The
financial meltdown in Europe and North America has continued in spite of the
large sums of money governments have pumped into the financial markets to prop
them up. On October 10th, both the Dow Jones Index in New York and the FTSE in
London fell by 7%. For Ugandans, what is this crisis about? What caused it? Who
was responsible? Could it have been avoided in time? How different is it from
other economic crisis before? What are its likely effects both on the global
economy and on Uganda? Is there something that we in Uganda should be afraid
of?
The background
The
source of the crisis can be traced to the liberalisation of the financial
sector beginning during the presidency of Ronald Reagan in the USA and the
premiership of Margaret Thatcher in Britain what many call the neo-liberal
revolution. It then spread to other countries on the globe in poor countries
largely through Structural Adjustment Programs. Before 1930, Western economies
were run on free market principles known as laissez faire i.e. little or no
government interference in the operation of markets. This system led to the
great depression which began with the collapse of the stock market in New York
in 1929.
The
lesson learnt from this experience was that governments should intervene in
markets to avoid such pitfalls. A consensus in favour of an intrusive state in
the economy emerged. Governments began not only to regulate banks, but to own
them also. Governments also took over telecommunications, energy etc. That
consensus sustained economic growth and low employment in the 1930s, 40s and
50s but began to enter diminishing returns in the 1960s. By the 1970s, sluggish
growth and high inflation caused an ideological swing back to liberal ideas of
free market competition. Reagan and Thatcher were thus products of this swing
rather than the cause.
The
1980s were the period of rolling back the state Public enterprises were
privatised, state monopolies disbanded and price controls removed. All this
unleashed innovation especially in sectors like telecommunications, ICT and for
purposes of this discussion in financial markets. The result was high
growth rates in the 1990s the boom of the Bill Clinton and Tony Blair years. In
many ways therefore the success of Clinton and Blair was premised on the
reforms of Reagan and Thatcher. But they too recognised the necessity of these
reforms and therefore deepened them.
The financial bubble
What
were the innovations in financial markets during the 1980s, 90s and the early
2000s that led to the current crisis? Many new financial products came to
the market often called derivatives. They included credit default swaps,
interest rate swaps, securitisation of credit card debt etc. What are these
things anyway? We begin with mortgage backed securities. Let us assume that
Barclays Bank has US$ 10m and gives mortgages (loans to buy houses) worth that
amount to its customers. In the short run, it will have run out of money to
lend to other customers who turn up looking for mortgages. People repay
mortgages over a period of 20 years. Barclays would have to wait for many years
to collect the money and loan it to other clients.
This
shortage in the supply of money was overcome by securitisation of the
mortgages. What is this? Barclays would package the mortgages according to the
quality of the underlying asset and borrower. For those mortgages where the
owners had low risk of defaulting, they were called prime. Those where there
was a high risk of default were called sub-prime. The interest rate on each of
these products was determined by the underlying risk. Having thus packaged them
this way, Barclays would sell them to for example the East African Development
Bank (EADB).
Let
us assume that Barclays gave out the mortgages at 10% interest rate per annum.
It can sell to EADB at say 8% and promise that it will every remit to them that
amount. EADB (in the US, this role was largely played by Fannie Mae and Freddie
Mac) would then issue a bond (a piece of paper) promising that anyone who buys
that paper will earn an interest of say 6% per annum. Pension funds e.g. NSSF
hold long term money from their subscribers. They would buy these bonds
otherwise called securities from EADB which would in turn guarantee them an
annual income of say 6% from their investment every year.
Because
Fannie Mae and Freddie Mac had an implicit federal government guarantee, many people
thought their bonds to be very safe. In almost all these cases, the securities
these two institutions issued were underwritten by prime mortgages.
Barclays
has committed to pay 8% interest to EADB every year. If those who took its
loans default, it will be exposed i.e. it will not be able to meet its
obligation to EADB. To cushion against this, Barclays would now go to a hedge
fund let us assume Bear Sterns in this case and hedge itself against the risk.
Bear Sterns would promise to pay the 8% to EADB if Barclays Bank borrowers
defaulted.
This
fear of exposure was multiplied. EADB also has obligations to those who bought
its bonds e.g. NSSF. To cushion against likely default by Barclays, EADB would
buy insurance from, let us say, AIG. Bear Sterns knowing the likely risk would
also go and re-insure its obligations to AIG. Now you have the entire financial
sector locking itself up in many obligations. Initially, this innovation was
thought to be a way of spreading risk. Today, with the benefit of hindsight, it
shows it was actually concentrating risk: the failure of one would cause the
rest to buckle.
Mortgage
securitisation itself was not an innovation of the 1990s. It came in the 1930s.
Its major result was to increase the supply of mortgage finance and Uganda
needs to do it yesterday. But the 1990s and early 2000s brought multiple risk
insurance platforms that seemed to reduce exposure. Thus you got credit default
swaps (where investors buy insurance against corporate default they are worth
US$ 62 trillion in the US) and interest rate swaps (where one party agrees to
exchange a fixed rate obligation with another that has a floating rate
exposure). The craze hit the sky with the securitisation of credit card debt.
I
was initially enthusiastic about these innovations because they seemed to
spread risk across many institutions. I still have a strong fascination with
them. They drove the financial sector in the West to unprecedented growth over
the last two decades. People working in the sector made fortunes over night as
profits soared. By 2006, financial firms represented 25% of total profit in the
US up from less than 5% in the 1980s. The market for credit default swaps grew
from US$ 100 billion in 2000 to US$ 62 trillion in 2008. Only one man saw the
danger Warren Buffet. He called these derivatives of financial weapons of mass
destruction. A man of incredible foresight, Buffet warned refused to invest in
dotcom during their boom. Everyone wrote him off as an outdated old man. He was
proved right.
It
would be incomplete not to recognise the technological changes that have
underpinned this transformation of the financial sector. The introduction of
ATMs, trading stocks on the web and internet banking created a non-stop
electronic finance network that works 24/7. Its implications are yet to be
assessed. Bankers in Singapore would close at 7pm but leave their money to be
electronically traded by their counterparts in New York. As New York went to
bed, it would leave the money to be traded by Singapore who would now be going
to work. The fusion of time differences, electronic money transfers and cross
continental trading brought an entirely new dynamic to the financial sector.
The collapse
That
a financial crisis in the US was looming was an open secret. The first signs
were in the real estate market. Prices of homes soared in America and Britain
largely driven by increased supply of mortgages. Annual price increases were
about 20%. Developers poured money into the market by putting up more houses.
Because of rapid appreciation of home values, individuals began to refinance
their mortgages i.e. borrowing against the increased value in their home. Home
equity loans became the in-thing you could refinance your mortgage and put money
into stock. Why was there so much money in the system? The Federal Reserve had
been cutting interest rates by 2007 down to 1%. Banks therefore had too much
liquidity and were under pressure to find clients to lend. This meant they had
to reduce their risk assessment. Those who didn’t missed the opportunity.
Consequently, even people who would under normal circumstances not qualify for
home loans were getting them.
I
am suspicious that banks did this because they expected home prices to go up
forever. Assume someone bought a house at US$ 100,000 at an interest rate of 3%
per year. Let us also assume that they expect prices to increase by 20% per
year. In this case, if someone defaulted for two years, the value of the house
would be US$ 144,000 (a capital gain of US$ 44,000) yet the accrued interest on
the loan would US$ 7,000. The bank would auction it at a handsome return.
The
US has rating companies that tell investors and firms how risky or not a given
product or company is. I know only three rating companies in the US; S&P,
Moodys and Fitch. The structure of incentives of these companies lends itself
to abuse. Corporations hire rating companies to rate them.
Of course every
corporation would want to be rated AAA. Now let us assume that Fitch rated
Lehman Brothers AAA but S&P was very strict and rated them at only A. Of
course, the incentive of Lehman brothers would be to shift business from
S&P to Fitch. One can argue that these rating companies rely on reputation
and therefore cannot overstate the rating they give a given company even if it
is paying them for it. But this assumption is illusory because of the
oligopolistic nature of the industry, and also because there can be a million
justifications for either a good or a bad rating.
Many AAA companies along with
the instruments they had issued have been found to have been wanting. Did the
rating companies not see how highly leveraged and risky these financial
instruments were? Most unlikely and only partly! My suspicion is that in the
competition for clients, rating companies found themselves compromised. Their
earnings came from getting more clients, not less.
It is this later
factor that justifies regulation. One often-advanced reason has been that the
free marketers refused calls for regulation from an ideological point of view,
arguing that competition was a better regulator. This is only partly true. The
fundamental issue is that it is difficult to organise a consensus on regulation
during a boom because no one wants to end the party. Now that there has been a
crash, regulation will be easy to sell politically. This possibly justifies
Allan Greenspans argument against trying to fix markets that have not yet
crashed.
How unique?
There
will always be a crash after a boom. The challenge is how to mitigate its
effects and how to clean up the mess it leaves in its wake. The cyclical growth
of capitalism was initially identified by classical economists like Adam Smith,
John Stuart Mill, David Ricardo and Karl Marx. The economist who gave it the
most robust expression was Joseph Schumpeter in his famous phrase the gale of
creative destruction.
For
Schumpeter, every innovation drives profits in an industry, thus attracting a
swarm of imitators. Initially, these profits and the entry of imitators create
a boom until prices reach a level that is economically unsustainable. This lays
the ground for a burst as competition drives prices down. Profits plummet,
leading to losses everywhere. Schumpeter, like Marx, saw this as the way the capitalist
beast works, not the way it fails. The collapse creates space for renewal by
killing enterprises with old technologies and old organisational forms thus
paving way for the emergence of new and reconstituted firms that will bring new
innovation into life.
For
every collapse, there is always a fall guy. In this case, it is President
George Bush and the Republicans and/or the corporate leaders who presided over
the collapse of enterprises. Government policies have powerful implications on
how markets work. But governments are not omnipotent and omnipresent in the
life of markets. That is why Britain under New Labour and Europe largely under
the control of left-leaning parties are both almost in the same boat as the US
under Bush.
Individuals
also accentuate the crisis through greed and/or stupidity. From the early 1990s
when all these new financial products reared their ugly head, the economic boom
in the West was clearly driven by increasing debt on the part of both consumers
and firms. The longer such a debt fuelled boom lasted, the greater would be the
disaster when finally the edifice unravelled. Didn’t these corporate executives
see the crisis on the horizon? The structure of incentives favoured ignoring
the red lights. Why?
Some
banks were raking in huge profits from clearly risky lending. Yet the day of
reckoning was not coming. If you tried to be prudent, you lost market share.
CEOs and other executives don’t get rewarded for losing market share in the
name of some uncertain future. They get fired. In such circumstances, risky
lending crowds out un-risky lending. It is called the herd mentality when one
antelope in a herd runs, all others follow suit. If there is a lion, the one
that didn’t will be eaten. Yet if there was no lion, the antelope can come back
later and eat the grass. The lesson: it is always better to join the crowd.
Although
details of any crash differ, the broad outlines of how it unfolds have remained
largely the same for over four hundred years. In all cases, some economic
variable e.g. the price of houses, or stocks or a currency reaches a level that
is economically unsustainable. Many people may notice this, many don’t. Even
those who notice think they will be jump off before the train hits a steel
wall. When the time comes, few succeed. Remember that a speculative bubble is
most profitable when it is about to burst.
Finally,
the day of reckoning comes. Prices fall. What were good loans become bad loans,
adequate collateral becomes inadequate collateral. What was a good balance
sheet becomes a bad balance sheet. This sets in motion a panic. Loans that are
not adequately collateralised get called. Fearful of default themselves or
short of liquidity, banks don’t renew short term loans that would in normal circumstances
get automatically rolled over. Credit markets freeze up. Suppliers, afraid that
they would not be paid insist on cash before delivery. Working capital dries
up. A healthy company becomes an unhealthy company. What then are the
implications for the global economy and for Uganda?
Continues next week.
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