ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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Seven Triggers of the US Financial Crisis

What were the factors that catalysed the financial meltdown in the United States? A listing and discussion of seven triggers of the crisis.

It took four years to unwind General Re Securities’ portfolio of credit derivatives – at a loss of $ 400 million till 2007, and another $ 500 million in Q1 2008 [Morris 2008].

Most financial instruments on the scale of CDS, like treasury futures, are traded on exchanges. Once brokers match a treasury future trade, the clearing corporation of the exchange steps in as the CCP for both the buyer and the seller. The CCP insists on daily collateral postings. More importantly, a CCP aggregates outstanding positions data participant-wise, sets up participantwise limits, and enables netting of long and short positions participant-wise; all very vital systemic risk mitigation functions. In the absence of a CCP in the OTC market where the

CCP could have mitigated if not prevented a systemic crisis in the CDS market.

COMMENTARYnovember 1, 2008 EPW Economic & Political Weekly22bankrupt, the accounting requirement of fair valuing financial instruments would have triggered a financial system-wide cascading effect ofMTM writedowns, a write off of capital of highly leveraged institutions and would have unleashed a chain of rating down grades across the system, which in turn would have caused another cascading and mounting cycle of MTM losses, rating down grades and finally acute credit contractions. A similar problem seems to have brought downAIG. A small AIG corporate subsidiary apparently wrote $ 441 billion worth of credit default swaps on corporate bonds, and worse, mortgage-backed securities. As the value of these insured-referenced enti-ties fell,AIG had massive write-downs and additionally had to post more collateral. And when its ratingsweredowngradedon September15, 2008, the company had to post even more collateral, which it did not have. In short, what happened in one smallAIG corporate subsidiaryappears to have blown apart one of the largest insur-ance company globally [Gilani 2008].The financial system would surely have been better off had it introspected upon Warren Buffet’s words: Many people argue that derivatives reduce systemic problems, in that participants who can’t bear certain risks are able to transfer them to stronger hands. These people be-lieve that derivatives act to stabilise the economy, facilitate trade, and eliminate bumps for individual participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies. Charlie ((Munger), vice chairman of Berk-shire Hathway) and I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by non-dealer counter parties. Some of these counter parties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic prob-lems….History teaches us that a crisis often causes problems to correlate in a manner un-dreamed of in more tranquil times.(iv) ExcessiveLeverageLeverage is a double edged sword. It is the life blood of business and economic growth when used wisely and moderately. Indeed, economic activity would come to a grinding halt if no credit or leverage were available from the banking or shadow financial system. Concomitantly, without lending the banking system would have no avenue to deploy their deposits, except in treasury securities. Thereby, the house-hold savers would have no safe avenue of earning a fixed return, except by investing in treasury securities directly or through banks. The role of leverage and credit is therefore central to growth. Yet, excessive leverage leaves little margin of error if things go wrong, and can have a damag-ing impact. At what level leverage is moderate or excessive may differ across economies, businesses and business cycles. Nonetheless, in any economy, financial firms tend to use more leverage than the real economy firms. It is this inherent leveraged nature of banks and financial firms that forms the basis of regulatory capital requirements and other regulations to which these firms need to be subjected to in the larger public interest. Within the financial system, banks tend to be most rigorously regulated due to their deposit taking activities, cheque writing features, and their role in the clearing and settle-ment systems. And, banking regulations usually limit the leverage ratio of banks through a minimum capital to risk-weighted assets ratio (CRAR) on an ongoing basis. The BaselII framework evolved by the Bank for International Settlements (BIS) in 2006 sets aCRAR of 9 per cent for adop-tion by banking regulators globally. At 2007 year end, Fannie Mae and Freddie Mac had an effective leverage of an astounding 65x and 79x respectively. And, the leverage ratio for the big five invest-ment banks at 2007 year end was 27.8x for Merrill Lynch, 30.7x for Lehman Bros, 32.8x for Bear Stearns, 32.6x for Morgan Stanley, and 26.2x for Goldman Sachs. Notably, when financial assets are valued in the mark-to-market/model in the financial statements under fair value accounting, the leverage ratio computed on suchMTM asset base tends to be understated in boom years when asset prices may be higherthan their fundamental value. This euphemistic leverage ratio of tranquil years can rise sharply in years of asset price downturns, without adding a dollar more to the liabilities. Way back in 1975, the Securities and Exchange Commission (SEC) established a net capital rule that required broker deal-ers (such as these investment banks) who traded securities for customers as well as on their own account, to limit their lever-age to 12x. Reportedly, according to Lee Pickard, a formerSEC official,SEC granted exemption to these five investment banks from the net capital rule which limited their leverage to 12x (New York Sun, September 18, 2008), though, their annual reports suggest that leverage was higher than 12x even in 2003, at 15.7x for Merrill Lynch, 23.7x for Lehman Bros, 26.4x for Bear Stearns, 23x for Morgan Stanley and 18.7x for Goldman Sachs. Add to this, theirderivatives-heavy activities includ-ing in the toxic CDO andCDS obligations which in a generous measure were corre-lated to the US housing market and sub-prime credits. CALL FOR PAPERSThe Department of Economics, University of Mumbai, will host a seminar in the broad area of Public Policy inFebruary 2009. Broadly the seminar would deal with various issues pertaining to central, state and local governmentfinances and intergovernmental relations in the Indian context. We would also like to include papers which deal with International experience offiscal policy. Abstracts must reach us by 20th November and the full paper by 20th December (both, in hard and soft copy form) to Dr. Mala Lalvani or the Director, Department of Economics at the address given below. The papers would be rigorously vetted and the decision would be communicated to you in the first week of January. For any further queries please contact Director, Department of EconomicsUniversity of MumbaiMumbai, 400 098, India

on the back of a major rise in mortgage debt [Borio ibid].

After a prolonged rise in housing prices from 2000 to 2005 on the back of an ecosystem of easy availability of credit at low interest rates, the US entered a phase of a housing price correction in 2006, perhaps the worst in US history with no sign of it bottoming out any time soon. As

Against the backdrop of historically low interest rates and booming asset prices, credit aggregates, alongside monetary aggregates, had been expanding rapidly. Despite the rapid increase in credit, however, the balance sheets and repayment capacity of corporations and, to a lesser extent, households did not appear to be under any strain. The high level of asset prices kept leverage ratios in check while the combination of strong income flows and low interest rates did the same with debt service ratios. In fact, in the aggregate, the corporate sector enjoyed unusually strong profitability and a comfortable liquidity position, even though in some sectors leverage was elevated as a result of very strong leveraged buyout (LBO) and so-called “recapitalisation” activity. But debt-to-income ratios in the household sectors exhibited a marked upward trend,

Roubini, Nouriel (2008): ‘Rising Risk of a Systemic Financial Meltdown: The 12 Steps to Financial Disaster’, February, 12,

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