Research Paper# Alvin Lim Tutor: George Rennie POLS20031 Political Economy 14 April 2012 The Global Financial

Crisis: Causes, Remedies and Discourses The Global Financial Crisis of 2008-2012 is widely considered to be second in severity to only the Great Depression of the 1930s. Sardonically coined as the Great Recession by commentators and media alike, what began as a housing crisis in the United States rapidly degenerated into a systemic mess that wrecked brand-name nancial institutions, led to government bailouts and in some cases, liquidation. The crisis reduced consumer wealth in the region of trillions and sparked off a series of recessions in both the developed and developing world. In this essay we will look at the causes, evaluate the measures taken to contain it and examine some of the underlying discourses that plied the timeline of the recession.

The subprime mortgage crisis Easy credit conditions in the United States led by steadily decreasing interest rates and an inux of foreign funds created a housing bubble, which was nanced by a large number of subprime mortgages. These were easy to obtain and put home purchasing power into the hands of consumers who received poor credit ratings and ran higher risks of not maintaining the repayment schedule or worse, default. Such second-chance loans are offered to borrowers at higher interest rates and less favourable terms to hedge lenders against the higher credit risks (Barrow 2009). These mortgages were then repackaged and sold as investment products called collaterised debt obligations (CDOs) or mortgagebacked securities (MBS) in a process known as securitisation. Government-sponsored en1

Research Paper# terprises (GSEs) such as Fannie Mae and Freddie Mac traditionally bought the mortgages and repackaged them in a secondary mortgage market to investors, allowing lenders to reinvest into more lending and thus increase the number of lenders in the mortgage market. Intense competition between mortgage lenders for revenue and market share exacerbated relaxed standards in lending due to limited supply of credit-worthy borrowers. A limited supply of credit-worthy borrowers led to relaxed underwriting standards. As a result, less credit-worthy borrowers were able to secure loans in large numbers as nancial rms took on more risk. Many of these borrowers had taken on adjustable rate mortgages (ARMs), which carry xed interest rates for an initial payment period for two or three years, and then adjusts to a higher rate for the rest of the loan period. What this means is that the initial repayments may start off low and thus manageable to the borrower, but subsequent payments may be much higher. About 80 percent of all sub-prime mortgage loans originated in 2005 were ARMs (Janzen 2009).

Reckless speculation As mentioned earlier, the abundance of investment capital (coined a liquidity glut by some economists and observers) resulted in too much capital looking for too few investments. This preceded the peak of the housing bubble, when too much of this capital became invested in bad projects. Much of the oating capital preceding the GFC was invested in mortgage-backed securities and collateral debt obligations. A strong demand for for these bundled mortgages by the investment banks and GSEs further drove down lending standards and created an unsustainable speculative bubble. The top ve US investment banks increased their nancial leverage, reporting over $4.1 trillion in debt (by borrowing) during 2007, amounting to a massive 30 percent of the US economy (Choudhury 2011, p. 301). On the other hand, regulated GSEs such as Fannie and Freddie were 2

Research Paper# known for their conservative approaches towards lending. They were known to uphold high underwriting standards by lending only to those with low credit risk, even playing a constabulary role towards mortgage brokers. Before 2003, the mortgage securities market was dominated by the GSEs. But as market power shifted to the loan originators (banks that issue loans that are resold), they started to lose market share. The worst loans were issued between 2004 and 2007, incidentally the years of most intense competition, as the GSEs relaxed standards in order to catch up with private banks (Simkovic 2011). In his landmark book The Great American Bank Robbery, investigative journalist Paul Sperry accuses the US Department of Housing and Urban Development (or HUD) of arm-twisting in getting the GSEs to meet higher affordable housing requirements and close the home ownership gap. The federally subsidised GSEs had to meet HUDs affordable-housing mandates as part of their federal charter, or face stiff nes (Sperry 2011). Sperry found that in 1997, Fannie began offering mortgages of just three percent down, well below the standard rate of 20 percent, and in 2001, it underwrote mortgages with no downpayments at all. By 2007, 61 percent of the loans Freddie purchased were subprime, and Fannies portfolio reected a similar 58 percent (Sperry 2011).

Epidemic As the higher interest rates from the ARMs began to set in, many borrowers started to default. Defaults and losses on other loan types increased signicantly in what John Talbott (2010) termed as an epidemic, as the crisis expanded from housing to include other parts of the economy (Talbott 2010). Rising interest rates in mid-2007 caused housing prices to plunge so homes were now worth less than that their mortgage loans, giving banks incentive to foreclose. As lenders repossessed more homes and put them up on sale, the prices of homes fell even further through supply and demand. And banks, as Chi3

Research Paper# cago School economist Thomas Sowell (2010) argues, not being in the business of managing real estate, have every incentive to quickly dump repossessed houses on the market for whatever price they can get for them (Sowell 2010, p. 59). A 2009 Mortgage Bankers Association survey found that in 2007, foreclosure proceedings began on nearly 1.3 million properties, a 79 percent increase over 2006. This number increased to 2.3 million in 2008, a further 81 percent increase from 2007. By September 2009, 14.4 percent of all outstanding US mortgages were delinquent or in foreclosure10. Under the weight of defaulting mortgages, Fannie and Freddie were placed into conservatorship by the US government on 7 September 2008. Collectively, both GSEs had more than US$5 trillion in mortgage-backed securities and debt outstanding. Just over a week later, the 154-year-old Lehman Brothers crumpled and investment giant Merrill Lynch was absorbed by the Bank of America in what was widely acknowledged as a re-sale. The American Insurance Group (AIG), the USAs largest insurer, had saddled itself with US$400 billion in credit default swap (CDS) protection on tranches of multi-sector CDOs backed mostly by defaulting subprime mortgages (Mishkin 2011). Simply put, these CDS agreements made AIG guarantor for the faulty mortgage-backed securities that had saturated the market, and when it was time to pay up, the insurance giant crumpled because it simply did not have the nancial strength to support its numerous CDS commitments as the crisis progressed. On September 16 2008, AIG nally crumbled and the US Federal Reserves (or Fed) authorised an US$85 billion credit line in exchange for a 79.9 percent stake in the company (Luhby 2008). This had followed JPMorgan Chases May 2008 acquisition of investment bank Bear Stearns. Bear Stearns short-term nancing had dried up and long-term assets unable to be turned into ready cash to save itself (Mishkin 2011). The deal was partially brokered by the US government. Once-proud investment banks Goldman Sachs and Morgan Stanley became commercial banks. Following a collapse in the housing bubble, 4

Research Paper# rapid increases in a number of commodity prices slowed the economy further, as the price of oil spiked from approximately US$60 per barrel to a peak of US$147 in July 2008 (Esposito 2011, p. 189). A volatile pattern of variance in the price of oil was destabilising and has been argued by energy analyst Tom Theraramus to be the root of the crisis (Therramus 2009).

Fiscal stimulus The abovementioned measures describe actions taken by the Fed and US government to bail out nancial institutions with the Troubled Asset Relief Program, which had an initial authorisation of US$700 billion10. In addition, large scal stimulus packages were executed by governments around the world following the crisis by borrowing and spending to offset reduction in private sector demand. In the G-20 countries alone, this stimulus spending amounted to about US$692 billion in 2009, amounting for just over 1.1 percent of global GDP (Prasad & Sorkin 2009). Central banks also bought over large amounts of government debt in a method known as quantitative easing, which injected liquidity into credit markets (Bnassy-Qur et al. 2010).

Systemic causes A surge in neoliberal, free-market capitalist ideologies after the oil crises of the 1970s when Keynesian economics were targeted for criticism for exacerbating stagation, had led to extensive deregulations throughout the nancial system. These deregulations included the Clinton administrations 1999 repeal of the 1933 Glass-Steagall Act, which was passed in the thick of the Great Depression. For more than half a century, this act separated the risk-taking investment banking and brokerages from scally conservative commercial banks that held the savings of ordinary citizens (Truitt 2010). In 1997, Fed chair5

Research Paper# man Alan Greenspan had also fought to liberalise the derivatives market on the grounds that markets were best at self-regulation (Jacque 2010, p. 272). As mentioned earlier, derivatives such as credit default swops - which landed AIG in the soup - were used to hedge or speculate against credit risks. Fed Chairman Ben Bernanke himself furiously described AIG as effectively running a huge hedge fund inside an insurance company in a statement delivered in Congressional testimony (Torres & Son 2009). Incorrect pricing of risk led to over-dependency of actors (Van Order 2000, pp. 239-40) who focus on one part of the mortgage bundles on actors in the other parts. Van Order (2000) postulates that information asymmetry is a causal mechanism; if sellers did not have superior information about the loans they delivered to investors and insurers, there would be no limit to what the secondary market could buy (Van Order 2000, p. 240). After all, in principle, any measurable risk can be managed. It is perhaps ironic that Van Orders detailed analysis of the primary and secondary mortgage markets was released in Fannie Maes Journal for Housing Research nearly a decade before the crisis, and even more so that he mentions shoddy information as a causal mechanism for failure.

Effectiveness of measures Mishkin (2011) argued that the extraordinary actions by central banks and governments were successful in containing the GFC. However, he postulates that nancial regulation needs to be revamped by developing an understanding of how systemic risk can arise, and by designing policies to rein in this risk. Stiglitz (2008) reasons that the Fed was trying to combat the liquidity trap - where investors hold on to their cash despite drastically lowered interest rates aimed at restarting the economy - with scal policy, and that it had done the required thing. In an essay for The Monthly, Kevin Rudd, then Prime Minister of Australia, blames 30 years of dominant neo-liberal capitalist ideology, denounces nancial 6

Research Paper# over-deregulation and questions how the investment banks were allowed to engage in speculation on this scale, so great as to imperil the nances of any government that had to bail them out (Rudd 2009). There appears to be a general consensus that the bailouts had been successful and essential in easing the credit crunch and cushioning the impact of catastrophic failure.

Conclusion In a recovering world post-GFC, neo-liberals, social democrats and Keynesian proponents alike can do little but accept the interventionist measures taken to rescue the global economy. Regulation of securities, especially credit are now seeing heavy-handed intervention. Securitisation has lost its appeal, with dissenters like Warren Buffet famously referring to derivatives as nancial weapons of mass destruction5. The failure of regulators, credit agencies and even the market itself to tame the raging bull of Wall Street has resulted in a resurgence in Keynesian economic thinking, propagated by increased regulation across the board. For example, mortgages will now need to have at least a 20 percent downpayment if US lenders intend on repackaging to sell to other investors without keeping some of the risk on their books (Clarke 2011). Slovenian philosopher Slavoj iek (2008) has also argued that outside of the western world, a new, pragmatic brand of capitalism exists. In Communist China, neoliberal practices supplemented by authoritarian state controls are seeing rapid growth and fast removing the so-called marriage between democracy and capitalism. So to conclude the death of neoliberalism, or that Keynesian economics have indeed risen from the ashes of Hayeks and Friedmans arson is perhaps premature and arbitrary. What is pertinent is in our recovering world, where the collapse of one nancial system could spur the failures of many others, it is important to leverage on

Research Paper# retrospect and consider all discourses to ensure maximum preparedness and prudence. The crisis is contained for now, and there are lessons to be learnt.

Research Paper# Bibliography 1. Barrow, P 2009, Essential Business Finance: A Complete Guide to Starting, Expanding and Selling Your Business, Kogan Page. 2. Bnassy-Qur, A, Coeur, B, Jacquet, P & Pisani-Ferry, J 2010, Economic Policy: Theory and Practice, Oxford University Press. 3. Carter, G 2010, The Great Hangover: 21 Tales of the New Recession from the Pages of Vanity Fair, HarperCollins. 4. Choudhury, MA 2011, Islamic Economics and Finance: An Epistemological Inquiry, Emerald. 5. Clarke, D 2011, 'Repackaging Mortgages Would Require Large Downpayment Under New Rules', Hufngton Post, 29 May 2011. 6. 'Derivatives - A Nuclear Winter?', 2008, The Economist, Sep 18, 2008. 7. Esposito, E 2011, The Future of Futures: The Time of Money in Financing and Society, Edward Elgar. 8. Jacque, LL 2010, Global Derivative Debacles: From Theory to Malpractice, World Scientic. 9. Janzen, M 2009, Effects of the Subprime Crisis on the U.S. American Financial Reporting System: Focussed on Derecognition of Financial Assets, Special Purpose Entities, and Fair Value Accounting, GRIN Verlag GmbH. 10. Luhby, T 2008, 'Fed in AIG rescue - $85B loan', CNNMoney.com, viewed 18/04/2012, <http://money.cnn.com/2008/09/16/news/companies/AIG/index.htm>. 11. MBA 2009, 'Delinquencies Continue to Climb in Latest MBA National Delinquency Survey', viewed 18/04/2012, <http://www.mbaa.org/NewsandMedia/PressCenter/71112.htm>.

Research Paper# 12. Mishkin, FS 2011, 'Over the Cliff: From the Subprime to the Global Financial Crisis', Journal of Economic Perspectives, vol. 25, no. 1, pp. 49-70. 13. Prasad, E & Sorkin, I 2009, 'Assessing the G-20 Stimulus Plans: A Deeper Look', viewed April 19 2012, <http://www.brookings.edu/articles/2009/03_g20_stimulus_prasad.aspx#_ftn3>. 14. Report on the Troubled Asset Relief ProgramMarch 2012, 2012, Congressional Budget Ofce. 15. Rudd, K 2009, 'The Global Financial Crisis', The Monthly, February 2009. 16. Simkovic, M 2011, 'Is competition the solution or the problem? An analysis of US mortgage securitization'. 17. Sowell, T 2010, The Housing Boom and Bust, Basic Books. 18. Sperry, P 2011, The Great American Bank Robbery: The Unauthorized Report About What Really Caused the Great Recession, Thomas Nelson. 19. Talbott, JR 2010, Contagion: The Financial Epidemic That Is Sweeping the Global Economy... and How to Protect Yourself from It, John Wiley & Sons. 20. Therramus, T 2009, 'Oil Caused Recession, Not Wall Street', oil-price.net, viewed 2012/04/17, <http://oil-price.net/en/articles/oil-caused-recession-not-wallstreet.php>. 21. Torres, C & Son, H 2009, 'Bernanke Says Insurer AIG Acted Like a Hedge Fund', viewed April 18, 2012, <http://www.bloomberg.com/apps/news ?pid=newsarchive&sid=aqw5b2yJyB1o&refer =home.>. 22. Truitt, WB 2010, Power and Policy: Lessons for Leaders in Government and Business, Praeger. 23. Van Order, R 2000, 'The US mortgage market: A model of dueling charters', Journal of Housing Research, vol. 11, no. 2, p. 233. 10

Research Paper# 24. iek, S 2008, 'Introduction, and 'SOS Violence'', in Violence: Six Sideways Reections, Picador, New York, pp. 1-8, and 9-33.

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