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Sub-Prime Crisis : A Brief Comparison with the Asian-Pacific Financial Crisis and Possible Remedial Steps
(A Final Exam Paper Written for U21 Global, by Alwyn Lau)
A. The United States Sub-Prime Crisis The sub-prime phenomenon represents a shift in the way that mortgages have been traditionally funded. In the past, banks funded mortgage loans from the deposits they received from their clients1. When coupled with a system of regulations, loan viability evaluations, checks and balances, this minimized risks of defaulting loans, bank-run inducing panic, etc2. However, sub-prime financing began with a desire to cater to high-risk borrowers with weak credit histories and weak documentation of income3 hence the label, ‘subprime’. Banks processed the mortgage payments as mortgage-backed securities, mortgage bonds or collateralized debt obligations (CDOs’) and subsequently sold them to financial institutions worldwide. This also witnessed a rise in private sector involvement in the mortgage financing market, which reaped huge profits by riding on the demand for easy financing (the mortgage bond market was worth US$6 trillion as at November 20074). The success of CDOs’ was spurred on by a long-term trend of rising housing prices and loan incentives which encouraged borrowers to believe they would be able to refinance at more favorable terms later5. However, with the fall of house prices, mortgage lenders began calling in their loans. This affected borrowers many of whom, being high-risk and of low-(re)payability status in the first place, defaulted. As more defaults occurred and more foreclosures were announced, mortgage lenders and the third-party investors who had bought the credit-risk (via the CDOs’ and similar instruments) were also affected with significant losses. The dispersion of credit risk and the widespread effect on financial institutions in turn caused lenders to reduce lending activity or to make loans at higher interest rates, which in turn reduced the availability of and access of fund by individuals and corporations not originally involved in mortgage-backed securities, thereby creating a credit crunch, a economy-wide and multi-sector disappearance of credit as a spiraling result of falling confidence in one sector (in this case, the sub-prime market)6.
B. The East Asian Financial Crisis The East Asian financial crisis of 1997-8 developed along similar lines. As with the sub-prime fiasco, it began with a frontier of new opportunities for profit i.e. the new emerging Asian-Pacific markets. Massive expansion of credit occurred to fill the demand for a wave of new investments which took the form of both actual constructions and speculative activity7. The latter kind of investments eventually grew as unbridled optimism and promises of even greater gains fueled more and
more lending, then over-lending, far stretching the bounds of a healthy risk market. Also, many East Asian financiers were neither ordinary banks nor investment banks but institutions with good political connections. With access to funds on low interests, owners of these financial companies began lending out (on high interests) to speculators who wanted to make a killing by betting on, say, the real-estate market8. The liberalization of capital accounts to allow firms (including banks) to take on short-term foreign debt and the virtual non-existence of foreign exchange hedging created even more vulnerability9. In mid-1997, some speculators went bust, some finance companies closed shop, reducing confidence. Foreign lenders became more reluctant to lend. Local currencies were floated and immediately devaluated, thereby aggravating the debts of many local banks and finance companies, most of whom borrowed in foreign currencies, usually dollars. Central Banks then tried to limit the currency’s decline by raising interest rates, further stifling loans and economic growth10 – this is the parallel to US financial institutions raising lending rates as a result of overall reduced confidence in borrowers’ ability to repay. The combination of higher interest rates with falling investor confidence and dodgy balance sheets contributed to many East Asian economies entering a state of meltdown (apparently, only Hong Kong escaped devaluation11).
C. Comparing Both Crises There are many similarities between the two crises. They were both the result of unchecked profit-seeking taking the form of high-risk lending (which focused on realestate prices); in both cases, greedy optimism blinded most to cautionary measures (in the U.S. it was optimism in the housing market, in Asia it was buoyancy in Asia’s emerging economies); in both cases, financial regulation and supervision were slipshod; in both cases, the risks were extended across the financial community and, when the bubble burst, even parties not initially involved were affected because the entire lending/borrowing system was infected. On the other hand, there are also differences. First, the sub-prime crisis was limited to the U.S. national economy (although debate continues as to whether other regions were impacted12, the general consensus now is that they weren’t, or at least not significantly13) whereas the East-Asian crisis was almost by definition a region-wide event. Secondly, the East-Asian crisis was aggravated by the actions of financial and currency speculators14 (it was also the time when the name of George Soros would be one of infamy, especially among Malaysians and Thais15), which were non-existent in the sub-prime situation. Another key difference was that foreign investors played a major role in the EastAsian crisis, whereas in the sub-prime crisis it was mainly limited to American nationals. This suggests the culpability of non-Asian investors in the 1997 calamity who did next to no evaluations of their own, and who stood to lose nothing as long as their Asian ‘crony capitalists’ partners promised to pay them back. In a very sad way, it was the non-wealthy of Asia who suffered the most from the actions of their rich leaders and even richer foreign lenders (not to mention the currency
speculators16). In the sub-prime crisis, however, all parties suffered and in this sense it may be right to say that the misery was shared all across instead of being concentrated on the underprivileged many.
D. Tackling the Sub-Prime Crisis Immediate efforts by the U.S. Federal Reserve to manage the crisis include supporting market liquidity and using monetary policy (see Appendix 1 on the relation between monetary policy and economic growth)17. The Federal Reserve has: i. ii. iii. conducted open market operations (i.e. short-term loans to banks collateralized by government securities) and Term Auction Facilities (TAFs’) to ensure that banks have access to funds lowered interest rates for short-term loans announced term-repurchase agreements to enhance the ability of financial institutions to sell mortgage-backed and other debts18
The hope is that short-term funds would stimulate the commercial paper market and general economic activity. Funds and guarantees have also been provided to enable JP Morgan Chase to purchase Bear Stearns (a large financial institution with heavy mortgage-backed securities instruments that has plunged in value), in order to avoid a potential ‘fire sale’ of nearly US$210 billion of Bear Stearns’ MBS and other assets, further exacerbating the crisis19. In addition, the Federal Reserve is also proposing the reduction of loan principal amounts to address a concern that U.S. house-owners with negative equity (i.e. homes worth less than the mortgage principal) will have a financial incentive to ‘walk away’ from the property20. In the 1997 Asia-Pacific crisis, the short-term imperative was to restore the decimated funds of the Asian economies as means of propping up their financial system and preventing further downwards-spiraling (via IMF funds or the use of capital controls to prevent the outflow of foreign currency, as in Malaysia 21). This appears to be the objectives of the Federal Reserve System i.e. to stop the defaults, to defeat the credit crunch and get the monetary system on its feet again. The fiat lowering of interest rates, whilst creating discomfort for lenders, would at least encourage more lending in other areas of the economy (where, perhaps, repayment risks are far lower). Medium- and long-term solutions include: i. Lenders assisting homeowners provide more favorable mortgage terms (via loan modification or refinancing)22 Credit rating agencies helping to evaluate and report on the risks of investment instruments, to reexamine and improve the rating processes. Large amounts of mortgage-backed debt have also been downgraded
Regulators and legislators are taking action regarding lending practices, bankruptcy protection, tax policies, affordable housing, credit counseling and the licensing and qualification of lenders.
How effective are all the above in preventing a crisis of a similar nature? Whilst ‘only time can tell’, we can nevertheless make a future-oriented assessment by comparing the solutions proposed/implemented with how well they tackle the causes of the crisis. If the sub-prime crisis was a result primarily of self-fueling speculation and unregulated access to funds, then certainly options like a revamping of the role of credit rating agencies and stern action by regulators and legislators go straight to the heart of the matter. What’s disturbing is how and why the credit rating agencies provided triple-A (i.e. ‘very safe’) ratings for mortgage-backed securities in the first place.23 Perhaps more fundamentally, the Federal Reserve must be more cognizant of the impact on under-priced (and under-reported) risks to the banks. This refocuses efforts more prevention rather than cure and gets the Central Bank deep into the nature of risk-assets held by banks (whether on or off their balance sheets) allowing them to better manage the supply of money and credit, instead of merely tackling short-term symptoms of inflation and credit crunches24.
E. Lasting Effects of the Sub-Prime Crisis The sub-prime crisis affects the rest of the world the way a major spender in any economy (in this case, the world’s economy) impacts all other players. Low spending in the U.S. causes slow demand and low expansion in American investments, both locally and abroad. This eventually hits world markets dependent on American investment and even leads to increase in world commodity prices like that of gold, wheat, grain, oil and, of late, rice. The dropping dollar and consequently the appreciation of foreign currencies, reduce the competitiveness of other countries’ exports which in turn ricochets into their respective economies25. In East Asia especially the central banks hold huge foreign currency reserves mostly in dollars. A weaker dollar will reduce the value of these reserves, and erode their “protective buffer” against potential financial panics and a prolonged recession. More than 20% of China’s exports go to the US, and about 54% to the high-income economies; the decreased purchasing power of the dollar and the global slowdown might take their toll26. India was notably affected because foreign (mainly American) investors began selling off their investments in Indian equity-based companies to cover their losses 27. Nevertheless, because the mortgage market in India and other East-Asian countries are nowhere as developed as those in the U.S. and Indian banks do not as easily embrace structured and innovative investment assets as do their American counterparts28. Indian banks must also comply with statutory liquid ratios (SLRs’), contra many other Asian banks, let alone the U.S. banks. The SLRs’ allow government-sponsored programs to access those funds at below-market interest rates. India's central bank also requires banks to put aside 40% of their advances for so-called "priority sectors" like agriculture and small business, where the returns are low and many banks face bad debts29.
Conclusion The sub-prime crisis may be viewed as a result both of unchecked greed and speculation which were fueled by the possibilities presented by non-conventional loan mechanisms and instruments. Whilst it appears likely that the present crisis will abate eventually and at least the worst is over30, with continuing financial innovation and poor memories of disasters by those responsible for regulating rogue financiers, there is every possibility a crisis provoked by heavy speculation on light fundamentals will occur in the near future.
Appendix 1: Monetary Variables and Economic Growth The banking and financial sectors of a country influence the creation and growth of the ‘real’ economy via the manipulation of interest rates, its handling of the exchange rate, its efforts at price stability and the printing of money. A Central Bank’s base rate (the rate of lending to other local banks) impacts housing prices, disposable income of mortgage payers, consumer demand for credit, business investments and consumer and business confidence which in turn may either encourage slumps or peaks in the economy31. An interest rate represents the cost of financing and, applying conventional economics, when the price of anything falls, demand for said item rises. In this case, when interest rate falls, the demand for money rises leading to more investments and so on. Likewise, a country’s exchange rates (the cost of purchasing one’s domestic currency), if overly high, can out-price its exports vis-à-vis its imports (because it becomes more expensive for foreigners to buy our money and hence our goods), affecting local producers (albeit delighting some of its consumers). However, depreciation of the currency may raise the value of the debts valued in a foreign currency. Similarly, there is evidence suggesting an indirect relationship between inflation and long-term economic growth32, hence the desire of Central Banks to stabilize prices33. In summary, using the terminology of macroeconomics, monetary policy can be used to control aggregate demand and supply. A ‘loose’ policy unleashes borrowing and spending (though not without costs, as the sub-prime crisis proves) whereas a ‘tight’ one seeks to reign in runaway prices and failing loans.
The US Sub-Prime crisis in graphics, BBC, 21 Nov 2007, viewed 17 May 2008, http://news.bbc.co.uk/2/hi/business/7073131.stm
Krugman, P. Partying Like Its 1929, 21 March 2008, The New York Times, viewed 17 May 2008, http://www.nytimes.com/2008/03/21/opinion/21krugman.html?_r=1&oref=slogin
BBC, US Sub-Prime Crisis BBC, US Sub-Prime Crisis Sub-prime Mortgage Crisis, Wikipedia, viewed 17 March 2008 http://en.wikipedia.org/wiki/Sub-prime_mortgage_crisis Wikipedia, Sub-prime Mortgage Crisis Krugman, P. The Return of Depression Economics, Penguin Books, 1999, p.86. Krugman, P. The Return of Depression Economics, p.88-89. Reinert, K.A. Windows on the World Economy: An Introduction to International Economics, Thomson South-Western, 2005, p.271-2 Krugman, P. The Return of Depression Economics, p.94-95. Reinert, K.A. Windows on the World Economy: An Introduction to International Economics, p.270. The Economist, Lessons from the Credit Crunch
Citi Says Sub-prime Impact Limited in Asia, 31 Oct 2007, Reuters, viewed 18 May 2008 http://uk.reuters.com/article/ousiv/idUKBOM11787820071031
Krugman, P. The Return of Depression Economics, p.99. Krugman, P. The Return of Depression Economics, p.89.
Speech by Federal Reserve Chairman, Ben S. Bernanke at the Women in Housing and Finance and Exchequer Club Joint Luncheon, Washington, D.C.,10 Jan 2008, viewed 17 March 2008, http://www.federalreserve.gov/newsevents/speech/bernanke20080110a.htm
Sub-prime Mortgage Crisis, Wikipedia After Bear Staerns, Others Could be at Risk, 14 Mar 2008, MSNBC, viewed 17 May 2008, http://www.msnbc.msn.com/id/23638138/
Elphinstone, J.W. Housing Market Spirals, No End in Sight, 6 Mar 2008, Yahoo! Finance News, viewed 17 May 2008, http://biz.yahoo.com/ap/080306/housing_woes.html
Malaysia’s Capital Controls Reasonable, 25 Oct 1999, World Banker, Asian Economic News, viewed 17 May 2008, http://findarticles.com/p/articles/mi_m0WDP/is_1999_Oct_25/ai_57162829
Knox, N. & Kirchhoff, Criticism Rains Down on Mortgage Industry, 23 Oct 2008, USA Today, viewed 17 May 2008 http://www.usatoday.com/money/economy/housing/2007-10-23-mortgages-refinance_N.htm
Moore, E. Rating the Credibility of Credit Agencies, 17 Nov 2007, viewed 17 May 2008 http://uk.biz.yahoo.com/17112007/399/ratingcredibility-credit-agencies.html
The Economist, Lessons from the Credit Crunch
Chng, J. The Restructuring of Asian Market Amid Sub Prime Crisis, Press Exposure, viewed 17 May 2008 http://pressexposure.com/The_Restructuring_of_Asian_Market_Amid_Sub_Prime_Crisis-15244.html
Bocchi, A.M. Will East Asia Suffer the US Slowdown? 27 Feb 2008, East Asia & Pacific on the Rise, viewed 17 May 2008, http://eapblog.worldbank.org/content/will-east-asia-suffer-the-us-slowdown
Mehta, V.H. 10 Feb 2008, The Sub-prime Crisis and Implications for India, The Financial Express, viewed 17 May 2008, http://www.financialexpress.com/news/The-sub-prime-crisis-and-implications-for-India/271436/2
Sub prime crisis to have limited effect on India say analysts,7 Oct 2007, Domain-B.Com, viewed 17 May 2008 http://www.domainb.com/economy/general/2007/20071006_analysts.htm
How Indian Banks Cope with Unwanted Baggage in the Global Pecking Order, 10 Jan 2008, India Knowledge Wharton, viewed 17 May 2008, http://knowledge.wharton.upenn.edu/india/articlepdf/4251.pdf?CFID=57774025&CFTOKEN=76965073&jsessionid=9a306cf16a564a31 1fa3
Desmond, M. Lehman Chief: Sub-prime's End--Near; Pain--Not Over, 16 Apr 2008, Forbes, viewed 17 May 2008 http://www.forbes.com/facesinthenews/2008/04/16/rishard-fuld-lehman-markets-face-cx_md_0415autofacescan03.html 31 Macroeconomics / International Economy: Monetary Policy, Tutor2u.net, viewed 17 May 2008, http://tutor2u.net/economics/revisionnotes/as-macro-monetary-policy.html
Papademos, L. The Contribution of Monetary Policy to Economic Growth, Speech Delivered at 31st Economic Conference (Vienna), 12 June 2003, European Central Bank, viewed 17 May 2008 http://www.ecb.eu/press/key/date/2003/html/sp030612_3.en.html#ftn.fn10
Towards this end, The Economist proposes extending the definition of inflation to include property and shares. See Lessons from the Credit Crunch, 18 Oct 2007, The Economist, viewed 17 May 2008, http://www.economist.com/opinion/displaystory.cfm?story_id=9988758
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