2008 GLOBAL FINANCIAL CRISIS – THE BLAME GAME

Subprime Mortgages

The GDP of US had been slipping since 1990s, the housing crisis just brought this to light.

Post-2000s, subprime mortgages had increased drastically in the US due to two Government sponsored enterprises called Fannie Mae and Freddie Mac. “Subprime” mortgages are loans extended to people with low credit ratings, by taking their property (houses) as collateral. They were popularly known as “NINJA” loans i.e. No Income, No Job, No Assets. The loans were given at “teaser rates”, to attract investors, and later these interest rates were increased dramatically. The rationale was that even if the investors would default, the banks could sell the mortgages for high returns, considering that the value of these houses was appreciating due to high demand. However, when the interest rates became too high the demand for houses reduced, leading to the burst of the housing bubble in the year 2007. Furthermore, these loans were non-recourse borrowings, implying that even if the outstanding loan amount exceeds the value of the collateral, the borrower does not have any personal liability for the outstanding loan amount. Thus, when the housing bubble burst, the banks which held these mortgages suffered huge losses, while the borrowers were free to walk out of their house with no liability.

Many analysts are of the opinion that there is a risk of a property bubble forming in countries such as Brazil, China, Canada or Germany. Due to the huge availability of credit prices are going up, and buyers are not realising that these do not correspond to fundamental values. Will this lead to another housing bubble is a separate topic that requires much debate. However, India is not much exposed to the risk as private housing is not that big a part of our domestic economy.

Securitisation

Hull (2010) describes securitization as a way to transfer the credit risk of loans to an outside investor so that a bank is able to originate more loans without increasing its regulatory capital. He describes how loans were pooled and then divided into tranches called asset-backed securities (ABS) or mortgage-backed securities (MBS). The senior tranches had the highest credit rating, implying lowest risk of default, and low rate of return, while the equity (lowest) tranch had the lowest credit rating and highest rate of return. The MBSs were further divided into tranches called collateralised debt obligations (CDOs), making it all the more difficult to trace original loans, the collateral, and the performance of the individual tranches. Initially, these products were very popular when teaser rates were low, as borrowers were able to pay their interests, and the holders of MBSs were getting high returns. Thus, the markets got filled with MBSs and CDOs. Later when teaser rates became high, borrowers were no longer able to honour their payments, leading to banks defaulting on their payments to holders of MBSs. Since, securitisation had become a complex web, banks were no longer able to trace the actual loans to these MBSs. When the market realised this, even AAA rated MBSs became worthless overnight, leading to huge losses, and many financial institutions became bankrupt. However, many banks were bailed out, using tax payers money, to prevent a systemic failure.

In India, securitisation is still in preliminary stages. Along with reconstruction Securitization and Reconstruction of Financial Assets & enforcement of Securities Interest Act, 2002 governs securitisation in India. The Act allows only banks and financial institutions to undertake securitization (trough a Special Purpose Vehicle (SPV)), unlike US and UK. In India, securitization is popular in Auto Loans and Infrastructure loans, and quite underdeveloped in housing (mortgages). However, India has a huge potential for growth in the latter, subject to amendments to the current Act. Having witnessed what happened in US, India will definitely be more cautious in expanding its MBSs market.

Role of Credit Rating Agencies (CRAs)

CRAs have attracted much criticism for their rating of Residential Mortgage Backed Securities (RMBSs). These securities had an AAA rating when they began to default. This questioned the capabilities and intentions of the CRAs. Several banks held huge portfolios of RMBSs, and when they were subgarded post the crisis as junk, the portfolios became worthless, leading to bankruptcies. But CRAS, on the other hand, escaped any legal liability for inaccurate ratings, under the protection of the First Amendment in US (Herring, 2009), and made huge profits even during the crisis.

The Big Three also received criticisms for rating sovereign bonds of countries such as Greece. However, what is interesting is that they were criticised both ways: once for not having downgraded the Greek bonds before they started defaulting, and then again when they finally downgraded the Greek bonds, claiming that the downgrade further increased the cost of debt for Greece, and worsened the situation. With respect to the crisis in Greece, India is not directly impacted by Greece. However, it could be indirectly impacted by rest of the European Union. For instance, if due to the Greece exit the interest rates in EU go up, there will be significant capital outflows from India. However in Indian context, RBI governor Raghuram Rajan said that the Indian economy’s robust forex reserves of $355 billion will cushion any possible impact of the crisis.

Until the financial crisis of 2008, the credit rating industry was self regulated; it was believed that the CRAs relied upon reputation for business, a belief, which post-crisis was proved incorrect. There were no incentives to maintain reputation. Unlike bonds, RMBS were limited and complex, which made detecting any errors difficult; plus, they offered huge profit margins.

From an alternative school of thought Boylan (2012) argues that the inaccurate ratings of RMBSs were due to unconscious bias created due to non-availability of information. There was no historical data that suggested the possibility of significant defaults in the US housing market. Also, the CRAs took the good past performance of the US housing market as representative of the future.

As per Fennell and Medvedev (2011), the references to ratings in regulations and in investment mandates created a demand for highly rated products even among investors. This pressure on CRAs to inflate ratings. Hence, this led to a compromise on the quality of the product, and the rating did not reflect its true risk. The issue was not just limited to the way ratings were produced. Investors did not treat CRA ratings just as inputs to their investment decision, but they based their investments entirely on them.

This affirms that the hardwiring of ratings in regulations and the negligent use of ratings that lead to the systemic breakdown in 2008, and not the inaccuracy of ratings by itself. Thus, it can be concluded that even if CRAs had been regulated it might not have prevented the crisis.

CRISIL, ICRA and CARE are the three largest CRAs in India. Unlike the Big Three, they have not attracted much criticism owing to good operational performance and rating accuracy. This is reflected in their share prices, with their share prices reaching record highs in April 2015. The relatively lower concern about the Indian CRAs ratings can also be attributed to the simplicity of financial securities traded in India. However, considering the high rate of innovation and growth of the Indian financial markets it’s imperative to assess risk accurately by reducing mechanistic reliance on CRAs, and regulatory hardwiring of CRAs in the financial system. In line with the global scenario, India as a member of Financial Stability Board (FSB) has been working on reducing the mechanistic reliance on ratings while encouraging market participants to develop strong internal credit risk assessment techniques.

Trading derivatives in the Over the Counter (OTC) markets

Derivatives, primarily those that were traded in the Over the Counter (OTC) market, have been blamed as the primary reason for the financial crisis in 2008. Business Insider (online) highlights that there are roughly $604.6 trillion in OTC derivative contracts which is more than ten times the world GDP ($57.53 trillion). This makes the OTC derivatives bubble much larger than the US housing bubble.

During the financial crisis, the risk of trading derivatives in the OTC markets became apparent. OTC markets are largely unregulated, and pose high counterparty credit risk; as transactions in the OTC markets are netted only bilaterally, they have very little collateral requirements, and the collateral may not be adjusted daily based on the market movement (mark to market). IMF (online) explains that bilateral netting led to proliferation of redundant overlapping contracts which increased the interconnections in the financial system. Thus, when one party to a contract defaulted, the other party to the same contract was unable to honour his obligations to another contract. Due to several such interconnections, there was a domino effect where a single default led to several defaults, affecting all the participants in the market. Also, OTC derivatives such as credit default swaps (CDS), were bought based on grounds of speculation rather than on hedging which led to huge losses to the buyers, and to bankruptcies of the issuers.

Post the crisis, in 2009, as per the recommendation of the G20 leaders, regulations across the world, including India, are trying to move most standardised OTC derivatives to be exchange traded and centrally cleared through a Central Counterparty (CCP ) which would take over the credit risk of a default of the parties to a financial transaction, whereby reducing systemic risk. I agree with this as it would bring more stability to the financial system. However, OTC markets will continue to exist as large institutions require customised contracts which are illiquid, and thus, cannot be exchange traded. Thus, apart from the focus on CCPs, regulators should be proactive in overseeing the OTC markets as well. The size of the OTC market in India is very small compared to that in US, but it has high growth prospects considering the growth of securitisation. Thus, the increased focus on the OTC markets is a positive factor in assuring the safety of the expand- ing OTC markets.

Blind Faith in Efficient Market Hypothesis (EMH)

EMH states that stock prices reflect all available information that is relevant to its value. Thus, its direct implication is that it is impossible to make abnormal returns, at least consistently, as any deviations from equilibrium do not last for long (The Economist, online).

According to The Economist (online) a blind faith on EMH was one of the major causes for the 2008 financial crisis. It explains that the believers in EMH did not doubt that the valuation of stocks could have such a large deviation from their true value over such a long time. They also argue that humans are extremely over confident about their abilities which contributes to creation of bubbles, and are irrationally risk averse after they make losses which further exaggerates losses. Thus, as against the assumption of the EMH, investors behaved irrationally during the boom that preceded the crisis which led to the stock market crash in 2008.

A possible contradiction to the EMH is the Chinese stock market crash in August 2015. The investors’ “panic sentiment” caused the Chinese stocks to continue to dive despite several support measures taken from Beijing. This led to India’s benchmark index, Sensex, seeing it’s biggest ever intra-day fall in absolute terms on 24th August 2015. However, the Indian stock markets soon stabilised, indicating the validity of the EMH. The equity markets in India draw a lot of direction from the US markets, so the Yuan devaluation will have only a temporary negative impact on the rupee. In fact, a slowdown in the Chinese economy isn’t a terrible event if you consider that Mr. Modi is trying to attract manufacturers with his Make-in-India initiative. In fact, Several Chinese companies have opened their factories in India because of favourable demographics and Government subsidies. This will contribute positively to India’s GDP, and India could become the fastest growing BRICS economy, considering that China is transitioning to a mature economy with a declining growth rate.

Several papers have found strong empirical evidence in support of EMH. Hence, the ocurrence of the global financial crisis is insufficient in ruling out the validity of the EMH. Furthermore, an alternative school of thought that explains the stock price movements has to be developed, before the EMH can be rejected.

Conclusion

As discussed above, it was an interplay of many factors that led to the crisis. The exponential growth of subprime mortgages, the borrowings were non-recourse, securitisation, inaccurate high credit ratings, OTC all together lead to the financial crisis. The crisis definitely raises questions on the validity of the EMH, which however cannot be rejected. The crisis led to several changes in the regulatory framework of the financial industry, such as, through the introduction of the Dodd-Frank Act in the US and the European Markets Infrastructure Regulation (EMIR) in Europe. According to me, though this was a necessary and positive move, the regulations are so elaborate that many argue that they have introduced new complications.

Despite all this, the strength of the Indian economy can be seen in its resilience to the Global financial crisis, the Greece sovereign crisis, and even to the recent Chinese stock market crash. Thus, even though so much has been discussed, analysed, and written about the crisis, wouldn’t we be to prevent such a crisis from occurring in the future?

References:

Amtenbrink, F. and Haan, J.D., (2009), ‘Regulating Credit Rating Agencies in the European Union: A Critical First Assessment of the European Commission Proposal’. Available at: http:/ /papers.ssrn.com/sol3/papers.cfm?abstract_id=1394332&download=yes (Accessed: 15 August 2015)

Boylan, S.J., (2012), ‘Will credit rating agency reforms be effective?’, Journal of Financial Regulation and Compliance, Vol. 20, Iss. 4, pp. 356-366. Available at: http:// www.emeraldinsight.com/doi/pdfplus/10.1108/13581981211279327 (Accessed: 15 August 2015)

Business Insider, May 2010, ‘Forget About Housing, The The Real Cause Of The Crisis Was OTC Derivatives’, Available at: http://www.businessinsider.com/bubble- derivatives-otc-2010-5?IR=T (Accessed: 31 August 2015)

Fennell, D. and Medvedev, A., (2011), ‘An economic analysis of credit rating agency business models and ratings accuracy’, Financial Services Authority Occasional Paper 41 Available at: http://www.fsa.gov.uk/static/pubs/occpapers/op41.pdf (Accessed: 15 August 2015)

Hull, J., (2010), ‘Credit Ratings and the Securitization of Subprime Mortgages’, University of Toronto, Available at: http://citeseerx.ist.psu.edu/viewdoc/ download?doi=10.1.1.169.5692&rep=rep1&type=pdf (Accessed: 15 August 2015)

IMF, ‘Making Over The Counter Derivatives Safer: The Role of Central

Counterparties’, Available at: https://www.imf.org/external/pubs/ft/gfsr/2010/01/ pdf/chap3.pdf (Accessed: 20 August 2015)

The Economist, July 2009, ‘Efficiency and beyond’, Available at: http:// www.economist.com/node/14030296 (Accessed: 20 August 2015)

Utzig, S., (2010), ‘The Financial Crisis and the Regulation of Credit Rating Agencies: A European Banking Perspective January’, ADBI Working paper No. 188. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1592834 (Accessed: 20 August 2015)

Veron, N., (2011), ‘What Can and Cannot Be Done about Rating Agencies’, Peterson Institute for International Economics Policy Briefs 11-21. Available at: http://www.iie.com/ publications/pb/pb11-21.pdf (Accessed: 15 August 2015)

White, L.J., (2010), ‘Credit Rating Agencies and the Financial Crisis: Less Regulation of CRAs Is a Better Response’, Journal of international banking law, Vol. 25, Iss. 4. Available at: http://web-docs.stern.nyu.edu/old_web/economics/docs/workingpapers/2010/ White_Credit%20Rating%20Agencies%20for%20JIBLR.pdf (Accessed: 20 August 2015)

About the author:

The author is a Banking and Financial Service student of batch 2015-2017 at TAPMI. Her area of interest is economics research, capital market, and fund management. She is the managing editor of TJEF and also co-convenor of Finance Forum. You can contact her at monica.bkfs17@tapmi.edu.in