Rob M Pt. 1
This is a personal discussion on the current global financial discussion. I am not an expert on the subject and only wish to forward my thoughts on the issues so that they can be critiqued and I can learn more about what is an important issue affecting a lot of people across the world.
The current financial crisis that started in America now seems it will affect developing countries too. This post discusses the background of the crisis, outlines the main contagion channels, the effects it will have on developing countries, and the potential policies/actions that these countries can implement now and in the future to shield themselves from similar events.
The root cause of the current financial crisis can be traced back to the burst of the dotcom bubble where as a result of the over-valuation of dotcom companies the NASDAQ dropped from the heights it had reached at the turn of the century.
The fall negatively impacted on the American economy. GDP growth slowed down and was negative in some quarters, the rate of unemployment increased in sectors outside those directly linked to dotcom companies. To stop the economy entering a recession, the US Federal Reserve aggressively eased monetary policy to boost growth.
The Fed’s Fund rate was reduced 27 times between January 2001 and June 2003 falling from 6.5% to 1% over the stated period. The low interest rates stimulated a boom in the housing market. Because of the large percentage house values contribute to peoples’ overall incomes, the housing boom overcompensated for the loss in wealth that had occurred during the stock market decline of 2001-02 creating growth in the economy (with this eventually leading to a housing bubble). The growing incomes in the US economy were further supported by Government expenditure on the wars in Afghanistan and Iraq and the increased spending on domestic security. This led to high levels of liquidity in the real economy and in the financial markets creating an environment in which investors took greater risks and were innovative in maximising their yields.
The full repeal of the Glass Steagall Act in November 1999 under Bill Clinton’s second term was one of a number of financially liberal policies adopted in America at the time. The Glass Steagall Act allowed Banks to fully engage in underwriting securities and dealing activities exposing previously safe Banks to the risks associated with such financial transactions. Bank reserve requirements were relaxed under the Bush administration allowing banks to use a bigger proportion of reserves for trading.
One of the instruments heavily invested in by financial institutions were mortgage-backed securities (MBS). These are basically individual home mortgages pooled together (the pool is usually divided horizontally into credit quality tranches) so that they can be priced and analysed like a bond. Compared to any other financial asset mortgages were given a higher credit rating based on the assumption that when squeezed for income most people will pay their mortgages and cut back on the consumption of other products/services. Various Wall Street firms and an assortment of institutional investors binged on MBSs because of the enormous income fees they generated. And due to their high credit rating, banks/firms/financial institutions could borrow heavily to purchase them and many of them did.
When the housing bubble burst, the value of these MBSs was reduced due to rising default rates on the underlying securities/mortgages. Because a lot of these MBSs had been purchased with borrowed money, creditors raised their capital positions to manage their counter-party risk. In the cases where MBS had been purchased with company funds, the companies found they were making losses on these assets and had to readjust their operations.
Given the manner in which these MBSs had been divided up and sold and the fact that a number of financial institutions had bought tranches of these MBSs for their own accounts (Merrill Lynch and Bear Stearns being the biggest culprits), when the underlying default rate started rising financial institutions became weary of lending to one anther. No government or institution could be sure of which institutions were holding what was now being referred to as toxic debt. This created a credit crunch. As banks stopped lending to each other, the credit supply available to consumers and businesses in the economy dried up.
The effects of this reduction in credit have been far reaching and have stretched beyond the domiciles of those institutions involved. Indeed few if any countries will go unscathed by the overzealous activities of banks and other financial agents in maximising profit. In developing countries, the economic impact of the financial crisis is going to depend on how closely linked national economies are to the developed world (contagion channels) and the policy space governments’ have available to counteract the inevitable negative impact.
Footnote for those who feel that blog-posts are more aesthetically pleasing if there's some text after the quote: Regular readers , such as they are, will probably have noticed that we've been a little light on the posting of late. Dunno about anyone else, but for my part there's the usual plethora of excuses about thesis-related death-marches, time spent getting hit in the face, and a burning urge to consume my own body-weight in ethanol over the seasonal period. Pick your favourite.