers believing that as bankruptcy was a difficult option, the consumers would have no other option but to keep on paying their minimum balances. These companies would increase their profitability by increasing the amount due by customers on levying higher fees, interest and complicated interest calculation methods. They intended to create debt slaves out of the maximum number of citizens who borrow from them and lifelong are unable to make themselves debt free. This dilution in ethical standards by global financial institutions resulted in compromising corporate governance and corporate social responsibilities and further created moral hazards for these financial institutions in pursuit of short term profits to maximise remuneration and bonuses.
The failure of a major finance company like Lehman Brothers in 2008, set off a chain reaction which burst the biggest credit bubble created in the history of our planet. Many of the life insurance companies, public fund management companies who had invested in the, presumed safe, mortgage-backed securities and exotic financial products marketed by the financial institutions were facing heavy losses and were holding assets which they could not sell. Apart from this, the banks faced heavy losses and were on the verge of bankruptcy asked the governments for bailouts without which they could not survive. A major liquidity problem had arisen.
The liquidity crisis caused a major slowdown in the real economy as businesses and individuals were not able to access loans which they were accustomed to in order to smoothly run their activities. Banks stopped lending to each other as well as to their customers for the fear of default and the decreasing demand for loans due to economic slowdown. Expansion plans were put on hold by companies which in turn led to pressure on wages and increased unemployment. This increased foreclosures and further risk of debt defaults in the economy. The government tax revenues in the form of income tax and property taxes too plunged due to falling profits, lower wages and fall in home prices. On the other hand the expenses of the government increased due to more and more citizens availing the unemployment benefits thus increasing the fiscal deficit forcing them to resort to more borrowings to meet their obligations.
The causes of the biggest financial bubble can be attributed to the role played by the financial industry and the failure by the regulatory bodies of the government and the central bankers to understand and prevent the crisis from becoming too huge to control. The key issues which led to these credit bubbles are :
The unregulated banks unleashed a flood of complex financial products in the form of derivatives (futures and options), credit default swaps etc. across the world which make the whole financial system extremely unstable and volatile. This applies to all the currencies, commodities, stock and bond markets. An example of such products taking over the markets are that more than 75% turnover in any markets is attributed to these products. The derivatives were basically evolved as financial instruments in order to hedge risks or act as an instrument to insure against risks. Over the years these instruments became the prime source of speculation as they were high risk/ high returns financial trading instruments. The only group to benefit from these products are the very financial institutions which create and sell them, earning commission, resulting in increase of speculation without any meaningful contribution to the main economy other than creating an unstable financial environment. According to the executive summary of the quarterly report Q1/11 issued by the Office of the Comptroller of the Currency, the notional value of the derivatives held by the commercial banks at the end of the first quarter of 2011 was $244 trillion out of which $229 trillion were held by just four banks namely, J.P.Morgan, Citigroup, Bank of America and Goldman Sachs (http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/dq111.pdf). To get an idea of the derivative market size, the gross domestic product (GDP) of the global economy in 2010 was in the range of $63 trillion. The effect of complex financial products like derivatives, excess leverage, commission based fees structure, lack of regulation, political influence and access to cheap funds provided by central bankers encouraged the banks to take huge risks for short term profits using the savings of the rest of the population. They turned the stock, commodity and currency markets into huge casinos controlled by a handful of financial institutions.
As the derivatives and other exotic financial products were not subject to regulation, they represented risk in the form of a shadow banking system whereby the financial institutions were able to take leveraged positions to the extent which made the global financial markets fragile and subject to wipe out of capital on small adverse price movements. No rules were laid down as to the extent of capital required to be kept by the financial institutions before taking enormous credit and liquidity risks in the derivative markets.
2. Price Discovery Mechanism
The old age economics says that the price of a product is determined by its demand and supply. The present financial institutions, thanks to their gambling ways, have changed it to “the price of a product is whatever the speculators or market operators want it to be”. Using leveraged derivative positions and with enormous money power the financial institutions are in a position to alter the price of any commodity, currency or stocks to the price which suits their motives without much dependency on the actual demand or supply of the same. Earlier if an individual or entity bought a commodity and created an artificial shortage by hoarding it while waiting for its price to rise so that they can sell it to the actual user, they were branded as hoarders and were punished under law. Nowadays, the same activity (buying of commodities on the electronic exchanges with no intention of consumption with the motive of selling it at a higher price) is termed as investment demand and the institutions engaged in such activities are awarded bonuses for doing so. The fact that such activities are the main source of increasing commodity prices and the increase of the cost of living for a majority of the population in times of stagnant earnings have ceased to matter to the governments and the central bankers. Even as the construction activity around the world has slowed down substantially since the bust in 2008, copper prices are approaching their all time highs solely due to the so called investment demand. Similarly the prices of other basic consumable commodities like oil, sugar, coffee, spices etc. have jumped up substantially mainly due to investment demand. This has led more and more people around the world to be pushed below the poverty line as their purchasing power is eroding fast. The fluctuations in the price of a commodity, stock or currency today is a direct result of changes in speculative derivative positions in the electronic exchanges and has little to do anything with the change in its actual production and consumption or it’s demand and supply. Moreover the price movements are extremely volatile due to the trigger happy trades which move the prices sharply both up and down on flimsy rumors. The basic mechanism of price discovery has been terminally corrupted because of the large speculative community using superfast computers for high frequency trading and leveraged products like futures, options, credit default swaps etc.
3. Role of Media
The media and news channels play an important role in assigning logic to the price movements in stock, currency and commodity markets, however ridiculous they may sound. The main source of revenue for media today is the advertisements they get from their high net worth clients. They also owe their loyalties to the people having a majority of stake in their ownership or those who control the actual operations of their business. There is little interest in the media today to report events and news in an unbiased manner. They highlight the news which the people controlling them would like their viewers to believe in and ignore or underreport the news which does not suit the objectives of the politicians or rich clients / owners. An blatant example of this is the world economic recovery hype the media is portraying to their viewers since last couple of years whereas the actual data of unemployment, manufacturing index, workforce participation rate, falling housing prices, falling real wages etc. in the USA provides proof that the economy for the majority of the population is mired in recession.
4. Failure of Governments and Regulatory Bodies
The elected politicians in the democracies today are aware of the fact that they have the powers and benefits of the office for a few years before the next elections take place, when they might or might not get elected again. The loyalties of the elected politicians lie towards the individuals, corporations and unions who have helped them get elected and they do everything in their powers to provide them with maximum benefit. The desire to do something for the upliftment and benefit of the citizens of the country takes a lower priority. This creates a cycle of corruption whereby the rules and regulations laid down favor a small percentage of well connected individuals and entities. A corrupt government encourages weak and corrupt law enforcing agencies so that they can achieve their objectives with minimal resistance. The most preferred path taken by the politicians to tackle the actual problems facing the economy is to postpone them as far as possible in the future so that the subsequent governments have to deal with them. Rarely would you find a politician who would be willing to go against his/her sponsors wishes and take tough decisions which would be beneficial for their country or a majority of the citizens of the country.
The economic system before the bursting of credit crisis was one of capitalism and free economy where businesses took risks to earn profits and bonuses and closed shop if they were not successful and incurred losses to be replaced with better managed companies. Since 2008 this has changed to one where the influential and well connected corporations enjoyed enormous profits and bonuses when they took exceptional risks with other people’s money and if they incurred heavy losses, the sympathetic governments and central bankers would arrange for the taxpayers to bear those losses so that they continue to take huge risks and enjoy their bonuses. As a result of this short term approach to problem solving and having transferred the private losses to the country’s balance sheets the debt levels compared to GDP of countries has shot up sharply in the last couple of years. Many governments find themselves overburdened with debt and this is leading to a risk of higher borrowing cost of funds for countries and the economically weaker ones are on the brink of bankruptcy.
5. Global nature of the Crisis
A study done at the World Institute for Development Economics Research in 2008 (The World Distribution of Household Wealth by James B. Davies, Susanna Sandström, Anthony Shorrocks and Edward N. Wolff, Discussion Paper No. 2008/03, United Nations University World Institute for Development Economics Research, February 2008) revealed that the richest 1% of the world population owned 40% of the global assets, the richest 10% of the population owned 85% of global assets and the bottom 60% of the world population owned barely 1% of the global assets. The majority of wealth being concentrated in the hands of the miniscule percentage of the population would imply that the surplus money is deployed through hedge funds and financial institutions to earn maximum profits by their owners. The rules and regulations in most countries around the world have been relaxed to allow global money to flow in and out with minimum regulation. Hence we see heavy concentration of money flow in various asset classes causing price spikes in stock, commodity, bond and currency markets when liquidity situations are accomodative and sharp fall in them when the liquidity tightens. This leads to governments and central bankers of various countries grappling with problems of sudden inflationary and deflationary pressures alternatively within short periods of time. The problems have been compounded because the flow of money is global whereas the rules and regulations are country specific allowing the controllers of the money flow and the derivative markets flexibility to keep their operations in the countries whose rules and regulations suit them keeping them successfully unregulated. Hence financial crisis in one country alters the flow of money around the world because of the complex nature of the financial markets and products.
In the event of the failure of Lehman Brothers in 2008, the elected politicians and central bankers adopted measures which postponed the hard decisions to the future even though it would create a much bigger problem down the road. The short term approach to problem solving led to the decision by the governments and central bankers around the world to provide trillions of dollars of bailout to banks to keep them functioning even though by traditional parameters they were bankrupt. Even the managements of the big financial institutions which had brought the world financial system on the brink of collapse were neither sacked nor were any criminal charges brought against them. The central governments allowed the banks to value the investments on the basis of costs instead of the earlier practiced method of cost or market value whichever is less. This portrayed the illusion that the banks were solvent and did not have to provide for losses had they valued their investments on it’s market value. The governments bought these investments from the banks at cost value which was much higher than the value for which they could sell them for. The governments effectively transferred the bad loans on the books of the banks to their own books at full value in exchange for government bonds.
The United States government also announced billions of dollars worth of incentive schemes to induce people to buy cars and houses in an effort to revive the economy. They believed that this will revive the economy by creating more jobs and reviving the credit market and consumer spending. They also slashed the interest rates in line with reduced inflation assuming that a cheaper cost of loan will lure the consumers to take on more loans. The government used all the means it had to kick start the economy and to avoid the onset of deflation which is marked by falling prices of all products and assets.
The actions of the government did not have the desired effect that they presumed. The excess funds available with the banks were not being lent out to corporates or consumers. The banks invested them in government bonds keeping in mind the risk of default in lending money to those who were already drowning in debt. The housing market too showed signs of stability while the incentive schemes by the government were prevailing. The housing prices started dropping once the incentive schemes expired, as there was no genuine increase in the true purchasing power of the customers due to lack of jobs and earning opportunities.
The short term approach to tackling the credit crisis by buying bad or doubtful loans from banks by the governments had severe negative effects on the soverign balance sheets across the globe. The debt levels compared to gross domestic product (GDP) of all developed countries who engaged in the bailout of their banks have shot up sharply in the last couple of years. Many governments now find themselves overburdened with debt and this is leading to the yields of their bonds increasing sharply and the economically weaker ones are on the brink of bankruptcy.
The short term approach to problem solving is very evident even today. The European Union is offering billions of dollars to Greece and Spain to save them from default, who is suffering from excess borrowing and spending and the repercussions of a housing bubble burst. There are only three final outcomes to debt, repayment, default, part repayment part default (lender books losses). No logic suggests that a problem of someone suffering from excess debt can be solved by taking on more debt. The only objective this solution serves is to assure a bigger default in the future. Even if Greece adopts the austerity cuts and reduces its expenditures by sacking government employees, the subsequent result would be lower gross domestic product (GDP), lower tax revenues and higher deficits resulting in increased borrowings. Moreover lending money to Greece by the foreign banks and lenders was a commercial decision whereby they received a higher interest rate to compensate for the risk they took in lending to Greece. The losses of this mess ought to be borne by lenders who enjoyed supernormal profits in good times and knowingly took the decision to lend to Greek banks and should not be borne by the tax payers of Greece or the taxpayers of other European countries by funding endless bailouts. The foreign banks being backed by politicians of bigger and stronger countries and global financial institutions are insisting that the Greek banks repay them in full even though this is likely to push the Greek economy in recession for the foreseeable future. The politicians of the weaker or highly indebted countries facing default are being pressurized to keep the interests of the lending financial institutions ahead of what is in the best interest of the citizens of their countries.
This short term approach of first bailing out banks by the governments and central bankers and subsequently weaker governments by better performing countries is likely to continue. This is the easiest possible solution available to the governments to postpone the problem, without addressing the main causes of the credit crisis, though creating a much more fragile financial environment in the future. This would continue till the debts become so large that it would not be possible to role them forward without causing major hyperinflation by money printing leading to sharp drop in standard of living for a majority of the population.
There is a widespread awareness and resentment brewing over this issue amongst the citizens of the countries engaging in bailouts. The majority of the population sees their own financial conditions deteriorating whereas the bankers and financial institutions thriving with bonuses and getting away with fraud and manipulation. This frustration is bursting into the streets of these countries in the form of strikes and lockouts and the governments will have a very difficult time trying to convince its citizens that somehow this is going to benefit the country as a whole in the long run.
By Akhil Khanna
I am an MBA Finance from the University of Sheffield, 1992 and have more than 20 years of experience in the field of Financial Management. I am a keen student of the Flow of Money around the World and enjoy studying the fields of Currencies, Stock markets, Commodity Markets and Bonds and my book “Let’s Talk Money” has been recently published by the Times of India Group. http://www.letstalkmoney2012.in/
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