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Thursday, 23 October 2008

BOZ / MoFN Statement on Kwacha Depreciation

The Kwacha has taken a beating in recent days, especially against the dollar, prompting BOZ and Ministry of Finance and National Planning to issue this statement yesterday.


  1. Cho, Thanks as always for providing such relevant and timely access to documents such as this one. I feel that it is important to elaborate somewhat on the rather oversimplified explanation of the causes of the financial crisis.

    First of all, while it is true that defaults by homeowners can be considered as triggering events, such events would not in and of themselves have caused the failure of many of the world's largest banking and insurance companies. Rather it was (and is) the existence of a US$50 Trillion unregulated market in exotic derivatives called Credit Default Swaps (CDS).

    CDS were created in the wake of passage of the US 1998 Banking Modernization Act, which among other things removed the Glass-Spiegel rules established in 1934 to prevent home mortgages from being traded on securities exchanges or to insurance companies. At its most basic, a CDS is an insurance policy, payable in the event that a homeowner defaults on their mortgage.

    This presented US mortgage lenders with an alternative to the regular risk v. return calculation in assessing homeowner eligibility for loans. By purchasing a CDS from an institution such as AIG or Lehman Bros, the mortgage lender could reduce their risk to zero in exchange for a somewhat lower return on each mortgage they sold. Certainly they would have to increase the volume of new loans sold in order to maintain the same overall return to stockholders, but with zero risk of losses, any loan which could be covered by a CDS became a good loan for the initial lender.

    Meanwhile the companies which were selling CDS to lenders were eager to do so, as they generated regular premium payments without any upfront capital outlays. As the market for CDS increased in volume, it also became more competitive and complex, as companies vied with each other to package CDS in as many different ways they could think of: selling bundles of CDS, or pieces of CDS, or pieces of bundles of CDS, even CDS bundles to insure other CDS bundles.

    As this fevered haste to tie as many different securities as possible to individual home mortgages began to overwhelm the ability of banks to support their potential liability with tangible assets on hand (otherwise known as leverage ratio), the US Government stepped in with a 2004 law (the name escapes me atm) which effectively removed the standard 12:1 leverage limitations on institutions which were larger than US$5B.

    At the time of their appeals to the government for assistance this year, companies such as AIG and Lehman Bros were running leverage ratios in excess of 30:1, which goes a long way to explaining how low-income home mortgage defaults can result in the collapse of wall street investment banks and international insurance giants (without them ever selling a single mortgage to a single homeowner themselves). At 12:1, even if 8% of an institution's potential liabilities have to be covered with tangible, liquid assets on a single day, they can weather the storm. At 30:1, it becomes impossible to cover more than 3.33%.

    There is the usual institutional combat occurring between the democrats and republicans in Washington over which aspects of the crisis are highlighted, in hopes of assigning blame and directing reform efforts along partisan political lines. The White House and republicans in general are hammering on the changes in federally assisted home loans pushed through in the waning years of the Clinton administration, which softened eligibility requirements for support to lenders targeting lower income and otherwise marginalized borrowers seeking loans from the large federally chartered Fannie Mae and Freddie Mac. They argue that the unrealistic standards set by these relatively powerful semi-public facilities led through competition to industry-wide relaxation of lending requirements.

    The democrats meanwhile are trying to emphasize aspects related to corporate greed, such as excessive salaries and bonuses for top executives even in the face of massive job cuts (defined in US as more than 50 persons by one company in one day) and losses for shareholders (which now in many cases will include taxpayers as a whole). They further argue that imposition of regulation over the trading of CDS and other exotic credit derivatives is the primary avenue for reform.

    Both sides are advocating in favor of "keeping families in their homes," however with approximately 4.2 foreclosures over the last 22 months, it is unclear if anything they are actually doing is helping such families. The general atmosphere that I can detect on "main street" is one of fear and uncertainty, with resulting declines in consumer spending. This will likely affect Zambia primarily through lower commodity prices as forecasts of demand are scaled back (bad for copper revenue, good for import prices on fuel, etc).

    On the brighter side, it may be possible to pitch the relative isolation of Zambia's banking and investment sector as a potential flight to safety, rather than a risky "emerging market". Targeted investments and entrepreneurial activities in an environment of overall growth (even 6% can look attractive with many forecasts for other economies in the negative) should be able to significantly outperform the nation as a whole, making double digit return projections not unreasonable for investors.

    In contrast to credit availability, the amount of cash being held by potential investors is well above average levels (ie those who recently liquidated assets have yet to be persuaded to re-invest them somewhere). At the very least, if Zambian banks can be persuaded to offer inflation-positive interest on savings, the relatively tiny savings pool held domestically could be significantly augmented, which in turn could increase the volume of private lending for business and housing development (hopefully without CDS, artificial lending standards and similar traps attached).

  2. Yakima,

    Thanks for the detailed info on Credit Default Swaps.

  3. Yakima,

    Thanks for this insightful explanation. I have uploaded this more widely for the others, in case they miss it.

    The financial crisis (Guest Blog - Yakima)

    I'll respond on that guest blog, with regards the CDS...and also your assessment of opportunities.

  4. More info on CDS


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