THE FINANCIAL CRISIS:
As the US lawmakers and the FED are busy in making strategy for the bail out from the severe financial mess and the worst crisis since the great depression of 1930’s, let us try to diagnose the genesis of the crisis that has triggered worldwide financial instability:
There may be many economic and fundamental reasons behind the current crisis. But the seeds of the problem were sown in the aftermath of 9/11 attacks, when Greenspan lowered the interest rates in order to fight the slowing growth. But, low interest rates coupled with government populist policies that generated demand for housing and other consumer loans. When demand rose, the housing prices soared to a record high and at a speed that was totally absurd. At the same time, default spreads in the bond market also diminished to the historical lows.
In the second stage, these housing mortgages, were bundled into mortgage backed securities and were traded thereby shifting more and more risk on the last holder of the MBS. The profit shown by the Investment Banks lured even the commercial Banks to take exposure to the Highly risky and grossly mispriced securities. (Was it due to fierce competition to performand take away huge bonuses.)
Financial services companies (Banks, Investment Banks and Insurance Companies) were the initial investors in these mortgage backed securities, with the former using debt to fund their investment. In some cases, investment banks were buying the riskiest layers of the mortgage backed debt, using short term financing.
Here is how it unraveled:
1. Housing prices started their decline at the end of 2006 and accelerated into 2007. The contemporaneous economic slow-down also started pushing up default spreads in bond markets.
2. The values of the mortgage backed securities on the books of buyers started dropping as the built in assumptions about increasing housing prices and low default risk came under assault.
3. A few financial service companies reacted quickly and sold some or most of their holdings by mid-2007, taking their losses. Most held on, hoping for a market turn-around.
4. Accounting requirements on marking-to-market required banks to begin restating the values of their securities to reflect current value. As the values of mortgage backed securities dropped, the liquidity in these markets also dried up, leading to big write-offs in value, which in turn reduced the book equity at these firms.
5. As the book capital dropped, these firms started showing up on regulatory warning screens as being under capitalized, based on book equity. (In late 2007, firms like Lehman and Bear Stearns could have made equity issues or raised fresh equity to provide a safety margin, but they believed they could ride out the storm).
6. As the liquidity problems in the mortgage backed security market worsened, the write downs continued. By the beginning of the summer of 2008, firms like Bear Stearns and Lehman had lost any buffer they might have had, and the equity options available at the end of the prior year had also dried up.
7. Bear Stearns is liquidated, with the Fed's help. If Lehman had one last chance to raise fresh equity, it would have been in the weeks after the Bear liquidation.
8. The hits keep coming and Lehman falls. The question, given the absence of liquidity in the mortgage securities market, is who's next? That turns out to be AIG, but it is quite clear that there will be always someone else next in line who will be targeted to fall.
9. The recognition that this is as much a liquidity problem as a valuation problem comes to the Treasury and the Fed. The Paulson bailout is a liquidity plan, where the illiquid securities will be taken off the books of financial service firms, and held by the Federal Government, the only institution that can create its own liquidity (nice to control those printing presses).
As the US lawmakers and the FED are busy in making strategy for the bail out from the severe financial mess and the worst crisis since the great depression of 1930’s, let us try to diagnose the genesis of the crisis that has triggered worldwide financial instability:
There may be many economic and fundamental reasons behind the current crisis. But the seeds of the problem were sown in the aftermath of 9/11 attacks, when Greenspan lowered the interest rates in order to fight the slowing growth. But, low interest rates coupled with government populist policies that generated demand for housing and other consumer loans. When demand rose, the housing prices soared to a record high and at a speed that was totally absurd. At the same time, default spreads in the bond market also diminished to the historical lows.
In the second stage, these housing mortgages, were bundled into mortgage backed securities and were traded thereby shifting more and more risk on the last holder of the MBS. The profit shown by the Investment Banks lured even the commercial Banks to take exposure to the Highly risky and grossly mispriced securities. (Was it due to fierce competition to performand take away huge bonuses.)
Financial services companies (Banks, Investment Banks and Insurance Companies) were the initial investors in these mortgage backed securities, with the former using debt to fund their investment. In some cases, investment banks were buying the riskiest layers of the mortgage backed debt, using short term financing.
Here is how it unraveled:
1. Housing prices started their decline at the end of 2006 and accelerated into 2007. The contemporaneous economic slow-down also started pushing up default spreads in bond markets.
2. The values of the mortgage backed securities on the books of buyers started dropping as the built in assumptions about increasing housing prices and low default risk came under assault.
3. A few financial service companies reacted quickly and sold some or most of their holdings by mid-2007, taking their losses. Most held on, hoping for a market turn-around.
4. Accounting requirements on marking-to-market required banks to begin restating the values of their securities to reflect current value. As the values of mortgage backed securities dropped, the liquidity in these markets also dried up, leading to big write-offs in value, which in turn reduced the book equity at these firms.
5. As the book capital dropped, these firms started showing up on regulatory warning screens as being under capitalized, based on book equity. (In late 2007, firms like Lehman and Bear Stearns could have made equity issues or raised fresh equity to provide a safety margin, but they believed they could ride out the storm).
6. As the liquidity problems in the mortgage backed security market worsened, the write downs continued. By the beginning of the summer of 2008, firms like Bear Stearns and Lehman had lost any buffer they might have had, and the equity options available at the end of the prior year had also dried up.
7. Bear Stearns is liquidated, with the Fed's help. If Lehman had one last chance to raise fresh equity, it would have been in the weeks after the Bear liquidation.
8. The hits keep coming and Lehman falls. The question, given the absence of liquidity in the mortgage securities market, is who's next? That turns out to be AIG, but it is quite clear that there will be always someone else next in line who will be targeted to fall.
9. The recognition that this is as much a liquidity problem as a valuation problem comes to the Treasury and the Fed. The Paulson bailout is a liquidity plan, where the illiquid securities will be taken off the books of financial service firms, and held by the Federal Government, the only institution that can create its own liquidity (nice to control those printing presses).
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