2007 – 2008

The first World financial

crisis
Michael R. Krätke
University of Amsterdam
 Chronology of a world event
 2006 – the first warnings
 Summer 2007 – the first hedge funds fall
 August 2007 collapse of the market for mbas
- the credit crunch begins
 From september 2007 to august 2008 – banks
tumbling down all over the world
 September 2008 – the black september of
financial markets
 October 2008 – fighting the Big Bang
 The world economic crisis – the next Great
Depression – coming closer
Not the first (probably not the last)
international financial crisis
 The US stock market crash of 1987
 The US savings and loans crisis of 1986 -96
 The Japanese real estate and banking crisis –
1990 – 2000
 The EMS crisis in Europe 1992
 The Mexico – crisis of 1994-95
 The Asian crisis 1997 – 1998
 The Russian crisis 1998
 The dot.com crisis 2000 – 2002
 The Argentina crisis 2001
 The new pattern of cycles and
crises since the 1980s
 The business cycle is still there, but…
 The short term erratic cycle of financial bubbles and
crises prevails
 On average: one major international financial crisis every
three years
 From one bubble to the next – the flight of international
capital from one object of speculation to the next (from
ITC to real estate, from real estate to world trade
commodities like oil)
 Booms are driven by bubbles / bursting bubbles trigger
off major crises
 What is new today?
 All previous financial crises were regional /local crises
 In all previous financial crises the effects could be
contained
 The present financial crisis is the first truly world crisis
of financial markets / financial capitalism
 It hits all the stock markets in the world / all financial
centres of the world (more or less at the same time)?
 It hits all internationally operating banks /financial
concerns / institutional investors
 There are no safe havens (not even Zwitserland)
 A real world crisis starts in the USA (like it did before)
Has Capitalism changed recently?
 Capitalism with derivatives – the explosion of finance in general –
and of the trade in derivatives in particular
 Stock markets as multinationals
 International banks- present on all the major financial markets (as
capital markets perform the traditional function of banks)
 Institutional investors (mutual funds, pension funds, insurance
companies)
 Shift from Commercial Banking to Investmentbanks – and their
structured investment vehicles and “conduits”
 Rise of the Hedge Funds and Private Equity Funds (completely
different from traditional “long-only” mutual funds / investment
funds)
 The waning divide between banks and non-banks
 Financialization
 What financialization means:
 The predominance of finance – the relative rise
of the FIRE (finance, insurance, real estate)
sector which becomes more important than
manufacturing (22,6 % of GDP in the US to
14,9% in 2005)
 households are urged to behave like businesses
 businesses are urged to behave like banks
 banks are urged to behave like hedge funds
 basic rationale: creating profits without creating
new value (thriving on mere price differentials)
 Securitization
 basic logic: transforming illiquid loans in banks’
portfolios into marketable / tradeable /
negotiable assets
 expanding the secondary markets for
derivatives / creating new derivative markets
 inventing / creating compound (structured)
financial derivatives
 inventing / creating off-balance sheet conduits
– SIVs (structured investment vehicles) to hold
such assets
 For instance: creating a MBS
(mortgage backed security)
 first step: a new mortgage is issued
 second: the mortgage bank /company sells it to a firm
specialized in buying and reselling mortgages (like
Fannie or Freddie)
 third: the buyer aggregates many such loans into a pool
and issues a new bond based upon this pool (a right to a
profit arising from payments for the original loans)
 fourth: the buyer (Fannie or Freddie) sells this new
paper – the MBS – to others – typically institutional
investors and /or hedge funds
 Fifth: the hedge funds (or other buyers) start trading
these papers on the secondary markets (making profits
from rising prices / price differentials arising on those
markets
 The explosion of the trade in
derivatives
 Since the 1970s the volume of international trade in
derivatives has exploded
 The real news: the rise of “financial” derivatives to the
forefront
 Among them: “structured” products like mbs / the most
important class of new “structured” financial assets
being the CDOs (collaterized debt obligations) and CMOs
(collaterized mortgage obligations) – rapidly growing
between 2000 and 2006
 For instance: volume of outstanding interest swaps,
currency swaps and interest options was 3450bn $ in
1990
286000 bn $ end 2006 (six times global gross product)
 The explosion of the trade in
structured financial products
 different types: the “alphabet soup”
 The brave new world of
international finance: Deregulation
 The race to reduce / abolish capital controls and foreign
exchange controls started in the 1970s
 It continued throughout the 1980s and 1990s
 Two US examples: the repeal of the Glass – Steagall Act
of 1933 (in 1999) and the passing of the Futures
Modernization Act in 2000 (both still under Clinton)
 By mid – 20th century the financial sector was
everywhere highly regulated
 Today, the global financial sector is as liberalized as it
was before 1914
 The brave new world of
international finance: Beyond
regulation
 Shift towards non-regulated area’s
 The rise of “shadow-banking”
 Non-banks becoming banks (like GM, Chrysler
f.i. – making more profits with their financial
activities than by producing cars)
 Intermediaries abound
 The explosion of OTC – transactions
 The rise and multiplication of offshore-markets
and offshore-finance (offshore-markets and tax
havens throughout the world – more than half of
them in good old Europe)
The rise of “financial engineers”
 the new “science of finance” in economics
 In the 1960s Fischer Black with associates
(among them Nobel prize winnars Scholes and Merton) developed
new models to describe / analyze asset pricing in financial markets
 Their major finding was quickly forgotten: no empirical evidence
whatsoever that the activity of funds managers added anything to
the value of the funds’ assets (more embarrassing findings)
 However, the new generation of funds managers claimed to be
scientifically trained experts
 Fischer Black rethinking the “efficient market hypothesis” –
referring to “values” and very wide margins
 Fischers “science of finance” is not exact at all
 Fischer was a market radical, but clear-sighted enough to see the
futures exchanges as “gambling houses” (if people wanted to
gamble there, the state should tax their gains heavily as he does
with other forms of gambling)
The peculiar riddle of today’s world
financial crisis
 It started in one relatively small segment
of the US – real estate and mortgage
market (the socalled “subprime” segment)
 and it ended up as a world financial crisis
affecting all international financial
markets and all capitalist countries in the
world
 How was this possible?
 Subprime and prime – the US-
housing market
 What is peculiar about the subprime segment
 Selling properties to the ninjas (no income, no job, no
assets)
 Teaser rates and other tricks – apparently very low
costs (at the beginning) – but renewal of the loan due at
variable conditions – variable interest rates to begin with
 Credit default – no problem as long as the bubble
thrives
 Credit default swaps – decoupling the loan from the
default risk
 subprime mortgages – 160 billion $ in 2001 to more
than 600 billion $ in 2006
 Subprime and prime – the US
housing market
 simple mortgages – homeowners and (local)
banks
 the ever extending system of financial
intermediation
 an ever wider range of highly specialized
institutions
 mortgage finance, refinance (public concerns
like Fannie and Freddie) and insurance
 the thriving secondary markets for the
mortgage based assets
 Selling US-mortgages (subprimes)
worldwide
 Basic technique of financial capitalism – securitization
 Secondary markets for mbas are local – but the market
actors (hedge funds / banks) are operating on a global
level
 Volume of mbas shot up from 56 bn$ to 528 bn$ in five
years
 US structured financial products are sold, repackaged
and resold to investors all over the world (Europe, the
America’s, Asia)
 on an ever larger scale: the US real estate bubble
provides more and more of these assets
 A hyperspeculation arises – the Minsky moment occurs
The brave new world of structured
financial products
 From the simple IOY (I owe you) to the “alphabet soup”
 Investment banks buying and reselling structured
financial products all over the world
 packaging and repackaging debts (poor and good, of
very different origins) into cdo’s (collaterized debt
obligations) and other products
 selling and reselling / trading cdo’s all over the world
 Hence: the risk of bad loans (subprimes) and / or the
default insurance risk is everywhere
 The housing bubble – rising
mountains of debt
 Bubble driven by rising house prices (at double digit
rate)
 House prices driven by increasing demand
 Increasing demand driven by the permanent expansion
of mortgage finance
 from prime to subprime – expansion of the market
 stagnant labour incomes – explosive growth of private
debt, but also – growth of pirvate wealth (making
money by selling a house / by refinancing the mortgage
based upon ever higher real estate / house prices)
 the US consumption levels based upon rising mountains
of debt (with stagnant wages for the large majority of
workers)
 The making of an international
speculation bubble
 Securitization – the chance to sell any sort of
debt and loans immediately at a good price is
the base for the expansion of mortgage finance
 Huge amounts of capital flow into the
secondary markets all over the world (mostly
OTC transactions)
 Investment banks playing the game – pass the
parcel (with mba’s, cdo’s etc.) – among
themselves, the financial markets follow their
example
 not one housing bubble, but several (Spain, UK,
Ireland, Belgium and so on)
The importance of high leverage
 All these transactions are financed by credit – basic
rule: you don’t risk your own money, you risk other
people’s money
 Speculators (hedge funds in particular) use very high
leverage (up to 1 : 26) to finance their transactions
 Hence: if the asset purchased is losing its market
“value” or becoming worthless, all that remains is a huge
amount of debt!
 Intermediaries flock to the markets as long as the
markets are on the rise – helping to establish “high
leverage” for more and more participants
The dubious role of rating agencies
 The structure of the market for ratings
 The big three – Standard & Poor’s, Moody’s and Fitch (together,
they control nearly 90% of the market for ratings world wide)
 How they make their money – creating structured financial
products and evaluating them – while the issuing agent who wants
to bring these products on the markets pays them a fee for their
double service
 Impressive ratings were a prerequesite for the rising demand for
such products
 At the height of the cdo’s /cds’s boom, rating agencies received
more than half their income from such fees
 Such papers were rated as high as state / treasury bonds, but
yielded much higher returns – hence the frenzy of institutional
investors
 The bubble bursts
 Credit defaults happen – first and foremost in the
subprime sector
 Rising interest rates – rising levels of foreclosures - a
faltering market (rapid decline of new mortgages)
 More and more subprime mortgage loans get foul
 Declining house prices make refinance ever more
difficult
 Credit rationing by the banks (flight from mortgage
finance)
 And – flight from trash and into quality, rapid selling off
of mba’s, cmo’s and other structured products – the
market for these derivatives crashes
 Fear spreads
 Everybody in the financial world is
involved
 The mortgage backed securities have
been traded world wide
 Mortgage backed securities have been
bought by banks all over the world
 But where are the foul credits
 They can be everywhere, everyone is
probably at risk
 The first banks fall – the case of
Northern Rock
 The fifth largest mortgage financier in the
UK
 One of the major actors in the British
housing bubble
 Credit defaults – falling price of NR shares
 The reaction: A classical “run” on the
bank in october 2007
 followed by a bail – out (later
nationalization in early 2008)
 The big credit crunch – a crisis of
the money market
 Interbank lending – the central part of the money market
 From september 2007 onwards: banks restrict or refuse interbank
lending (sharp rise of interbank interest rates like the LIBOR and/or
credit rationing)
 There is no “liquidity crisis” - banks are not lacking liquidity but
hoarding it – because they don’t trust each other’s solvency in the
longer run
 Institutional investors rush to state papers (and commodity
exchanges)
 There is an “insolvency crisis” – hidden bankruptcies because of the
losses still undisclosed
 Since october 2007 central banks have stepped in several times –
sometimes in joint actions - as money market lenders of the last
resort
 The giants fall
 The big Wall Street five in crisis
 From Bear Stearns to Lehman Brothers
 Fannie Mae and Freddie Mac in crisis
 AIC - the second largest insurance corporation
 Dozens of larger banks have fallen - hundreds
of larger and smaller banks (in the US and
elsewhere) are presumably in trouble
 The fearsome domino effect (some banks are
just to big to fall)
The big Bail-out begins: Banks first,
women and children last!
 Bailing out – an old and common practice
 An ever increasing volume of bail outs
 First stage (september 2007 – august
2008) – selective bail outs for individual
banks in distress (ad hoc rescues)
 Second stage (from september/october
2008 onwards): bailing out the whole
banking sector
 The return of state socialism
 Nationalizing the banks, socializing the losses
 UK leads the move: First nationalizing single
banks (at least temporarily)
 now: nationalizing the junk papers of all the
banks
 US plan following the same pattern: helping the
banks to get rid of the “junk papers”
 no rescue for the shareholders, rescues for the
managers are restricted
 tens of thousands of bank employees have
already lost their jobs, much more to come
 The return of central banking
 A series of individual and collective actions taken by
central banks of the major capitalist countries (Fed, BoE,
ECB, BoJ, Swiss National Bank) to provide liquidity (short
term credits) for the banking system
 A few days ago: the first concerted action to pump
liquidity into the markets and to reduce the bank rate
 Lowering the standards: More and lower rated papers
are accepted as collaterals for central bank credits
 To no avail – actually, the central banks are now
substituting the private banks as providers of interbank
loans
 How long can the central banks go on?
The meaning of this crisis: The end
of the Wall Street Regime
 A month ago, only two of the big Five
investmentbanks at Wall Street were left
 Today – none
 The last two giants have chosen to transform
themselves into commercial banks!
 The stock markets crash worldwide – but Wall
Street even more (last week a series of
unprecedented stock market crashs all over the
world)
The meaning of the crisis: The end
of the dollar hegemony?
 Due to the decline of the USA as the leading
financial power of the world, the dollar will loose
further
 The rescue actions of the US government drive
the US public debt to unprecedented levels
 Depending upon the succes of the rescue
actions in Europe and Asia, other currencies will
further gain in relation to the dollar
 A major dollar crisis remains possible
 Anyway, the fate of the dollar will be decided in
Beijing
The meaning of this crisis: The end
of Neoliberalism?
 Certainly the end of the myth of the self-
regulating markets
 Probably the end of the myth of financial
market “efficiency” under minimal or no
regulation at all
 Rising doubts and second thoughts about
“freedom for speculators”
 The myth of the superiority of the US-
model of capitalism is shaken
 When will the financial crisis tear
down the real economy?
 In March 2008 the world economy seemed still growing
 Except in the USA (where a severe recession had already
begun / the US consumer is broke)
 But now it’ s completely different:
- four major and several smaller EU-economies are in
crisis
- Germany’s export industry (the leading export economy
of the world) is slowing down
- Japan’s banks are profiting an buying the spoils of the
financial crisis in the US and elsewhere, while the
Japanese real economy is stagnant
- the crisis will continue during 2009!
 Will the financial crisis affect the
NICs and NACs of today?
 The financial crisis has already hit the Chinese
banks and big insurance concerns
 Asia’s stock markets are hit by a series of
crashes as well
 The slow down of world trade in raw materials
has already begun (as several indicators show)
 The BRIC countries will be affected (how much,
depends on the relative size of their domestic
markets)
 Long term effects
 A new architecture of world finance in the
making
 A “World Financial Authority”
 A new role for the IMF?
 The shift between financial markets / financial
centres of the world
 An end to offshore financial centra?
 The end of banking as private business as we
knew it?
 When and where will the next
bubbles rise?
 Financial market capitalism Anglosaxon style
has only one chance to survive:
 Finding new objects for worldwide speculation,
creating the next bubble
 Candidats: Alternative energies, biotechnology
 But new bubbles will not solve the underlying
problem: a bifurcation between a stagnant real
economy (with huge overcapacities all over the
world) and a hyperactive financial economy
(with still huge surplus capital all over the world)