Beruflich Dokumente
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FINANCIAL CRISES
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M.WAHAB
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Because of its complexity the current financial situation invites simple political messages that connect with voters; it does not lend itself to full explanations that illuminate. So, when Sen. Obama says, its the Republicans fault, he is expressing a simple idea that a lot of people buy into, but doesnt explain anything. It is a silly oversimplification unworthy of a man who would be President. It appeals to emotional prejudices and ignores inconvenient realities, and most important of all, it is just plain wrong. When Sen. McCain suggested that Securities and Exchange Commission head Christopher Cox didnt do his job, and if he were president he would fire Mr. Cox, the Senator didnt offer specifics. Well know more about Mr. Coxs role as time passes and we learn more of the details, and can then judge if Mr. McCains simple message to voters about firing Chris Cox was a proper evaluation of the situation. Sen. Obama described the current agony as "the most serious financial crisis since the Great Depression, ignoring all the recessions since then, even the ones in the 80s and the one following the 9-11 attacks, both arguably more serious crises. Of course, it remains to be seen just how serious this problem will ultimately be, but given Mr. Obamas abysmal understanding of things economic, we would do well to take his prognostications with a grain of salt. The root of this problem is the housing markets sub-prime loan crisis. A sub-prime loan is a loan made to someone who under normal circumstances would not qualify for a loan, based upon their income and their ability to make payments. That begs the question: Why would a bank make a loan to someone it believes is unable to make the payments? The Community Reinvestment Act (CRA) was given life during the Carter administration, and empowers four federal financial supervisory agencies to oversee the performance of financial institutions in meeting the credit needs of their entire community, including lowand moderate-income neighborhoods. Whenever an institution wants to make virtually any change in its business operation, such as merging, opening up a new branch, or getting into a new line of business, it must first prove to regulators that it has made ample loans to the government's preferred borrowers, those in low- and middle-income neighborhoods who normally would not qualify for a loan. The government can fine lenders with low ratings. The Carter administration used tax dollars to fund numerous "community groups" that helped the government enforce the CRA by filing petitions against banks whose cooperativeness didnt measure up, and sometimes stopping their efforts to expand their operations. Banks responded by giving money to the community groups and by making more loans. One of those organizations was the Association of Community Organizations for Reform Now (ACORN). An active associate of ACORN in the 90s was a young publicinterest attorney named Barack Obama. So, starting in 1977 the federal government began encouragingperhaps strongarming is a more accurate termbanks to make loans to people to whom they normally would not make a loan, and in 1995 the Clinton administration pushed through revisions to the CRA that substantially increased the number and amount of these loans.
All of the bad loans werent caused by the CRA, of course, but billions of dollars in CRA loans did go bad, as should have been expected. When Fannie Mae and Freddie Mac came along and made it possible for banks to escape the risk associated with these ill-advised loans, conditions were just right for a large portion of the banking industry, even institutions that did not fall under the CRA, to become involved in making loans to unqualified borrowers, and banks participated in big numbers. The federal governments fingerprints are all over this crisis, and the Democrats who are today so righteously indignant and blaming the administration are at least as guilty as the Republicans.
quite an astounding liberal achievement. But when you factor in regulations and place us in the continuum we are nowhere near the freedom side and getting closer and closer to the socialist side. So following the empirical argument we should be suffering and we are. I suppose you could call it experimental verification the hard way.
also bailed out key financial institutions and implemented economic stimulus programs, assuming significant additional financial commitments.
deficits required the U.S. to borrow money from abroad, which bid up bond prices and lowered interest rates. Bernanke explained that between 1996 and 2004, the USA current account deficit increased by $650 billion, from 1.5% to 5.8% of GDP. Financing these deficits required the USA to borrow large sums from abroad, much of it from countries running trade surpluses, mainly the emerging economies in Asia and oil-exporting nations. The balance of payments requires that a country (such as the USA) running a current account deficit also have a capital account (investment) surplus of the same amount. Hence large and growing amounts of foreign funds (capital) flowed into the USA to finance its imports. This created demand for various types of financial assets, raising the prices of those assets while lowering interest rates. Foreign investors had these funds to lend, either because they had very high personal savings rates (as high as 40% in China), or because of high oil prices. Bernanke referred to this as a saving glut. A "flood" of funds (Financial capital or liquidity) reached the USA financial markets. Foreign governments supplied funds by purchasing USA Treasury bonds and thus avoided much of the direct impact of the crisis. USA households, on the other hand, used funds borrowed from foreigners to finance consumption or to bid up the prices of housing and financial assets. Financial institutions invested foreign funds in mortgage-backed securities. The Fed then raised the Fed funds rate significantly between July 2004 and July 2006. This contributed to an increase in 1-year and 5-year adjustable-rate mortgage (ARM) rates, making ARM interest rate resets more expensive for homeowners. This may have also contributed to the deflating of the housing bubble, as asset prices generally move inversely to interest rates and it became riskier to speculate in housing. USA housing and financial assets dramatically declined in value after the housing bubble burst.
Sub-prime lending:
The term sub rime refers to the credit quality of particular borrowers, who have weakened credit histories and a greater risk of loan default than prime borrowers. The value of U.S. sub rime mortgages was estimated at $1.3 trillion as of March 2007, In addition to easy credit conditions, there is evidence that both government and competitive pressures contributed to an increase in the amount of sub prime lending during the years preceding the crisis. Major U.S. investment banks and government sponsored enterprises like Fannie Mae played an important role in the expansion of higher-risk lending. Sub prime 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 encouraged the largest five investment banks to dramatically increase their financial leverage and aggressively expand their issuance of mortgage-backed securities. This applied additional competitive pressure to Fannie Mae and Freddie Mac, which further expanded their riskier lending. Sub prime mortgage payment delinquency rates remained in the 10-15% range from 1998 to 2006, and then began to increase rapidly, rising to 25% by early 2008. Some, like American Enterprise Institute fellow believe the roots of the crisis can be traced directly to sub-prime lending by Fannie Mae and Freddie Mac, which are government sponsored entities. On 30 September 1999, ''The New York Times'' reported that the Clinton Administration pushed for sub-prime lending: "Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton
Administration to expand mortgage loans among low and moderate income people...In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980s. In 1995, the administration also tinkered with President Jimmy Carter's Community Reinvestment Act of 1977 by regulating and strengthening the anti-redlining procedures. The result was a push by the administration for greater investment, by financial institutions, into riskier loans. A 2000 United States Department of the Treasury study of lending trends for 305 cities from 1993 to 1998 showed that $467 billion of mortgage credit poured out of CRA-covered lenders into low and mid level income borrowers and neighborhoods. Nevertheless, only 25% of all sub-prime lending occurred at CRA-covered institutions, and a full 50% of sub-prime loans originated at institutions exempt from CRA. Others have pointed out that there were not enough of these loans made to cause a crisis of this magnitude. In an article in Portfolio Magazine, Michael Lewis (author) spoke with one trader who noted "There werent enough Americans with bad credit taking out bad loans to satisfy investors appetite for the end product." Essentially, investment banks and hedge funds used financial innovation to synthesize more loans using derivative (finance). "They were creating loans out of whole cloth. One hundred times over! Thats why the losses are so much greater than the loans.
Predatory lending:
Predatory lending refers to the practice of unscrupulous lenders, to enter into "unsafe" or "unsound" secured loans for inappropriate purposes. A classic bait-and-switch method was used by Countrywide, advertising low interest rates for home refinancing. Such loans were written into extensively detailed contracts, and swapped for more expensive loan products on the day of closing. Whereas the advertisement might state that 1% or 1.5% interest would be charged, the consumer would be put into an adjustable rate mortgage (ARM) in which the interest charged would be greater than the amount of interest paid. This created negative amortization, which the credit consumer might not notice until long after the loan transaction had been consummated. Countrywide, sued by California Attorney General Jerry Brown for "Unfair Business Practices" and "False Advertising" was making high cost mortgages "to homeowners with weak credit, adjustable rate mortgages (ARMs) that allowed homeowners to make interest-only payments. When housing prices decreased, homeowners in ARMs then had little incentive to pay their monthly payments, since their home equity had disappeared. This caused Countrysides financial condition to deteriorate, ultimately resulting in a decision by the Office of Thrift Supervision to seize the lender. Former employees from Ameriquest, which was United States leading wholesale lender, described a system in which they were pushed to falsify mortgage documents and then sell the mortgages to Wall Street banks eager to make fast profits. There is growing evidence that such mortgage frauds may be a cause of the crisis.
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, derivative (finance) and off-balance sheet financing. In other cases, laws were changed or enforcement weakened in parts of the financial system. Key examples include:
In October 1982, President Ronald Reagan signed into Law the Garn-St. Germain Depository Institutions Act, which began the process of banking deregulation that helped contribute to the savings and loan crises of the late 80's/early 90's, and the financial crises of 2007-2009. President Reagan stated at the signing, "all in all, I think we hit the jackpot". In November 1999, President Bill Clinton signed into Law the [[Gramm-LeachBliley Act]], which repealed part of the Glass-Steagall Act of 1933. This repeal has been criticized for reducing the separation between commercial banks (which traditionally had a conservative culture) and investment banks (which had a more risk-taking culture). In 2004, the Securities and Exchange Commission relaxed the net capital rule, which enabled investment banks to substantially increase the level of debt they were taking on, fueling the growth in mortgage-backed securities supporting sub prime mortgages. The SEC has conceded that self-regulation of investment banks contributed to the crisis. Financial institutions in the shadow banking system are not subject to the same regulation as depository banks, allowing them to assume additional debt obligations relative to their financial cushion or capital base. This was the case despite the Long-Term Capital Management debacle in 1998, where a highly leveraged shadow institution failed with systemic implications. Regulators and accounting standard-setters allowed depository banks such as Citigroup to move significant amounts of assets and liabilities off-balance sheet into complex legal entities called structured investment vehicles, masking the weakness of the capital base of the firm or degree of financial leverage or risk taken. One news agency estimated that the top four U.S. banks would have to return between $500 billion and $1 trillion to their balance sheets during 2009. This increased uncertainty during the crisis regarding the financial position of the major banks. Off-balance sheet entities were also used by Enron scandal as part of the scandal that brought down that company in 2001. As early as 1997, Fed Chairman Alan Greenspan fought to keep the derivatives market unregulated. With the advice of the Working Group on Financial Markets, the U.S. Congress and President allowed the self-regulation of the [[over-thecounter]] derivatives market when they enacted the Commodity Futures Modernization Act of 2000. Derivatives such as credit default swaps (CDS) can be used to hedge or speculate against particular credit risks. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47 trillion. Total over-the-counter (OTC) derivative notional value rose to $683 trillion by June 2008. Warren Buffett famously referred to derivatives as "financial weapons of mass destruction" in early 2003.
U.S. households and financial institutions became increasingly indebted or financial leverage during the years preceding the crisis. This increased their vulnerability to the collapse of the housing bubble and worsened the ensuing economic downturn. Key statistics include:
Free cash used by consumers from home equity extraction doubled from $627 billion in 2001 to $1,428 billion in 2005 as the housing bubble built, a total of nearly $5 trillion dollars over the period, contributing to economic growth worldwide. U.S. home mortgage debt relative to GDP increased from an average of 46% during the 1990s to 73% during 2008, reaching $10.5 trillion. USA household debt as a percentage of annual disposable personal income was 127% at the end of 2007, versus 77% in 1990. In 1981, U.S. private debt was 123% of GDP; by the third quarter of 2008, it was 290% From 2004-07, the top five U.S. investment banks each significantly increased their financial leverage, which increased their vulnerability to a financial shock. These five institutions reported over $4.1 trillion in debt for fiscal year 2007, about 30% of USA nominal GDP for 2007. Lehman Brothers was liquidated, Bear Stearns and Merrill Lynch were sold at fire-sale prices, and Goldman Sachs and Morgan Stanley became commercial banks, subjecting themselves to more stringent regulation. With the exception of Lehman, these companies required or received government support. Fannie Mae and Freddie Mac, two U.S Government sponsored enterprises, owned or guaranteed nearly $5 trillion in mortgage obligations at the time they were placed into conservator-ship by the U.S. government in September 2008.
These seven entities were highly leveraged and had $9 trillion in debt or guarantee obligations, an enormous concentration of risk; yet they were not subject to the same regulation as depository banks.
The adjustable-rate mortgage The bundling of sub prime mortgages into mortgage-backed securities (MBS) or collateralized debt obligations (CDO) for sale to investors, a type of securitization. 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.
Commodity bubble:
A commodity price bubble was created following the collapse in the housing bubble. The price of oil nearly tripled from $50 to $140 from early 2007 to 2008, before plunging as the financial crisis began to take hold in late 2008. Experts debate the causes, which include the flow of money from housing and other investments into commodities to speculation and monetary policy or the increasing feeling of raw materials scarcity in a fast growing world economy and thus positions taken on those markets, such as Chinese increasing presence in Africa. An increase in oil prices tends to divert a larger share of consumer spending into gasoline, which creates downward pressure on economic growth in oil importing countries, as wealth flows to oil-producing states.
Systemic crisis:
Another analysis, different from the mainstream explanation, is that the financial crisis is merely a symptom of another, deeper crisis, which is a systemic crisis of capitalism itself.
According to Samir Amin, an Egyptian economist, the constant decrease in gross domestic product, economic growth rates in Western world since the early 1970s created a growing surplus of capital, which did not have sufficient profitable investment outlets in the real economy. The alternative was to place this surplus into the financial market, which became more profitable than capital (economics), productive capital, investment, especially with subsequent deregulation. According to Samir Amin, this phenomenon has led to recurrent economic bubble/financial bubbles (such as the internet bubble) and is the deep cause of the financial crisis of 2007-2009. John Bellamy Foster, a political economy analyst and editor of the Monthly Review, believes that the decrease in GDP rates since the early 1970s is due to increasing market saturation. John C. Bogle wrote during 2005 that a series of unresolved challenges face capitalism that have contributed to past financial crises and have not been sufficiently addressed: "Corporate America went astray largely because the power of managers went virtually unchecked by our gatekeepers for far too long...They failed to 'keep an eye on these geniuses' to whom they had entrusted the responsibility of the management of America's great corporations." He cites particular issues, including:
"Manager's capitalism" which he argues has replaced "owner's capitalism," meaning management runs the firm for its benefit rather than for the shareholders, a variation on the principal-agent problem Burgeoning executive compensation Managed earnings, mainly a focus on share price rather than the creation of genuine value; and The failure of gatekeepers, including auditors, boards of directors, Wall Street analysts, and career politicians.
Recommendations:
1. Stabilize the financial system. 2. Stabilize the economy. 3. Arrange long-term financing for steps #1 and #2 with our foreign creditors.
Click on the above links for details. A conclusion follows below, explaining why we will not implement such measures and the possible consequences. The above links go to posts explaining each recommendation in greater detail.
(a) Re-capitalize the financial sector by a transfer of wealth from the taxpayers to banks and brokers This is probably the key element of the Paulson Plan, done by the government buying assets at above market prices. (b) Close defunct or weakening financial institutions under new bankruptcy legislation, under which the courts could act with extraordinary speed and authority. This should involve replace managements. New managements could be selected by a bi-partisan committee of business leaders that should have only a minority of members from the financial industry. (c) Outright nationalization As done the defunct Savings and Loans during the early 1990s, and today with the GSEs and AIG. Large-scale nationalizations might be required. If so, our political regimes survival might depend on how this is done. Not just their acquisition, but their operation and eventual privatization (if any). Creation of an agency like the Depression era Home Owners Loan Corporation, as recommended by Nouriel Roubini, can play a role in any of these policy choices.
III. Arrange long-term financing for steps #1 and #2 with our foreign creditors
This means a negotiated agreement with the foreign central banks who are our primary creditors, with the appropriate support from Congress. We will need to reschedule our debt and obtain new financing. Our government will have to rollover roughly $500 billion/year, plus the trillion or so in additional borrowing (as tax revenue declines and expenses skyrocket) for the next two years (perhaps longer). Plus measures will be needed to stabilize the value of the US dollar, allowing a orderly decline.
These extraordinary negotiations will be inherently destabilizing, putting in question both the US Dollars role as reserve currency and Americas role as global hegemon. This is the price paid by our past folly, getting us into this crisis. Obtaining and executing this agreement must be concluded successfully. It is a jump across a chasm to a new world. But the chasm lies ahead of us, and must be crossed eventually. Lets strike a deal while we can negotiate from a position of strength. Rather than waiting until we are desperate. The cost will be high. An agreement will be in the best interest of all, but that does not mean that we will not have to make concessions. To give just one example, China might ask that the US break our relations (esp military) with Taiwan.
Conclusion
I believe that the downturn can be mitigated by immediate and decisive action. Building public support for these measures and avoiding panic will require the highest level of statesmanship by our leaders and responsible citizenship by us. Of course we will not take such actions in a timely fashion. Our leaders happy talk was intended to maintain spending and investment during a brief slowdown. The unintended consequence is that the American people are psychologically unprepared for this crisis. Worse, our Observation-Orientation-Decision-Action loop is broken. Despite years of warnings (see this list) we have not seen the danger ahead. Now that it is upon us, our fixed optimism prevents us from orienting ourselves to changed conditions. I doubt that our leaders can either formulate adequate plans or execute them. As so often in American history, we must fall back on the resourcefulness of the American people. Our ability to act together, to force our leaders onto the right path, to have the resilience to weather difficult times.