globaleconomy
may 2009www.capital-me.com
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By Dr. M S S El Namaki
A myriad of reasons have been given for the currentcredit crisis and the ensuing dramatic economicepisode. Practices within the investment bankingindustry, lax government regulation, creativefinance, bad monetary policies and irresponsibleexecutives are all pointed out as culprits. Culture,ideology and the sheer desire to amass wealth arealso added. In the end, greed has been identified asthe underlying common denominator and the forcethat transcended functions, structures and people.
One of the primemistakes madeby contemporarybankmanagement isfocus on currentrevenue andmaking that thebase for mobilityand rewards.
ANew
BankingAftertheCreditCrisis
T
he question on everybody’s mind today ishow long it will all last and what will emergefrom this virulent force of nature.
Roots of Crisis
The crisis can basically be attributed to three trig-gers: faulty financial instruments, bad institutionalframework and aberrant strategies.
Instruments
One of the prime instruments involved in the ongo-ing crisis is securitization. It was the pivot in creditvolume expansion and credit risk enhancement. It isa form of structured finance whereby financialassets, especially those for which there is no readysecondary market, such as mortgages, credit cardreceivables and student loans, are pooled and usedas collateral for new securities. Securitization,through highly rated mortgage backed securities(MBSs), allowed mortgages with a high risk ofdefault to be originated almost at will, with the riskshifted from the mortgage issuer to investors atlarge. Securitization also meant that issuers couldrepeatedly relend a given sum, greatly increasingtheir fee income and dodging default risk.Investment banks assumed a key role in securitiza-tion.
Institutions
A shadow banking system devoid of regulation dis-regarded common sense and assumed a high riskmantel. Investment banks, as the prime players with-in the shadow banking system, went into massivedebt and invested the proceeds into MBSs, essen-tially betting that house prices would continue to riseand that households would continue to make theirmortgage payments. What they did was borrow atlower interest rates and invest the proceeds at high-er interest rates, or practice financial leverage. Thisis a strategy that would work under normal marketconditions or conditions where real estate pricesassume a stable upward trend. The oppositeoccurred. Result: mortgage default and collapse inthe value of MBSs.Losses in MBSs among investment banks resultedin a decline in their operating capital and a loss ofconfidence of creditors. Three investment banks col-lapsed: Bear Stearns, Lehman Brothers and MerrillLynch.
Strategies
Speculative leverage had become a mainstreamstrategy for banking and insurance institutions, withspeculation and greed replacing sound businessstrategies and becoming the prime force withinfinancial markets. Three types of borrowers con-tributed directly towards the accumulation of insol-vent debt: The hedge borrower who expected tomake debt payments from cash flows from otherinvestments; the speculative borrower who bor-rowed believing that the appreciation of the value ofthe assets would be sufficient to refinance or pay offtheir debt and who did not have sufficient resourcesto repay the original loan; and the Ponzi borrowerwho relied on continually rolling over the principalinto new investments. Speculation reached epidem-ic levels in the U.S.
The End of the Tunnel
The following table projects forecasted values forGDP growth, unemployment, consumption expendi-ture, investment expenditure and current accountbalance for a few key economies and two crucialyears: 2010.The countries and areas involved are the U.S., theEU, Japan and China.
Landscape
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