In 1991, Alan Greenspan testified that ‘job insecurity’ is beneficial to the economy. Arguing that workers are likely to be more productive if they believe that their job is in jeopardy.
Most financial instruments in use today are not based on an asset or collateral, but are effectively 'bets' on value of underlying assets. Initially, this appeared mathematically to reduce risk, as the bank could 'bet' against it's own assets as a way to hedge the downside. As this practice expanded, banks began to make money through these instruments by selling them to each other. What originated as an idea to reduce risk ended up compounding it exponentially, which led to the worst financial crisis since the Great Depression.
While the 2007-2008 losses on US subprime mortgage bonds created mounting losses for US pension funds, corporations and financial institutions, as that crisis mounted, a supplemental crisis began to hit. In September-October 2008, loses on US subprime mortgage bonds and mortgage-backed securities began to trigger credit calls.
In 2005-2006, US insurance giant AIG began insuring against a fall in mortgage bonds. These credit default swaps (CDS) were paid for in premiums by investment banks and other financial institutions. As house prices began to drop and more and more US mortgage holders failed to make their payments in 2007-2008, AIG was forced to pay out on insurance policies backing hundreds of billions of dollars.
In March 2008, investment banking giant Bean Stearns began to enter financial distress as hundreds of billions of dollars of MBS and CDOs began to default. The SEC, Federal Reserve Bank and the US Treasury were required to step-in to facilitate a purchase of Bear Stearns by JPMorgan Chase were the US taxpayer would backstop any losses on MBS and CDO products, also known as ‘toxic assets’, or assets of unknowable value in a non-functioning market worth trillions of dollars.
When the size of the crisis became more clear, global banks began to review the potential damage from the fallout of the collapse of Bear Stearns. Global banks like Citigroup, UBS, Barclays and Deutsche Bank began to review their exposure to US subprime mortgage defaults. Pension funds and investment funds began to dig into the quality of the financial products they had been sold by US investment banks. Upon inspection, many banks began to ‘mark-to-market’ their ‘toxic assets’. When they began to seek pricing in the opaque market for MBS and CDS, they began to see large instances of defaults and prices quickly plummeted as financial institutions of all kinds began to unload their ‘toxic assets’ onto the market.
In September 2008, investment bank Lehman Brothers began to suffer tremendous losses on their mortgage-backed assets and CDOs, and at the close of business ended without enough cash to resolve their accounts, resulting in their bankruptcy.
The US Treasury Secretary, Hank Paulson, defined what he called ‘moral hazard’ if we were to bailout Lehman Brothers or backstop any potential losses from ‘toxic assets’ on the balance sheet as they had with Bear Stearns.
Failing to find a buyer for Lehman Brothers without support of the US Treasury and taxpayer, the investment bank went bankrupt September 15, 2008. As the counterparty to hundreds of billions of dollars of trades, when Lehman Brothers entered an unstructured liquidation of assets, trillions of dollars of assets began to decline in value precipitously. Other US investment banks began to discharge their mortgage assets and CDS creating a disorderly market and a desperate raise to raise cash to ensure solvency for the bank. Eventually the markets stopped working as no buyers could be found and market makers had exited. That evening, when the banks reconciled their books, massive write downs were required, essentially bankrupting large sectors of the US financial system.
As Congressional legislators and the US Treasury sought a resolution, a supplemental crisis was looming in investment giant AIG. AIG had ignored their own risk management group’s advice, and bought heavily into the MBS and CDS market near the peak of the asset bubble. Crushingly, the insurer, following the guidance of investment rating companies Standard & Poor’s and Moody’s, had calculated that the risk of a decline in US house prices or a wide-scale default on mortgages was negligible and sold hundreds of billions of dollars of insurance policies against declines in US home prices, as well as other securities and CDS. The credit default swaps would destroy the value of the insurer overnight, and with it bankrupt the US financial system.
Vowing to ‘use the bazooka’ to protect the US financial system, US Treasury Secretary Hank Paulson sought at $700 billion bailout package for the banking system. A number designed by Treasury Department officials as enough to cover the decline in the value of ‘toxic’ mortgage assets.
September 19, 2008, the US House of Representatives voted against the $700 billion bailout fund designed by the US Treasury. By the end of trading, the US New York Stock Exchange saw a decline in the Dow Jones Industrial Average of 777 points, one of the largest declines in market history and ended down nearly fifty percent before stabilizing in 2009.
The severe decline in the stock market led to massive declines in US pension funds, and with losses nearing 50% in 2008-2009, many funds began to lack the solvency to pay current pensioners, or lacked a long-term strategy to return to solvency for future benefit recipients.
The US subprime mortgage crisis created a ripple effect in global banking. In 2007, US mortgage assets were classified as ‘AAA’ investment grade for bank collateral, pension funds seeking moderate returns were able to stock up on ‘AAA’ bonds paying higher yields and reaping rich returns for the funds. International banks from Australia to Switzerland to Iceland to Japan began to feel the ripple effects as the recognized the new true value of the assets on their balance sheets. Icelandic bank Landsbanki saw writedowns on its balance sheet that led to insolvency at the bank. UK banks, Northern Rock, RBS and Barclays saw writedowns on their US subprime related assets resulting in their insolvency. Swiss bank UBS and Germany’s Deutsche Bank suffered losses on their books leading to their insolvency. By seeking to globalize risk in the US subprime mortgage markets, the financial institutions tied the global financial system and the financial systems of key trading partners, Japan, UK, France and Germany to US assets. As these assets were rated ‘AAA’ and US house prices had continued to rise for decades, banks failed to calculate the cost of a severe rise in defaults on assets viewing them as a ‘safe’ asset class for their balance sheets.
As all global banks sought safety in cash, global asset prices plunged and credit and interbank lending ceased, resulting in a rare, or ‘black swan’ economic event known as a credit crunch. The financial system fails as markets cannot find buyers and prices plummet, credit stops and businesses begin to fail as short-term credit is called in and businesses are unable to make their payroll resulting in their bankruptcy.
As all global banks sought safety in cash, global asset prices plunged and credit and interbank lending ceased, resulting in a rare, or ‘black swan’ economic event known as a credit crunch. The financial system fails as markets cannot find buyers and prices plummet, credit stops and businesses begin to fail as short-term credit is called in and businesses are unable to make their payroll resulting in their bankruptcy.
Seeing the national and global effects of the financial crisis, the US House of Representatives, lead by House Speaker Nancy Pelosi, resolve a $700 billion bailout fund to support US financial firms from entering bankruptcy. The FDIC raises deposit insurance coverage to $100,000 and the US Federal Reserve opens its overnight window to allow all US financial institutions to borrow at extremely low interest rates.
In coordination with the IMF and World Bank, the US government begins negotiations over requirements on US-denominated mortgage bond assets. US banking institutions are able to move their toxic assets off of their balance sheets to the Federal Reserve Bank to be valued at a future date when market liquidity is returned.
By bailing out the US banks, the US Congress and the Bush Administration’s Treasury Department were able to free up credit markets and forestall the breakdown of business lending.
 |
| Customers queue at Northern Rock branch in hopes of securing cash in the event of a bank collapse. |
Within the EU, things were even more dire. Ireland, Spain, Portugal and Greece all saw their banks invest heavily into the high yielding US subprime market, but they also witness subprime mortgage bubbles of their own. Using cheap credit from the US and northern Europe, these countries saw speculative property bubbles form. When the global financial crisis started and credit dried up, the property market collapsed and mortgage holders began to default on their debts en masse. The combined effects of the collapse in US and domestic European assets led to tremendous losses at Spanish, Irish and Greek banks. The resulting bank bailouts required financing from the IMF and World Bank as they represented an amount greater than the domestic GDP of the countries.
In 2009, the United State Federal Reserve Bank began to purchase assets with newly created cash, seeking to remove more ‘toxic assets’ from bank balance sheets and reopen credit market liquidity.
As the US Fed dropped its bank lending rate to 0.05%, and began purchasing government bonds and municipal bonds, the ECB also dropped its rate as did the central banks of other EU countries.
The final casualty of the financial crisis was Fannie Mae and Freddie Mac, the gargantuan, government backed, publicly traded company. Entering government conservatorship wiped hundreds of billions out of investors, such as large pension funds. Fannie Mae and Freddie Mac have been forced to write down hundreds of billions of dollars, but with government guarantees, was able to value assets at a fixed price to begin market making and to seek value of the assets.
 |
| Value of deposits in Icelandic banks. |
Icelandic bank defaults led to tremendous losses for UK and Spanish depositors who lost savings during the crisis. This compounded the 50% losses in the stock market to lead to the threat of bank defaults. Some US, UK and Spanish banks saw runs of withdrawals, but were backed by central banks so as to finance any withdrawals.
In 2010, Greece began to reach the upper limit of its debt threshold, whereby their tax revenues were not sufficient to pay the interest payments on their outstanding debt. As a result this created a debt crisis in Greece and interest rates for Greek debt skyrocketed making the situation critical and requiring intervention from Germany, Italy and France and the EU and the ECB to lend to Greece at a lower rate to ensure they could maintain essential services. Greece entered negotiations with the EU, IMF and World Bank to determine how to reform government services to reduce the deficit to a sustainable level. As the Greek economy began to stagger and government cutbacks became felt, business investment ceased and workers were laid off.
As the Greek debt crisis worsened, Greek negotiators sought to dramatically cut their debt to creditors, while German bondholders, still reeling from the US subprime crisis and credit crunch, were not sympathetic to allow for ‘haircuts’ to bonds.
With the possibility of another sovereign default imminent, holders of Euro denominated debt began to examine the possibility of the collapse of the Eurozone and the ECB and began looking at other countries at risk of a debt default.
The interest rate for sovereign debt of Spain, Portugal and Ireland skyrocketed as investors re-assessed the ability of the country to reduce its deficits long-term. The European debt crisis ensued and crushed the markets of those countries. Eventually the ECB and IMF negotiated with backing from the US government, the Fed, France and Germany by providing and guaranteeing low interest rate purchases for Eurozone bonds.
As the Eurozone crisis created risk, US and international banks began to move into US dollar denominated assets, driving up the cost of US dollars and undermining the US Fed mandate to ensure ‘full employment’. As US interest rates were already essentially zero, the Fed entered a policy of printing new cash to analyze and write down the toxic assets on the balance sheet, to purchase government bonds on the open market and to support other assets. All this in an effort to reduce the exchange rate of the US dollar to provide an export advantage to US companies.
By settling into a period of ‘forward guidance’ that the Fed was buying bonds, this allowed the largest financial institutions to reap high rewards by front running the Federal Reserve to acquire US Treasuries. This has been a source of profit to begin to restore bank balance sheets.
By acting to support the US labor market and manipulating the currency to favor US exporters, the Fed neglected the greater importance of US imports and how higher import costs would affect US consumers who represent two-thirds of the economy. This combined with the significant loss of household wealth due to the collapse of home prices and the stock market, led to a depression in the US economy that was exited in 2012 resulting in a loss of $14 trillion dollars in US wealth.
An uncertain legislative agenda involving investigations into the financial crisis and the Dodd-Frank reforms led banks to become more conservative. In 2012 the Doha III round of talks international governments passed new rules and regulations for international assets following the investigations into failed risk management, poor oversight and accountability at rating agencies, a lack of due diligence and a failure in government oversight.
After successfully stabilizing global financial markets, the tripartite of the ECB, the US Fed and the IMF entered a period of prolonged monetary experimentation. By 2013, US bank balance sheets had been restored, the $700 billion bailout had been repaid to the US Treasury and banks began the slow process of adjusting to a new low interest rate environment with the new constraints of regulations. As the recession continued, international policy makers decided to continue the process of quantitative easing, or printing new cash, to purchase assets. US fiscal policy entered into severe deficits in the years following the financial crisis as the Obama Administration attempted to provide fiscal stimulus by providing cash-starved state and local governments with an infusion to ensure that essential services were not jeopardized as a result of the depression.
By 2015, the process of quantitative easing (QE2, QE3, QE4) had led to an appetite by European and Asian governments to monetize the debt of the nation as a policy tool to counter deflation. With interest rates near zero percent, and the US depressing the exchange rate value of the dollar to support exports and fight deflation, the euro and yen began to rise and exports from Eurozone and Japan lost competitiveness. To counter these effects, Japan began to print yen to monetize their sovereign debt, driving up yields. While this had the effect of supporting the Japanese Nikkei stock exchange, it did not provide growth to GDP.
Japanese banks had been deemed ‘zombie banks’ since their financial crisis in 1990, and had been on long-term state support hampering their growth for decades and depressing Japan’s economy. Debt-financed state funding for economic development failed to provide real results for the economy and the servicing on the massive two hundred percent of GDP debt have led the Japanese economy to become sclerotic, the entire banking system slowed by a ball-and-chain of debt.
Japan requires major fiscal and monetary policy changes as well as structural reforms to its economy to gain productivity and growth in the economy. Japan also needs to address the long-term structural problems in regards to its state pension and health care entitlements. 
Eurozone countries also began to feel the burden of a strengthening euro on their exports and began to call for monetary policy to equal the playing field. Germany opposed the deal as it was deemed to be a way to spur euro inflation. With countries like Spain, Italy and Greece looking to monetize their debt to restructure their national balance sheets, Germany did not support the proposal.
With long-term structural deficits now becoming an international problem, investors began to flee sovereign debt of Greece, Portugal, Ireland, Spain and Italy, but as well France. At this point, with the German taxpayer directly buying Eurozone bonds to support other economies, Germany allowed the ECB to being a process of quantitative easing to pass through cash to investors through asset purchases.
To facilitate this, Germany required technocratic governments to administer the countries and restore their balance sheets to order. In Spain, the sudden collapse in government fiscal spending coupled with banking weakness and business failures led to a Spanish Great Depression that has lasted since 2009, with unemployment nearing 30%. Greece as well suffered under the German requirements for fiscal austerity. Greece’s punishing debt servicing cost and inability to refinance or reduce its overall debt load has left Greece with barely enough cashflow to run essential services and still relies on foreign cash injections. With government spending reduced substantially, the Greek Depression that hit in 2010, and continues, has seen tremendous emigration into the northern European Union countries.
The Eurozone now has a crisis of systemic proportions brewing. Countries are facing three profound challenges: an aging population and declining childbirth are increasing burdens on working people slowing economic growth; reduced tax income resulting in larger deficits as the aging population draws upon their savings and draw on the entitlements they were promised.
Continued in Part 2
Continued in Part 2
No comments:
Post a Comment