Waves of hysteria have forced the global financial system into meltdown. Banks and mortgage lenders have collapsed, governments have pulled bailout bonanzas out of the tax payer’s pocket, share prices have plummeted, commodity prices are close to rock bottom, Iceland’s in ruins and the mythical bubble of hedge funds is about to burst.
There are many places to lay the blame for this crisis. Former Chairman of the US Federal Reserve from 1987 – 2006 Alan Greenspan is one such candidate. Greenspan has been heavily criticized for his experiment in encouraging market forces to run free through the use of derivatives. Derivatives are complex contracts that promise to protect investors from losses.
Their name comes from the fact that their value “derives” from underlying assets like stocks, bonds and commodities.
One of the easiest ways to understand derivatives is to consider traders in Chicago in the 19th century buying corn futures. A contract, known as a future, that guaranteed a certain amount of corn, at a certain price, at a specific date in the future helped reduce the risk a trader faced since he would have some protection if prices rose. That future also had a value, one that rose and fell with the price of corn — when prices went up, a contract for corn at a cheap price was worth more. As a result futures were traded as avidly as corn.
Theoretically intended to limit risk and ward off financial problems the contracts allowed financial services firms and corporations to take more complex risks that they otherwise would avoid – such as issuing questionable mortgages or excessive corporate debt. The fact that the contracts can be traded in one sense limits risk but also increases the number of parties exposed to loss when problems emerge.
Throughout the 1990s, some argued that derivatives were a danger to the financial system and demanded some form of federal oversight to protect the markets. But the industry lobbied heavily against such measures, and won backing from important figures, including Alan Greenspan.
Mr. Greenspan keenly supports the use of derivatives as a market institution. “What we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so,” as he announce at the Senate Banking Committee in 2003. Greenspan’s unshakeable belief in derivatives leads him perhaps unsurprisingly to blame greedy and irresponsible Wall Street traders.
Whilst traders must shoulder a lot of the blame for behaving recklessly with people’s money one does question under whose authority did they act? Private investors knowingly invest their money in markets all around the world accepting the associated risks as they do so. They even hire brokers to trade aggressively on their behalf. Companies are infinitely aware of the potential losses that may occur when listing their companies on the stock market but what is profit without risk? The majority of traders simply did their job- buying and selling shares to make as much profit as possible. The investment glut had to be thinned out somehow and stock markets seemed the best place to deposit excess funds. Profit making is arguably the cause of this disaster.
The American government also paid a role in the financial crisis by forcing listed companies to take on more debt than they could handle. Fannie Mae is one such example.
Fannie Mae had long helped Americans get cheaper mortgages by buying loans from lenders and then reselling them to Wall Street investors. Banks under this system were allowed to make more loans- increasing the number of homeowners and allowing Fannie Mae to make large profits.
This is the type of wrenching financial crisis that comes along only once in a century, says
Trouble arose when Congress demanded that Fannie Mae steer more loans towards low-income borrowers. The Chief Executive Officer of Fannie Mae ignored warnings that lenders were making too many loans that would never be repaid and ploughed ahead into the dangerous waters of sup-prime lending. For a time, that decision proved profitable. In the end, it nearly destroyed the company and threatened to drag down the housing market and the economy.
Fannie Mae never actually made loans. It was essentially a mortgage insurance company, buying mortgages, keeping some but reselling most to investors and, for a fee, promising to pay off a loan if the borrower defaulted. The only real danger was that the company might guarantee questionable mortgages and lose out when large numbers of borrowers defaulted on their loans.
The ripple effect of Fannie’s plunge into riskier lending was profound. Fannie’s stamp of approval made shunned borrowers and complex loans more acceptable to other lenders, particularly small and less sophisticated banks. Combined with an inflated housing bubble, American markets were at risk of implosion.
Fannie Mae panicked when it became clear that millions of borrowers would default on their loans. This raised the terrifying prospect of paying billions of dollars to investors to honor its guarantees.
Lawmakers, particularly Democrats, leaned on Fannie Mae and Freddie Mac to buy and hold those troubled debts, hoping that removing them from the system would help the economy recover. The companies, eager to regain market share and buy what they thought were undervalued loans, rushed to comply.
In September Fannie Mae was given a choice either to facilitate a takeover by the White House or have one forced upon them. Fannie Mae and Freddie Mac both agreed and were each given $100 billion of taxpayer’s money to replenish their coffers.
The move failed to stanch a spreading panic in the financial world. In fact, the takeover accelerated panic by signaling that no company, no matter how large, was strong enough to withstand the losses stemming from defaulted sub-prime loans.
Finally the irresponsible behavior of banks is also to blame. The activities of Bear Sterns, Goldman Sachs and Morgan Stanley, amongst others, were ignored by global financial authorities. Given free reign they acquired huge amounts of debt with ratios as significant as $33 debt to every $1 deposit.
The worldwide credit crisis has also contributed to recent financial turmoil. Unlike a dramatic crash in the stock market, a credit crisis happens almost invisibly in stalemated transactions between the banks. It is banks refusing to lend to other banks — even though that is one of the most essential functions of the banking system. It’s a loss of confidence in seemingly healthy institutions like Morgan Stanley and Goldman Sachs. It is panicked hedge funds pulling cash out of banks. It is buying credit-default swaps — a financial insurance policy against potential bankruptcy — at prices 30 times what they normally would pay. A credit crisis fuelled by the collapse of sub-prime mortgage lenders can pull down a global economy almost immediately.
The credit crisis began some months ago remember Northern Rock? However matters have only deteriorated since then. Bear Sterns, Freddie Mac and Fannie Mae were offered financial guarantees by the US government, the Federal Reserve backed AIG with an $85 billion loan, Lehman Brothers declared bankruptcy, whilst Goldman Sachs and Morgan Stanley are no longer investment banks.
Many European banks have also suffered. Halifax Bank of Scotland was close to ruin until it was bought out by Lloyds TSB, the Swiss government plan to invest 6 billion Swiss francs into UBS in return for a 9.3% stake in the bank, Credit Suisse have organized funding of Sfr10 billion from three investors, Iceland’s entire banking system collapsed and was rapidly nationalized, the EU are now planning a bailout plan close to €3 trillion whilst many EU countries including Ireland have promised to guarantee bank deposits.
While governments have promised to bailout the banks the stock markets are still in decline. Though they are no longer in freefall they remain a cause for worry. The Dow Jones and FTSE 100 have fluctuated wildly, Irish stock markets plummeted and even commodity prices are bottoming out as the global economy heads into recession. Now even the seemingly invincible hedge funds are about to collapse. The investment glut is over.
The only way forward is for governments and investors alike to take control and effectively plough enough cash into a flagging global financial system. We have already seen a positive reaction in the markets to promises of cash injections, guarantees and takeovers. It is vital that the major economic powers stop dithering and reach a viable solution. We are not immune to bad luck but we can certainly act to deter it.