Global financial crisis: From housing bubble burst to credit freeze
Monday, 20 October 2008
Zahid Hussain
The developed world and the emerging market economies are currently fighting a financial Tsunami that epicenters on the U.S. Fallout from the frozen subprime mortgage market in the US has spilled over into the credit and stock markets globally. A key question that would probably be debated for years is how did the bursting of the housing market bubble in the US flare into such a worldwide financial crisis, threatening to bring the wheels of the global economy into a grinding halt? I don't know the answer. I am sure economic historians will ultimately find it when they have the full benefit of hindsight. But I do know that the debacles in the market for financial derivatives and the commercial paper market would be core elements in whatever the full explanation may be. Let me elaborate.
In the early 1990s, bankers devised credit default swaps (CDS) in order to hedge their loan risks. This is essentially an insurance contract between a protection buyer and a protection seller covering a corporation's, or sovereign's (the "referenced entity"), specific bond or loan. A protection buyer pays an upfront amount and yearly premiums to the protection seller to cover any loss on the face amount of the referenced bond or loan. Typically, the insurance is for five years.
More simply, credit default swaps are like me insuring your house, not with you, but with someone else not at all connected to your house, so that if your house is washed away in the next flood or cyclone, I get paid its value. Isn't that strange? Whoever said truth is stranger than fiction probably anticipated CDS! Why are I, and not you, getting paid? Because, I made the bet.
Credit default swaps are bilateral contracts. Credit default swaps are not standardized instruments. In fact, they technically aren't true securities in the classic sense of the word. They are private contracts between two parties. They are subject only to the collateral and margin agreed to by contract. They are not transparent, not traded on any exchange, not subject to present securities laws, and are not regulated. They are traded over-the-counter, usually by telephone. They are subject to re-sale to another party willing to enter into another contract. Most significantly, credit default swaps are subject to counterparty risk.
Fundamentally, this kind of derivative serves a real purpose - as a hedging device. The actual holders, or creditors, of outstanding corporate or sovereign loans and bonds might seek insurance to guarantee that the debts they are owed are repaid. That's the economic purpose of insurance.
What happened, however, is that risk speculators who wanted exposure to various bonds and loans, or security pools such as residential and commercial mortgage-backed securities, but did not actually own the underlying credits, now had a means by which to speculate on them. They piled up bets on bets, debt on debt, but all built on the same source of risk-mortgage and subprime mortgage based securities which in turn depended on prosperity in the housing market. As housing market fell, the entire superstructure of debt built on it became toxic. Thus, instead of reducing risk by providing opportunities for diversification, the derivatives became a mechanism for risk magnification. Most players in this market had no clue that this was in fact the case because of the complexity of the instruments. Speculators sold and bought trillions of dollars of insurance on the expectation that these pools would, or wouldn't, default!
The turbulence in both the stock and credit markets is a direct result of what played out in the CDS market. The Fed Reserve could not risk wiping out the trillions of dollars of credit default swaps on the books of Bears and Sterns by allowing it to go under. All the banks and institutions that had insurance written by Bear would have to write-down billions and billions of dollars in losses that they have been carrying at higher values because they could say that they were insured for those losses. The counterparty risk that all Bear's trading partners were exposed to was so wide and deep that if Bear was to enter bankruptcy it would take years to sort out the risk and losses.
The same happened to AIG as it got too greedy. As of June 30, AIG had written $441 billion worth of swaps on corporate bonds, and mortgage-backed securities. With fall in the value of these insured-referenced entities, AIG had massive write-downs and additionally had to post more collateral when its ratings were downgraded, which it did not have.
There are a lot more. These instruments are causing many of the massive write-downs at banks, investment banks and insurance companies. It is a vicious cycle - one that eroded public faith in banks, and worse, banks' faith in other banks. As a result, banks ceased lending to each other out of the fear that the next round of write-downs and losses may imperil some of the trading partner banks that they used to lend billions of dollars to every night.
Let me turn now to the commercial paper market debacle.
The commercial paper market is the access road where Main Street merges into Wall Street. The cash main street investors deposit into money market funds and other short-term investment vehicles ultimately buys the commercial paper that is issued by corporations, finance companies and banks. These help fund everything from corporate payrolls to a manufacturing company's production inventory.
Banks used to run a "matched book", meaning they matched the maturity of the money they took in with the maturity of the loans they made. Not any more. In order to increase their profit margins, banks borrowed very short term, paid as little interest as they had to, and lent out the money for as long as they could. It's called "borrowing short and lending long." It is an interest-rate bet by the banks. It works if rates are steady or falling. If short-term rates rise, margins shrink. If banks end up having to pay more to borrow short than they are collecting on their long loans (this results from an inverted yield curve) they have a major problem. But relative to what actually happened, that's only a small problem.
Banks borrowed short-term CP money to buy collateralized residential and commercial mortgage backed securities for their own balance sheets. They thought it was a great borrow short/lend-long spread play. But when these short-term loans come due, they could not "roll" them over. They could not get the money to pay back the investors who bought their commercial paper when it came due. If no one will buy any more paper, that's a game-ending problem resulting from total loss of confidence. What then is the consequence? Simple, the public loose faith in banks.
My overall point is this. CDS massively expanded the volume of casino-type trading opportunities in the capital markets. Subprime mortgage crisis would not have been so magnified if they were not linked to these financial casinos where major stakeholders-financial institutions, non-financial corporations, and even governments-held bets, mostly unknowingly, and lost. We need a much better understanding of how that actually happened. (The author is Senior Economist at the World Bank Dhaka office. The views expressed in this article are the author's own, not that of the World Bank)
The developed world and the emerging market economies are currently fighting a financial Tsunami that epicenters on the U.S. Fallout from the frozen subprime mortgage market in the US has spilled over into the credit and stock markets globally. A key question that would probably be debated for years is how did the bursting of the housing market bubble in the US flare into such a worldwide financial crisis, threatening to bring the wheels of the global economy into a grinding halt? I don't know the answer. I am sure economic historians will ultimately find it when they have the full benefit of hindsight. But I do know that the debacles in the market for financial derivatives and the commercial paper market would be core elements in whatever the full explanation may be. Let me elaborate.
In the early 1990s, bankers devised credit default swaps (CDS) in order to hedge their loan risks. This is essentially an insurance contract between a protection buyer and a protection seller covering a corporation's, or sovereign's (the "referenced entity"), specific bond or loan. A protection buyer pays an upfront amount and yearly premiums to the protection seller to cover any loss on the face amount of the referenced bond or loan. Typically, the insurance is for five years.
More simply, credit default swaps are like me insuring your house, not with you, but with someone else not at all connected to your house, so that if your house is washed away in the next flood or cyclone, I get paid its value. Isn't that strange? Whoever said truth is stranger than fiction probably anticipated CDS! Why are I, and not you, getting paid? Because, I made the bet.
Credit default swaps are bilateral contracts. Credit default swaps are not standardized instruments. In fact, they technically aren't true securities in the classic sense of the word. They are private contracts between two parties. They are subject only to the collateral and margin agreed to by contract. They are not transparent, not traded on any exchange, not subject to present securities laws, and are not regulated. They are traded over-the-counter, usually by telephone. They are subject to re-sale to another party willing to enter into another contract. Most significantly, credit default swaps are subject to counterparty risk.
Fundamentally, this kind of derivative serves a real purpose - as a hedging device. The actual holders, or creditors, of outstanding corporate or sovereign loans and bonds might seek insurance to guarantee that the debts they are owed are repaid. That's the economic purpose of insurance.
What happened, however, is that risk speculators who wanted exposure to various bonds and loans, or security pools such as residential and commercial mortgage-backed securities, but did not actually own the underlying credits, now had a means by which to speculate on them. They piled up bets on bets, debt on debt, but all built on the same source of risk-mortgage and subprime mortgage based securities which in turn depended on prosperity in the housing market. As housing market fell, the entire superstructure of debt built on it became toxic. Thus, instead of reducing risk by providing opportunities for diversification, the derivatives became a mechanism for risk magnification. Most players in this market had no clue that this was in fact the case because of the complexity of the instruments. Speculators sold and bought trillions of dollars of insurance on the expectation that these pools would, or wouldn't, default!
The turbulence in both the stock and credit markets is a direct result of what played out in the CDS market. The Fed Reserve could not risk wiping out the trillions of dollars of credit default swaps on the books of Bears and Sterns by allowing it to go under. All the banks and institutions that had insurance written by Bear would have to write-down billions and billions of dollars in losses that they have been carrying at higher values because they could say that they were insured for those losses. The counterparty risk that all Bear's trading partners were exposed to was so wide and deep that if Bear was to enter bankruptcy it would take years to sort out the risk and losses.
The same happened to AIG as it got too greedy. As of June 30, AIG had written $441 billion worth of swaps on corporate bonds, and mortgage-backed securities. With fall in the value of these insured-referenced entities, AIG had massive write-downs and additionally had to post more collateral when its ratings were downgraded, which it did not have.
There are a lot more. These instruments are causing many of the massive write-downs at banks, investment banks and insurance companies. It is a vicious cycle - one that eroded public faith in banks, and worse, banks' faith in other banks. As a result, banks ceased lending to each other out of the fear that the next round of write-downs and losses may imperil some of the trading partner banks that they used to lend billions of dollars to every night.
Let me turn now to the commercial paper market debacle.
The commercial paper market is the access road where Main Street merges into Wall Street. The cash main street investors deposit into money market funds and other short-term investment vehicles ultimately buys the commercial paper that is issued by corporations, finance companies and banks. These help fund everything from corporate payrolls to a manufacturing company's production inventory.
Banks used to run a "matched book", meaning they matched the maturity of the money they took in with the maturity of the loans they made. Not any more. In order to increase their profit margins, banks borrowed very short term, paid as little interest as they had to, and lent out the money for as long as they could. It's called "borrowing short and lending long." It is an interest-rate bet by the banks. It works if rates are steady or falling. If short-term rates rise, margins shrink. If banks end up having to pay more to borrow short than they are collecting on their long loans (this results from an inverted yield curve) they have a major problem. But relative to what actually happened, that's only a small problem.
Banks borrowed short-term CP money to buy collateralized residential and commercial mortgage backed securities for their own balance sheets. They thought it was a great borrow short/lend-long spread play. But when these short-term loans come due, they could not "roll" them over. They could not get the money to pay back the investors who bought their commercial paper when it came due. If no one will buy any more paper, that's a game-ending problem resulting from total loss of confidence. What then is the consequence? Simple, the public loose faith in banks.
My overall point is this. CDS massively expanded the volume of casino-type trading opportunities in the capital markets. Subprime mortgage crisis would not have been so magnified if they were not linked to these financial casinos where major stakeholders-financial institutions, non-financial corporations, and even governments-held bets, mostly unknowingly, and lost. We need a much better understanding of how that actually happened. (The author is Senior Economist at the World Bank Dhaka office. The views expressed in this article are the author's own, not that of the World Bank)