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«Hedge Funds and their impact on the Global Financial Crisis,Atul Gulrajani Causes of Global Financial Crisis • Loan Securitization - the Devil ...»

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Hedge Funds and their impact on the Global Financial Crisis

,Atul Gulrajani

Causes of Global Financial Crisis

Loan Securitization - the Devil Unveiled

o

The current financial crisis traces its roots to the US subprime crisis; which in turn

emerged from the financial instruments such as securitization of loans by banks.

Securitization allowed packaging of the underlying cash flow from the pool of loans

into various tranches, which had multi-tiered risk-return structures i.e. investors could decide if they wanted to go for higher return and take up more risk or be conservative and accept lower return. Securitization also allowed banks to immediately offload loans and free-up the cash that would otherwise be locked in the long-term mortgages.

The mechanism initially worked well for both buyers and sellers, causing significant increase in their profits. This prompted banks to borrow more money (the savings corpus began to fall short) to lend out and create more securitization. Number of banks started leveraging their balance sheets to lend more and more and then package them in securitization structures to sell to prospective investors.

Investment banks such as Lehman Brothers started buying mortgage loans to securitize them and sell them on.

Given the quality of the collateral - the property - the banks started taking higher risks by lending money to less creditworthy borrowers and also by lending more compared to value of the underlying property with borrowing against the property reaching 100% of the purchase price of the property through Alt-A (secondary mortgage) loans. These loans were attractive for the lenders as they could command higher interest from the borrower given their lower credit scores. In addition, through the blessing of ratings agencies, who would rate the securitization structures based on the correlation of default amongst many thousand borrowers, underestimated those correlations and ended up rating large part in the investment grade arena, even though the individual loans in the pool would have never met those criteria. There is also a debate on whether the conflict of interest created by securities originator paying the ratings agencies to get rated led to poorer scrutiny by these agencies. The illusion that the property prices would never decline, prompted lenders to believe that they would recover their money by selling the underlying property at higher price even if the borrower defaulted. Such lending soon became popular across banks creating a large number of risky loans. Soon the proportion of total US mortgages classified as subprime rose from only 5% during 1994 to 20% in2006. Studies suggest that the same was true in economies of UK and Spain.

Various types of underlying obligations - from credit card borrowings to borrowings by the corporates - were packed and repacked leading to alphabet soup of structures - ABS, RMBS, CMBS, CDO, CLO, CDO, etc.

The business continued to be lucrative at this point in time and leading banks got into a form of investment banking business i.e. buying, selling and trading risky assets. On the other hand investment banks, not content with buying, selling and trading risk, got into home loans, and mortgages without the appropriate controls and management.

The Vicious Cycleo

Many of the housing loans were packaged with teaser interest rates - very low interest rates for the initial 2-3 years - which would later increase substantially. The income level of many borrowers could not support these increased mortgage payments and started defaulting, creating additional inventory in the already oversupplied housing market. This along with slowing economy transformed into significant slowdown in housing market, whereby equity of the owner in the home dropped further below reducing the lenders’ chances of recovering the amount lent by selling the property.

The riskier loans started defaulting on their loan payments and soon the situation went from bad to worse as banks began to cut back on further lending based on home equity lines of credit. This phenomenon was termed as subprime crisis.

Some of the banks even ceased lending altogether for a while. The house prices started to fall as there were no takers, further worsening the situations and defaults started to creep beyond subprime loans into the less risky loans. By September 2008, the situation had become so grim that banks with large capital reserves ran out of steam.

Other Causes of Global Economic Crisiso

Apart from the global fallout from the financial crisis in the United States and the bursting of the housing bubbles in the US and in other large economies; the soaring commodity prices, increasingly restrictive monetary policies in a number of countries, stock market volatility, unregulated or less regulated newly popular instruments like CDS also contributed to the current economic crisis.

Role of Hedge Funds, Other Financial Instruments • Evolution of Risk Mitigating Financial Instruments o Derivatives, financial futures, credit default swaps, and related instruments came out of the turmoil from the 1970s. The oil shock, the double-digit inflation in the US and a drop of 50% in the US stock market made businesses look harder for ways to manage risk and insure themselves more effectively.





The finance industry flourished as more people started looking at these securities not as insurance, but contracts to gain from speculation. To price these complex instruments, economists, mathematicians and computer programmers came together to devise new theories, sometimes adopting them from the other disciplines of natural sciences with little regard to the difference between the perfect world of physics and the one of financial market where psychology and emotions are also at play.

Once derivatives could be priced through formula, it became easier to trade. A whole new market in risk was born and exploded in size. Greed started to kick in.

Businesses started to go into areas that were not necessarily part of their underlying business. In effect, people started making more bets, speculating, or gambling.

Some institutions were paying for risk on margin so you didn’t have to lay down the actual full values in advance, allowing people to make big profits (and big losses) with little capital. As Nick Leeson (of the famous Barings Bank collapse) has explained,- each loss resulted in more betting and more risk taking hoping to recoup the earlier losses, much like gambling. Derivatives caused the destruction of that bank.

Hedge Funds Criticized Once Again o

Hedge funds have received a lot of criticism for betting on things going badly. In the present global financial crisis they were criticized for shorting on banks, driving down their prices. Some countries temporarily banned shorting on banks. It is possible that, the hedge funds may have been signaling an underlying weakness with banks, which were encouraging borrowing beyond people’s means. On the other hand the more it continued the more they could profit, as the banks’ difficulty in raising capital with depressed share prices was impaired - creating the selffulfilling prophecy.

The market for credit default swaps (a derivative on insurance on when a business defaults), for example, was enormous, exceeding the entire world economic output of $50 trillion by summer 2008. It was also poorly regulated. The world’s largest insurance and financial services company, AIG alone had credit default swaps of around $400 billion at that time - a lot of exposure with little regulation.

Furthermore, many of AIGs credit default swaps were on mortgages, which went downhill, and taking AIG along.

World over, the regulators turned blind eye to the explosive growth in trading of these derivatives under the impression that these instruments were transferring the risk from those who do not want to take to the those want to actively assume the risk. In reality, the trade in these swaps created a whole web of interlinked dependencies - a chain only as strong as the weakest link. The crucial part which got neglected was whether those who wanted to assume risks actually had the ability to weather the consequences in the downturn. The complex web on delicate interlinks became evident when the collapse of Lehman Brothers caused credit markets to come to grinding halt. Eventually the US Government had to bailout AIG to (to the tune of $150bn) prevent it from failing which would have led to more systemic shocks.

Derivatives didn’t cause this financial meltdown but they did accelerate it once the subprime mortgage collapsed, because of the interlinked investments. Derivatives revolutionized the financial markets and will likely be here to stay because there is such a demand for insurance and mitigating risk.

According to Evan Davies, BBC’s former economic editor and presenter “The challenge now is to reign in the wilder excesses of derivatives to avoid those incredibly expensive disasters and prevent more AIGs happening.” Impact of Financial Crisis on Global Economy •

–  –  –

The extent of the economic crisis has been very severe; some of the world’s largest financial institutions have collapsed. Others have been bought out by their competition at low prices and in other cases, the governments of the wealthiest nations in the world have resorted to extensive bail-out and rescue packages for the remaining large banks and financial institutions.

Many nations - including China whose economy is still growing, but at much slower pace than pre-crisis period - have resorted to stimulus packages in the form of tax relief and infrastructure spends. The costs are huge - the US taxpayers alone will spend some $9.7 trillion in bailout packages and plans, according to Bloomberg.

With falling tax revenues and increased government spending, the deficit will be extremely high. The Congressional Budget Office of the US forecasts deficits reaching 13% of the GDP in 2009 and 10% in 2010. World over, the government deficit will be funded through borrowing by the sovereigns which expected to be at levels never seen before. The US Government’s borrowing needs for the fiscal year 2009 are estimated to range between $1.5 trillion to $2.5 trillion, according to the US treasury’s borrowing advisory committee. Independent reports suggest that the US debt-to-GDP ratio may double to almost 80% by 2015.

At least the US Government debt has chance of being bought by the market due to perceived security and reduced risk appetites. However, many countries will not be so fortunate in raising the debt at cheaper cost. Even the Debt Management Office of the UK Government had difficulty in gathering sufficient buyers at its recent auction.

This has led to long list of countries going to IMF - Hungary, Serbia, Romania, Iceland, Ukraine, Belarus, Latvia, Colombia, Pakistan have all approached the IMF for funds. Mexico was recently granted $47 billion line of credit.

The global economic growth outlook has subdued. The US GDP is expected to decline by 1.6% in 2009, whereas the global GDP is forecast to grow by just 0.5% from an earlier estimate of 2.2%.

The UNCTAD report released in September 2008 says, “… the fallout from the collapse of the US mortgage market and the reversal of the housing boom in various important countries has turned out to be more profound and persistent than expected in 2007 and beginning of 2008. As more and more evidence is gathered and as the lag effects are showing up, we are seeing more and more countries around the world being affected by this rather profound and persistent negative effect from the reversal of housing booms in various countries.” Are Bailouts Justified?

o The bail-outs appear to help the financial institutions that got into trouble many of whom pushed for the kind of lax policies that allowed this to happen in the first place.

Nobel Prize winner for economics, Paul Krugman, commenting on Bernard Madoff’s $50 billion fraud, notes that much of the financial services industry has

been quite similarly corrupted:

“The financial services industry has claimed an ever-growing share of the nation’s income over the past generation, making the people who run the industry incredibly rich. … The vast riches achieved by those who managed other people’s money have had a corrupting effect on our society as a whole.

… But surely those financial superstars must have been earning their millions, right? No, not necessarily. The pay system on Wall Street lavishly rewards the appearance of profit, even if that appearance later turns out to have been an illusion.

… At the crudest level, Wall Street’s ill-gotten gains corrupted and continue to corrupt politics, in a nicely bipartisan way.”

- Paul Krugman, The Madoff Economy, New York Times, Opinion, December 19, 2008 “It is a disappointment, but not a surprise, that the administration came up with a bill that is again based on trickle-down economics. You throw enough money at Wall Street, and some of it will trickle down to the rest of the economy. It’s like a patient suffering from giving a massive blood transfusion while there’s internal bleeding; it doesn’t do anything about the basic source of the hemorrhaging, the foreclosure problem. But that having been said, it is better than doing nothing, and hopefully after the election, we can repair the very many mistakes in it.”

- Joseph Stiglitz, Nobel Laureate Joseph Stiglitz: Bail Out Wall Street Now, Change Terms Later, Democracy Now!, October 2, 2008 More Regulations Going Forward • While it can still be debated if lax regulations caused this crisis in first place, more regulation is definitely on its way. Bob McKee of the economic consultancy Independent Strategy says, "The current system is in crisis and we have an environment where dog eats dog. Electorates will expect more regulation, and politicians will push or it." British Business Secretary Peter Mandelson commented in October 2008 that new global solutions are needed because "the machinery of global economic governance barely exists", adding: "It is time for a Bretton Woods for this century." UK Prime Minister Gordon Brown has been arguing for the modernization and reform of the global regulations since January 2007.



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