Current Financial Crisis

44 English translation © 2009 M.E. Sharpe, Inc., from the Russian text © 2009 “Voprosy ekonomiki.” “O prichinakh sovremennogo finansovogo krizisa,” Voprosy ekonomiki, 2009, no. 1, pp. 40–51. A publication of the NP “Editorial Board of Voprosy ekonomiki” and the Institute of Economics, Russian Academy of Sciences. A. Suetin is a Doctor of Economic Sciences and professor at the Financial Academy of the Government of the Russian Federation. Translated by James E. Walker. Problems of Economic Transition, vol. 52, no. 3, July 2009, pp. 44–58. © 2009 M.E. Sharpe, Inc. All rights reserved. ISSN 1061–1991/2009 $9.50 + 0.00. DOI 10.2753/PET1061-1991520303 A. Suetin Causes of the Current Financial Crisis The article thoroughly analyzes various causes that have provoked the present financial crisis now spreading globally. Special attention is devoted to specific factors of the crisis origin and sudden expansion. The article emphasizes particular features of the progression of financial crisis in emerg- ing economies, underlining concepts of financial market adjustments. The article concludes that in the majority of developing economies assets are overvalued and there is a susceptibility to extreme cyclical factors. There were a number of causes of the bankruptcies of financial institutions and the inflation of a bubble in the financial market that preceded them. In addition to dubious lending, they include excessive use of derivatives, inflow of cheap money from emerging market economies, inadequate regulation of monetary relations, inconsistent government policy, and weak oversight. We will examine these causes in greater detail. Derivatives and the policy of deregulating financial markets Fall 2008 marked the end of an era. After refraining from serious inter- ference in the financial sphere for many decades, the governments of july 2009 45 developed countries were forced to take rapid and far-reaching measures to rescue the banking system and to carry out partial nationalization. At the same time, it would be incorrect to say that financial markets had not been regulated at all. But in the past thirty years the priority of market relations has been unquestionable. Each step toward further deregulation of the market seemed justified at the time and was a distinctive response to particular shortcomings of the financial system. It began with the adoption of floating exchange rates. In 1971, U.S. president Richard Nixon thought that problems associated with the country’s growing foreign trade deficit and financing of the expensive war in Vietnam could be solved by abandoning the convertibility of the dollar to gold. This meant terminating the Bretton Woods system of fixed exchange rates that was created at the end of World War II. According to the requirements of this system, free movement of capital was held in check by currency constraints. For instance, residents of Great Britain vacationing abroad at the end of the 1960s could only take £50, or $120, with them. Investing abroad involved considerable costs, so pension money was invested exclusively in the domestic market. With the beginning of free-floating currencies, the world changed. Companies with expenses in one currency and earnings in another had to hedge their currency risks. In 1972, Leo Melamed, a former attorney, recognizing the potential profits, started currency futures trading on the Chicago Mercantile Exchange. Commodity futures had existed long before that, providing insurance for farmers against a drop in prices for their future harvest. Today’s complex derivatives were a logical continu- ation of the first currency futures. Chicago was historically considered the center of free trade. Local scholars, led by Milton Friedman, debunked John Maynard Keynes’s theory of government regulation as inefficient in comparison with mar- ket theory. After the crises of the 1970s, representatives of the Chicago school found an appreciative audience in Ronald Reagan, elected in the United States, and Margaret Thatcher, elected in Great Britain. They were impressed by the idea of developing a nation of owners, who could resist tax increases and attacks on business by the left. Liberalization of markets significantly facilitated access to mortgage loans. Fearing the destabilizing effect of an inflow of “hot money,” the governments of continental Europe created the European currency system. But the United States and Great Britain almost completely rejected regulation, which led to appreciation of the dollar and the 46 ProblEmS of Economic TranSiTion pound and deterioration of conditions for these countries’ exports, as well as deepening of the recession at the beginning of the 1980s. At the same time, insurance companies and pension funds were allowed to invest money abroad, which was important because of the high com- mission charged by brokers for executing transactions on the English stock market. Working in the market on their own account, jobbers did not have the necessary capital at their disposal for carrying out large investors’ transactions. The stock market crash of 1987 eliminated the differences between brokers and jobbers and opened London’s doors to high finance. A similar reform took place in New York in 1975. Lowering the amount of com- missions made brokerage services less attractive in the long term and increased the popularity of transactions on one’s own account. With time, this led to restructuring of the financial sector. Investment and merchant banks had traditionally not been classified as big busi- ness and made most of their money on consulting services. They were forced to abandon their established structure as a business partnership, raise resources in the stock market, and merge with commercial banks. In 1999, the Glass-Steagall Act of 1933 was repealed, which had pro- hibited commercial banks from offering securities or engaging in other activities with them. Commercial banks began to compete aggressively with investment banks, especially in regard to offering, or underwriting, securities. Investment banks had to increase their capital and assets. The expansion and diversification of banking operations took place against an entirely favorable background. The measures taken by the U.S. Federal Reserve to restrain inflation in the early 1980s proved to be suc- cessful, and stock, bond, and real estate prices rose for two consecutive decades. As the financial sector developed, its American stock market share increased from 5.2 percent in 1980 to 23.5 percent in 2007. As the banking business expanded, the transactions it handled became more complicated. With the assistance of academics, financiers learned to distinguish various elements of risk and trade in them separately. Chicago again played an important role in this. In the 1970s, the growth of options trading there was explosive. As we know, representatives of the University of Chicago, Fischer Black and Myron Scholes, created a theory for estimating the value of options, and the Chicago Board Op- tions Exchange was founded in 1973. The next important step in risk management was the development of swaps. Currency swaps were the first to become common, and interest july 2009 47 rate swaps began to be used almost immediately. Credit default swaps appeared in the late 1990s. Futures, options, and swaps had at least one thing in common: a small original position could lead to significantly greater risks. Futures con- tracts can be acquired with very slight deposits or margin. Put options are supposed to prevent the buyer’s losses, which may be many times more than the amount of the premium. The risk in swap transactions is not high, but the absolute amounts of a position can be enormous if one of the parties to the transaction defaults. These circumstances make it hard for a regulator to determine how much risk an individual firm has. So, for many years, regulators’ efforts were aimed at improving the market structure and ensuring that transac- tions and their settlement through the appropriate clearing houses were properly documented. This last measure, by the way, is still not used for credit default swaps. Problems in the derivative market arose after the stock market crisis of 1987, when the technique of insuring security portfolios was criticized. Investors avoid the risk of a drop in value of their whole portfolio by selling stock index futures. As the prices of futures went down, so did the spot price of stock, which forced investors to sell more futures. In such conditions, the American authorities were forced to restrict the practice of insuring portfolios during financial turmoil. Derivatives also created problems in the 1990s, when out of naiveté officials in one California county and the finance departments of a number of corporations lost entire fortunes on contracts of which they had no understanding. Derivative markets were later recognized by the authori- ties. For instance, a stiff competition developed between Frankfurt and London for the right to trade in German government bond futures. On the whole, it was theoretically substantiated that the sharing of risks by business and investors should strengthen both the market and the economy. This idea was also supported by Alan Greenspan, the chairman of the U.S. Federal Reserve from 1987 to 2006. He praised credit default swaps in particular. Securitization, which is named as one of the main causes of the current crisis, appeared in the 1970s. It is based on the transformation of loans into packages of securities, which are then sold to investors. It first began to be widely used in the American mortgage market. What happened in practice is that homeowners’ pooled monthly mortgage payments went to investors in the form of interest payments on bonds. 48 ProblEmS of Economic TranSiTion Once again, the authorities supported business’s innovation, consider- ing securitization a means of risk sharing. It seemed that everyone ben- efited from it. Banks profited from providing loans without showing them on their own balance sheet. Investors acquired higher-earning assets in comparison with government bonds and diversified the mix of borrowers. It is not surprising that the use of securitization expanded rapidly. Securities based on traditional assets became more and more complex. Securitization gave rise to bonds backed by debt. This instrument made it possible to create packages of various bonds that were subsequently broken down into tranches, depending on how willing the investors were to take on a certain degree of risk. Precisely because such financial in- struments lack transparency, it is hard to predict when the current crisis will end. Securitization opened up new avenues for development of the bank- ing sector. Commercial banks no longer depended on attracting retail deposits and were now able to borrow in financial markets. As a result, Northern Rock Bank, which specialized in mortgage loans, became the first victim, but far from the last one. Financial innovations usually go through four stages of development. In the beginning, they are welcomed as a great invention, for example, of bankers. Then they become the object of rapidly developing specula- tive transactions. Next comes a period of apathy due to crisis events. The fourth stage may be expressed in rejection or, on the other hand, renewed interest. We know, for example, that in the 1987 crisis forward stock market instruments (futures and options) were blamed. At the same time, in 2007, the total amount of futures and options contracts in Chicago reached $45 trillion on the S&P 500 alone, while the value of all shares on the U.S. stock market was $10 trillion. However, no one names these futures as culprits in the crisis. Is it possible that a similar fate awaits credit default swaps twenty years from now? The bankruptcy of Lehman Brothers in mid-September 2008 showed that the main systemic risk contained in credit default swaps originated not because of widespread losses on the assets on which these instruments were based, but because of the bankruptcy of a major dealer. The shocks that followed reached far beyond the bounds of derivatives. Dissatisfac- tion with derivatives seems entirely understandable, but for some reason credit default swaps were particularly horrifying. Evidently, this was due to the threat of counterparty risk, that is, the possibility of the seller or buyer failing to fulfill their obligations. In addition, shortcomings in july 2009 49 the operation of back offices, to which no one paid any attention during the boom, made a contribution. By themselves, swaps could be used to conceal credit risks, since these positions did not necessarily have to be shown on balance sheets. Such instruments were conducive to the con- centration of risks. For example, American International Group (AIG), the largest insurance company, could have found itself in an equally serious situation if it had borrowed heavily to purchase mortgages. However, it took the easier route and became an active participant in the market for credit default swaps. If the compensating positions are offset, then the true amount of risk associated with credit default swaps does not exceed 3 percent of their nominal value, or $1.6 trillion. But in spite of the crisis, the market for credit default swaps proved to be very liquid, even in conditions of contraction of the money market. There are plans for a similar offset for other derivatives, including interest rate swaps. At the end of 2007, their total value was estimated to be $393 trillion. If these measures are successful, then the financial market’s infrastructure will undoubtedly be strengthened. At the same time, the profit of the largest dealers will be considerably diminished. It cannot be said that regulators were sitting on their hands all this time. They were involved in permitting the problems associated with the collapse of Drexel Burnham Lambert due to its activity in the junk bond market, and the bankruptcy of the British bank Baring Brothers because of the unscrupulousness of one of its dealers. However, these were all individual management mistakes and isolated cases of fraud. There was no talk of systemic problems. Even the U.S. crisis of 1986–96 in the savings and loan system, which was an early warning of the impending catastrophe as a result of the deregulation policy but was successfully resolved thanks to government support of lending institutions and mon- etary policy measures, was considered to be only an annoying deviation from the norm. Without disputing the need for deregulation in principle, the govern- ments of developed countries only revised the structure of their regulating agencies. In 1997, the Financial Services Authority was created in Great Britain, and the Bank of England was deprived of its bank regulating function in order to concentrate all oversight functions in a single agency. In the United States, on the other hand, the Securities and Exchange Com- mission shares oversight functions with the Commodity Futures Trading Commission, the Federal Deposit Insurance Corporation, and others. 50 ProblEmS of Economic TranSiTion A more significant attempt to regulate banking activity was made as part of the Basel agreements. The first version of them, in 1988, estab- lished requirements for the minimum level of banks’ capital. This took into account the probability of bankruptcy of even large banking institu- tions, because of which banks should hold part of their capital in reserve against unforeseen losses. Due to the expense of complying with this requirement, banks tried to take as much of their assets as possible off their balance sheet. One way to solve this problem was securitization; another was structured investment vehicles, which conceal subprime mortgages; and a third was the use of credit default swaps in partnership with insurance companies such as AIG. After the market collapsed, the threat of returning these assets to the banks’ balance sheets grew, and became the main cause of the current problems. It would be wrong to think that the policy being conducted could be more circumspect if, politicians, instead of bankers, were responsible for its consequences. They are the ones who approved the banks’ actions to provide risky loans. This particularly characterizes the United States, where a number of measures, starting with the 1977 Community Reinvestment Act, were intended to stimulate bank lending in disadvantaged regions. In practice, this amounted to a social policy: more loans for poor people. The government-sponsored giants of the mortgage market, Fannie Mae* and Freddie Mac,** were also oriented to guaranteeing enormous amounts of loans in the 1990s. The number of homeowners in the United States increased, and real estate prices climbed at the same time, which compli- cated the situation with issuing loans to low-income borrowers and made it necessary to lower lending standards. Thus, the seeds of the subprime mortgage crisis were sown, while the securitization technique enabled banks to provide such loans and not show them on their balance sheet. The increase in the number of homeowners and, hence, growth of the middle class were considered positive results of the deregulation policy. And the increase in consumer borrowing with the use of credit cards was similarly assessed. The authorities approved the growth of consumer de- mand that this caused. In the 1970s and 1980s, it is true, they might still have been concerned about the impact of these factors on inflation and the trade deficit. But the technological progress of the 1990s and the increased *The Federal National Mortgage Association (FNMA), commonly known as Fannie Mae.—Ed. **The Federal Home Loan Mortgage Corporation (FHLMC), commonly known as Freddie Mac.—Ed. july 2009 51 economic might of China and India in the 2000s led to a decline in the offi- cial inflation rate and liberalization of capital markets, and the accumulation of savings in Asian countries facilitated financing of foreign debt. Countries that had major financial centers considered this an advan- tage, since they provided a significant share of tax revenues. The authori- ties had no particular incentives to control the operation of the financial sector. They were also not worried about the fact that political parties in both the United States and Great Britain were receiving substantial donations from financiers. Deregulation was the result of many factors, including regulators’ desire not to lag behind the trends of international development, espe- cially the rapid creation of offshore markets. Market liberalization served voters’ interests because it helped to make loans cheaper. Because of the availability of inexpensive resources, financial innovations were aggres- sively used for speculation. Bankers and traders were always one step ahead of the regulators in this regard. In the current large-scale crisis conditions, it is easy to forget that deregulation facilitated access to loans for business and households. It made a significant contribution to economic growth and fostered an ap- preciable rise in the standard of living in the past thirty years. Will the new, regulated world be better? It seems that mankind has not been able to devise anything more ef- ficient than the market. It is not clear how much government interference should be stepped up in crisis conditions, but, in any case, the government should not permit the payment of rewards to the bosses and sharehold- ers of the banks they rescue. It is risky to channel loans to politically important sectors of