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Saturday, 25 October 2008

The financial crisis (Guest Blog - Yakima)

I have read a number of explanations for the credit crisis, but I thought Yakima's explanation here is extremely insightful and accessible, deserving a separate post. He also provides some interesting discussions on the opportunities for Zambia which are worth exploring.

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).


  1. Yakima,

    Thanks for the detailed info on Credit Default Swaps.

  2. Yakima,

    I assume the $50 trillion figure for CDS market covers the market as a whole, including other non-housing related? If so, is the argument that the housing related CDS simply became so large have come to dominate other areas.

    On the implications for the Zambian economy, I totally agree that opportunities exist, though I remain unclear on what government can do to exploit those opportunities. Interest rates are already above inflation.

    Which brings me to the pessism. I remain slightly pessimistic about the short to medium
    outlook of the Zambian economy, partly due to what I perceive as irrational excesses in recent months.

    As I noted to Lawrence in a separate discussion on global corporation tax trends, the current dangers to the Zambian economy as I see them are as follows:

    - the Kwacha depreciation leading to rising inflation
    - weakening of demand for commodities such as copper...
    - weakening of the “export led growth model that the govt has championed” face of global slowdown, it is a genuine question to ask whether the export led growth model can work for Zambia..
    - weak fiscal regime or rather the late implementation and subsequent renegotiation means that we have “no savings” to point to…let alone a stabilisation fund or indeed any infrastructure boom..
    - Unfortunately the Acting President, in search of electoral success, has been giving freebies that will worsen our fiscal position going forward (e.g. fuel tax removal, unplanned fertiliser support for civil servants)...Whoever wins will struggle with the excesses of recent months.

    - Then of course, we have the remittance reductions and the possible hit on tourism earnings etc...

    - Let us also not forget the UN battlecry today that aid may dry up....may ODA will remain the same, but its the smaller charities that may suffer..analogy to remittances crucial here!

    That said, on top of the possibility of Zambia positioning itself to reap the "capital flight" pluses:

    - Potential for weaker oil prices
    - Possibility of increased competitiveness from a weaker Kwacha if “inflation” can be managed better relative to our trading partners.
    - Mining is booming, and China remains hungry so in terms of quantities exported we should be okay.
    - Economy is diversifying…though more still needs to be done…
    - As you say, for investors looking for reasonable returns, if inflation can be contained, Zambia would remain an attractive destination
    - 2010 is on the horizon…investment in infrastructure, especially aviation would bode well for an effective tourism “bounce”.

    I can go on…but in short, much depends on the government…

    In time of crisis, you need a plan…we have have not seen one...what we contunue to hear is talk of Vision 2030 or Fifth Development Plan...which are helpful but are in need of update…

    What Zambia probably needs now is for whoever takes charge on 31st November to quickly articulate a plan for next two to three years that takes into account the changing dynamics.

  3. Cho,
    "in face of global slowdown, it is a genuine question to ask whether the export led growth model can work for Zambia.."

    Global slowdown are the norm in any capitalist system, it has both rising growth and falling growth at different periods in the economic cycle. So when the global economy recovers, exports will increase. Exports of competitively priced products create jobs in many countries, e.g. China.

  4. Kafue,

    I perhaps stated it simplistically. There's a real question to whether the export led growth model is the right model to rely on for a small country economy, like Zambia, susceptible to exogenous shocks.

  5. Cho,

    Thank you for the praise of my analysis, I hope that with collective scrutiny it can be refined further and perhaps lend insight towards practical steps for Zambian government and private enterprise to take in adjusting to the changes in the global investment climate.

    The US$50 trillion valuation is only approximate, but seems to be a consensus figure of convenience in congressional discourse and financial media such as Bloomberg and CNBC. As far as I know it is based on the face value of CDS contracts, the valuation in market trades or in the event of actual default settlements is likely to be significantly lower. The effects of bundling and re-insuring multiplies the total face value of all CDS far above the value of the initial reference asset.

    In other words, Bank1 may have purchased an $10M CDS from Bank2 to cover a $10M bundle of CDS that they sold to mortgage lenders to cover home loans, hedging their losses (and upping the face value ratio to $20M:$10M). Bank2 then chops its $20M into four $2.5M chunks which it bundles with chunks of other deals and sells to Investment Banks 1-4 (fvr $30M:$10M), and so on. The whole principle is to pass on all of the risk and most of the return to the next investor in the chain, similar to the children's game "hot potato:" the one holding it when the music stops gets burned.

    Of course I am simplifying tremendously, corporations like Lehman seem to have found sales traction with the concept of "exotic derivatives" and the name is apt. I owe thanks to the enthusiastic Lehman Brothers Guide to Exotic Credit Derivatives (2003) as well as Lehman's european publication Credit Derivatives Explained (2001), the latter of which attempts to explain the wonders of regulation-avoiding Special Purpose Vehicles:

    "SPVs have a number of applications and play an important role in the structured credit market. A classic illustration of the use of an SPV is in the securitization of an asset swap. Investment restrictions prevent certain investors from entering into an interest rate swap, as a result of which they cannot purchase asset swaps
    directly. However, if an SPV purchases the underlying security and enters into the interest rate swap, the same investor can purchase notes in the SPV that represent the combined economics of the asset swap package."

    and . . .

    "An SPV can be used to make an illiquid asset more liquid. For example, where there is a restriction on the number of times debt may be traded, or where transference of the debt requires notification or approval, an SPV structure can purchase the asset and issue freely transferable notes that pass through the economics of underlying asset. An example is the funding agreement securitizations that have become common in the Euromarkets. Another way to make debt more liquid is to use the SPV as the issuer in the securitization of loans and trade receivables that do not exist in any traded form."

    and finally . . .

    "In Europe, tax rules differ from those in the U.S. and enable SPVs to be incorporated companies rather than trusts. These structures are therefore also known as Special Purpose Companies (SPCs). The same SPC can issue any number of deals. However, within the company structure, the legal documentation of the SPC enforces a compartmentalization of the risk—each deal is collateralised separately and has recourse only to a defined pool of assets. This means that no deal can be contaminated by another.

    One of the purposes of the structure is to make it tax neutral to the investor. For this reason, Lehman Brothers has established a number of SPCs in both the Cayman Islands and the Channel Islands. We are also able to issue out of Gibraltar, the Netherlands, and Ireland.

    Other groups of investors may only be allowed to purchase loans or may prefer to make loans for regulatory or other reasons. Lehman Brothers has vehicles that enable investors to take exposure to a package of assets and/or derivatives by making a loan to the SPV, rather than by purchasing notes. The net economics to the investor are identical, but the regulatory treatment can be very different. More recently, the SPV structure has been used by Lehman to make it possible for an insurance company to buy a credit derivative. The SPV acts as a “transformer” that converts an ISDA credit derivative into an insurance contract that complies with the requirements of the insurance company."

    So to answer the question, yes, it appears that other forms of credit asset, such as corporate bonds, have also been covered by default swaps, which in turn are liquified into SPVs, and traded outside of the regulatory system for bond markets. I think the third quoted paragraph points to much of the problem (and why it started in the US), not so much the percentage of housing related CDS, but cross-contamination, such that the traded value of too many different "downstream" securities were tied to the same reference assets "upstream" in small ways. To grossly oversimplify, instead of 10% of home loans defaulting resulting in full losses for 10% of SPVs, it resulted in 10% losses for all SPVs (or 20% losses for half, etc).

    The whole sales pitch for these things is based on the promise of no risk, so I gather the traded values plummeted (I think some Lehman CDS contracts recently auctioned at 17 cents on the dollar, but I have no idea what the reference assets were). It is possible that we will see further disruption of the derivatives market in the wake of corporate bond ratings falling (eg New York TImes bonds were downgraded to junk status friday by S&P) as "interest rate swaps" begin to feel the strain.

    I also am unsure what government can do beyond reviewing their own banking regulations with an eye toward the kinds of holes exploited by the likes of Lehman Bros. The more confidence they can inspire in the marketplace of the strength of their regulatory regime, the more eyes will turn to potential investment within its bounds. I think it is up to the banking sector itself to take it from there, and offer savings and investment products geared to the kind of investor who are "on the fence" about re-investing in the G8 countries immediately.

    The government could of course take various strong actions to promote cash deposits into domestic banks, such as reduced or deferred taxation on earned interest, gross taxable income deductions for deposits up to a certain amount, nationwide savings/credit and necessary mathematics education programs, etc. Such steps may be desirable in and of themselves, however I do not think they are pre-requisites for creating a more attractive banking sector.

    I agree with your list of dangers wholeheartedly, my use of "likely affect" was solely in reference to direct results of changes in US consumer confidence on Zambian prospects. The remittance reductions and tourism losses will be far more dependent on the EU response to conditions I think, as africans in the US are the most educated and skilled immigrant group as a whole (less likely to experience job losses), and North Americans make up a relatively small percentage of the tourist pool at present. You are absolutely right that charities will take a big hit, and US government aid may be scaled back (even Obama has hinted at this), which likely means continuing "humanitarian" programs for disease and hunger, but cutting development assistance.

    [oh, and I left out the "million" after "4.2" and before "foreclosures" in the original post, I hope no-one was confused, sorry!]

  6. Let me add to Yakima's helpful analysis of the origin of the world financial crisis.

    How did it come about that massive and renowned organizations like Lehman Bros and AIG took on incredibly overleveraged 'sub-prime' mortgage debt? The explanation stems from the status of Freddie Mac and Fannie Mae as Government Sponsored Enterprises (GSEs). These organizations did not lend to home-owners directly, but encouraged finance houses to do so with insurance backing. Although they gave no formal guarantees, their status as GSEs implied government backing.

    The 2004 removal of the 12:1 standard leverage does not adequately explain the apparently reckless behaviour of taking on Credit Default Swaps (CDS) at ratios of over 30:1. The scene had been set long before. Here are quotations from a New York Times article of 30 September 1999.

    'Fannie Mae, the nation's biggest underwriter of home mortgages, has been under pressure from the Clinton Administration to expand mortgage loans among low and middle income people…..In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980s "From the perspective of many people, including me, this is another thrift industry growing up round us", said Peter Wallison…at the American Enterprise Institute. "If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry."'

    It is clear from the above that it was not reckless greed but government pressure that precipitated what now appears madly risky behaviour. Certainly there should have been better regulation, and it must now be put in place. But the origin of the crisis was government backing for insecure loans, coupled with inflated house prices due to excess funding.

    To quote a comment I have received,

    'The prime blame belongs to government, not to 'capitalism'. The lesson to be learnt is that it is a delusion that politicians and officials can improve on how people act in a free market. To suggest that blame is attributable to 'the market' is nuts. On the contrary, that there is a crisis is thanks to the market's ability to expose the madness of the US government having thrown tax payer's money recklessly at high-risk borrowers, forcing banks to provide sub-prime credit, and now using more taxes to ameliorate the mess it created.'

    Note: 'Sub-prime' is official parlance for insecure loans. Unofficially they are known as 'NINJA' - No Income No Job or Assets.

  7. More on CDS:

  8. Murray,

    We have to keep in mind that the present US administration of free marketeers, deregulators and other devotees of the 'Greed Is Good, Greed Works' philosophy of market regulation, will always preach 'personal responsibility', but only as a way to avoid taking any kind of responsibility themselves (because that would be disadvantageous to themselvs).

    Right now, they are trying to blame the mess created by deregulation of the mortgage banking industry on minorities owners. No surprise there.

    To quote Matthew Iglesias ( on the attempt to blame the subprime mortgage crisis on the Community Reinvestment Act:

    The technical term for this argument is “bulls***.”

    For one thing, the timeline is ludicrous. The Community Reinvestment Act was passed in 1977. Are we supposed to believe that CRA was working smoothly throughout the Carter, Reagan, Bush I, and Clinton years and then only under Bush II did overzealous anti-”redlining” enforcement come into play, perhaps a result of Dubya’s legendarily close relationship with ACORN? Or maybe overzealous enforcement back in the late 1970s is somehow responsible for a real estate blowout that only materialized 30 years later? It doesn’t even come close to making sense.

    Beyond that, the mere existence of “subprime” loans — i.e., mortgages given to less-creditworthy individuals at higher interest rates — isn’t the problem here. The problems have to do with what was done with the loans after they were packaged, sold and used to make leveraged plays.

  9. Murray,

    Well, I guess that Matthew Iglesias put it more strongly than I would have, but the essential thrust of his commentary seems correct.

    To be fair, there were some key adjustments in the criteria by which government chartered agencies (such as Fannie Mae and Freddie Mac, often in conjunction with the Federal Housing Authority) provided refinancing to wholly private local banks to encourage issuing loans to previously marginalized populations, classified en masse as "sub-prime", historically more due to the racist "red-lining" practices which would label an entire neighborhood with the highest possible loan-risk classification if a single family home there was owned by blacks, than due to application of actual employment and credit checks, on the assumption that the presence of blacks would automatically suppress housing market resale values. It is certainly arguable that this latest (1999) change in federal home loan insurance policy is the single greatest factor leading to the record number of home mortgage defaults in the US, and was a massively contributory factor in the overall valuation "bubble" in the US housing market over the last decade.

    What federal policy visa vie Fannie&Freddie fails utterly to explain is how the largest american investment banks and insurance companies could possibly be affected by the failure of the most marginal new homeowners in the country to pay their bills. With all due respect to the individual whose comment you quote, it sounds eerily similar to the political talking points emanating from the White House and Fox News this week, which makes it hard for me to credit as original thinking on the problem and not the politics. Don't get me wrong, I am not ideologically averse to the possibility that your associates are 100% correct, I am merely forced by Occam's Razor to assume that the political actors who are saying essentially the same thing have other priorities than correctness to consider in their public statements. I am similarly unwilling to accept anything that smacks too much of oft repeated talking points from Barney Franks (US House Dem, Massachusetts) or Christopher Dodd (US Senate Dem, Connecticut).

    For myself, when fellows at the AEI start talking about how much they were counting on the socialist tendencies of the US government under the most heavily republican majority in a century, on the basis of a 25 year-old reaction to the junk bond debacle**, I can only wonder what they are so eager to hide. I agree very much with Murray's quoted comment, that government is primarily to blame, and the folks over at AEI never ever pass up a chance to tell us how government interference is responsible for each and every business failure, economic downturn, or job loss. Sometimes they are right, sometimes they are just trying to score points with certain congressional constituencies, sometimes both. That's what they do, they are lobbyists, they are partisan, and they didn't become one of the pre-eminent lobbies in Washington without being able to craft effective message spin.

    What is clear to me is that both american parties wholeheartedly supported at least some of the key pieces of legislation that combined to allow this mess to happen unchecked (in many cases there is overlap, such as the 1999 Financial Modernization Bill [S. 900] that was approved by 90 votes to 8). As reported by CBS News' "60 Minutes" on Sunday night (thanks for the link Kafue), elements of the Commodity Futures Modernization Act of 2000 are now under close scrutiny for their effective removal of 1907 state-level restrictions on "bucket shops" (gambling emporia devoted to treating daily stock fluxuations as if they were horse races), and the connection to the proliferation of default swaps. To be fair, CBS is among the more left-leaning of mainstream american broadcast news, and they have been wrong before (though to their credit when they are proven wrong, senior heads actually roll, unlike many others).

    To clarify the timeline somewhat, Investment Banks like Lehman Bros. and Bear Stearns, which had very different licenses than most banks (eg they could not accept savings deposits or issue home mortgage loans to customers), were marketing mortgage-linked CDS securities through SPVs and SPCs as early as 2000, as their own sales brochures indicate. We don't know exactly how many they sold, because the only public disclosure required was purely voluntary. What does seem apparent is that prior to the relaxation of mandatory leverage requirements for selected institutions in 2004, those same institutions were lobbying for just such a result. I presume they sought a remedy to a problem, which leads me to believe that some or all of these institutions were finding it difficult to maintain the longstanding 12:1 ratio, even at the height of the housing valuation bubble. Very much like a problem gambler with a new "system", the answer to each loss appears to have been to double the bet (or in investment banking terms, declining average returns necessitated increased leverage to meet shareholder expectations of total return).

    The reliance solely on private credit and bond rating companies seems to have contributed as well. Almost all consumer credit decisions in the US are made on the basis of ratings by one of three companies, each of which maintains a virtual monopoly over a particular region of the country. For such companies, "sub-prime" loans include all potential borrowers with credit ratings at the lower end of the scale, many of whom fit the NINJA criteria (who would never have qualified for even government subsidized mortgages prior to 1999, very true), or had prior bankruptcies, or chronic medical conditions, or had simply never previously borrowed anything through the formal system before. I think it is important to note that these companies tend to give higher ratings to borrowers who only pay off interest monthly than those who regularly pay down their principal debt.

    The two primary bond rating agencies, Moody's and Standard & Poor's, are at times little better, tending to overrate high risk, high return bonds in periods of equity growth, rather than fulfilling a temporarily lower volume role as hedge against stock volatility. Another bit of what Greenspan called "irrational exuberance" during the tech bubble of the 90s, even as he apparently helped to sow the seeds of this latest bought of unreasoning excitement. For years, as the housing bubble grew and grew, people here would ask me why I owned a business but not a home, and my answer was always, "because houses don't make anything, it's a goal, not a tool." I'll be the first to agree that they were fools to take on mortgages at already inflated face values for housing, to believe that their home values would continue to rise, to agree to mortgage terms that included variable interest rates, etc. But these are very small fish in a very large pond.

    To somehow draw a straight line from the planning failures of marginal consumers to the balance sheets of all the world's major banks, the vast majority of which could never be forced to provide sub-prime credit to american borrowers by the US government, well, I'm just not seeing how the relative scale matches up. For example, if the failure of these home loans alone can explain how the government of Iceland woke up one morning to find that their nation's chartered banks owed five times the entire GDP of the country, I'm going to need someone to connect those dots for me.

    To sum up, I agree fully that this is not a failure of capitalism as a tool, as it appears that most of these self-styled "exotic" credit derivative products did not actually even attempt to contribute capital to the formation, operation, expansion, or re-tooling of any business. They did allow lenders with capital tied up in legitimate capitalist activities (even a high risk mortgage still has the value of the house attached, total losses are rare) to remove those liabilities from their balance sheets by buying swaps, thus enabling them to receive increased refinancing from semi-private Fannie&Freddie and giant private outfits like Countrywide. This is more akin to gambling contaminating capitalism, which has happened before, and inevitably breaks a system that was never supposed to be about "something for nothing."

    **[Again now, as it appears we should have learned from the 80s, there was nothing wrong with the thrift side of things, "savings and loan" and more specialized "building and loan" institutions had been operating successfully for decades, it was deregulation which allowed the institutions to engage in bond trading beyond their traditional roles, again in a declared effort to "modernize" the sector, which enabled them to funnel the small savings of millions into the riskiest form of security then legal to trade on the market, the appropriately named "junk" bond.]

    loosely related links for the curious and jargon tolerant:
    [1] U.S. Code Title 7--Agriculture, Chapter 1--Commodity Exchanges, Sec. 7a. Derivatives transaction execution facilities [current as of 2006]

    [2] Summary of Swaps Provisions in Commodity Futures Modernization Act [of 2000]

    [3] Commodity Futures Trading Commission, A New Regulatory Framework for Trading Facilities, Intermediaries and
    Clearing Organizations; Proposed Rule [of 2000]

  10. More info on CDS:

  11. Kafue,

    Great article, thanks!


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