A year after the financial crash
By Shahid Javed Burki
Monday, Sep 21, 2009
THE outline of the story is by now well known. My interest is in the part that has only begun to catch the attention of analysts and historians.
This relates to the part governments around the globe should have played but didn’t since the prevailing economic philosophy believed that the markets were allknowing and there were fancy ways of spreading the risk that would not produce financial shocks. In fact, exactly the opposite of what was expected happened.
There is nothing unusual about the fact that the global economy has gone so quickly through first a boom and then a bust. Such cycles have happened before and they will happen again. Each boom and bust cycle has a different set of players. What is common between them is that they try to play the system to the very edge of its tolerance. Some do it to innovate and some to make profit. The first class of people helps the economies and societies in which they operate. The second only help themselves at the cost of societies. Such people and the booms and busts they produce are not unique to America.They are to be found in all parts of the world.
There were three sets of players who performed important roles in the crisis that began in the United States in the summer of 2007 and probably bottomed out in the early summer of 2009. The first were the Chinese who managed their economic system in a way that it produced much more than they could consume. The surplus was exported to the West, mostly to the United States.
The Chinese ran up large trade surpluses with the United States which left them with large amounts of dollars which were invested mostly in the United States. The flow of large quantities of funds from China kept the rates of interest low and produced enormous liquidity in the market. A significant part of this went into real estate. Loans were given out at low rates which increased the demand for houses and also their prices.
A large number of people who borrowed to buy houses couldn’t really afford to service the loans they obtained, especially when the variable rates on which they had borrowed increased. This is generally referred to as sub-prime lending.
The Chinese were not the only people who had surpluses to dispose off. Almost the same amount was available with the oil ex porting countries. Leading into 2006, the capital exiting Saudi Arabia and Kuwait alone matched the funds leaving China – approximately $200 billion per year.
For five years, from 2003 to 2008 when the price of oil climbed to unprecedented heights, the Middle East’s massive petrodollar outflows, combined with excess liquidity due to low interest rates fueled the housing bubble not just in the United States but also in Britain and the Middle East itself.
Once sub-prime lending became pervasive, a third player – in addition to the Chinese and the oil exporting countries – entered the picture: financial engineers working in various parts of the financial system. They invented a number of fancy products that went under the name of deriva tives.
The loans given out by banks to those who couldn’t afford to buy houses were bundled and sold to the institutions that could bring longer-term securities on their books. These were mostly investment banks, pension and hedge funds, and large endowments. Having purchased these products, these investors insured them with insurance companies. The entire financial system got involved.
A big problem with this spreading of risk was that while the banks were tightly regulated, investment and hedge funds were not. There was logic behind this system of regulation. Since the banks received deposits from ordinary citizens, the governments were anxious to protect them. The hedge funds and pension funds relied mostly on the relatively well-to-do. If they wished to take risks there was no reason why the governments should protect them.
The crisis shows how modern finance is developing strong linkages within the system and how quickly shocks get transmitted from one part to another. It shows how policy makers, no matter the level of their sophistication have nothing more than raw instincts to work on. And it demonstrates how the same set of events appears very different with the lapse of time and upon cooler reflection.
This is a good time to go over some of the main elements of the story since this is the first anniversary of the bankruptcy of Lehman Brothers, the fourth largest investment bank in the US financial system. The United States Treasury working with the Federal Reserve System, the central bank, pulled the rug from under Lehman after having rescued Bear Sterns. This happened on September 15. The stock market sank more than 500 points that day. The Reserve Primary Fund, a money market fund that held Lehman bonds, ‘broke the buck’, or dropped below $1 a share in net asset value.
Two days later, American International Group, the AIG, the world’s largest insurance company that provided cover for many Lehman products, collapsed and had to be bailed out with an extraordinary $85 billion loan from the US government. Stanley Morgan, another financial giant, was rumoured to be next. Banks all over Europe were teetering on the edge of an abyss.
Ever since that weekend, most people have viewed the decision by Henry M. Paulson Jr., then the secretary of the Treasury and Ben S. Bernanke, the chairman of the Federal Reserve, to allow Lehman to go bust as the single biggest mistake of the crisis. For instance, Christine Legarde, the French finance minister, called the decision horrendous. In speeches and articles and books commentators of every political stripe have pointed to the Lehman bankruptcy as the event that turned the subprime crisis into a full-blown financial meltdown.
Passage of time has changed the way the official action that led to the Lehman collapse is being viewed now. It is quite likely that the financial crisis would have been even worse had Lehman been rescued. Although no body realised it at that time, Lehman Brothers had to die for the rest of Wall Street to live. Now that the crisis appears to be coming to an end, the governments are beginning to reform the system. The US is taking the lead but the going will be rough since so many vested interests are involved. President Barack Obama took the initiative by giving a speech in New York on September 14 to indicate why reform was necessary. The next step on the way will be the G20 meeting in Pittsburgh before the end of September.