Background of Financial Crisis 2007
The Banking/Financial crisis of 2007 was/is of such unparalleled ferocity that the only equivalent event that comes closer in magnitude is that of late twenties and thirties global depression in twentieth century from which world only recovered post World War of 1945. Hopefully, this time it would not require a major war to achieve complete recovery!
The epicenter for this crisis was definitely in banking/financial sector especially in USA but unlike previous crisis of 1929 depression it did not start with stock market but in financial/banking institutions. To attempt to begin to identify the cause(s) of this crisis we need to develop historical understanding of banking and financial industry which was fundamentally re-structured following thirties global depression. (This discussion will mainly concentrate on crisis effects, causes and remedies from USA perspective unless stated otherwise)
The key initiative introduced in banking/financial industry post 1933 USA to mitigate crisis effects and avoid future ones were:
- Regulatory Overhaul: Introduction of Glass-Steagall Act (Bank Act 1933) that caused for clear divide between various financial institution i.e. retail/commercial bank, investment/merchant bank, insurance, securities etc. This was a far-sighted decision which served its objective by clearly defining and distinguishing different financial business as each of them has its own distinct behaviour and risks associated with them. In addition each of these businesses would be regulated by its own specific regulator like Federal Reserve, SEC etc which would ensure a containment and also specific regulation for each industry.
- Federal Deposit Insurance (FDI): As the thrust of the crisis were felt by small bank deposit holder due to run on banks hence Govt introduce a scheme where by Fed (Central Bank) guaranteed these deposits up to a certain amount (currently $100K) which in turn ensured that trust in bank returned with public and also ensured that retail bank wont suffer liquidity problem (from liability perspective, assets side banks have to manage).
These regulation successfully serve their purpose for next five decades as during that time USA had seen many economic expansion/recession but all of them were devoid of any financial/banking crisis and were mainly induced by Fed's monetary policy. During this period financial industry has mostly the image of staid bean-counters with regular jobs and not the glamorous millionaires that it started to resemble in 1980's.
These regulations have to be understood in wider context of changes taking place in USA (and worldwide), as post depression marked a huge change in political/economic ideology where in
the idea "Govt is good" started to flourish as oppose to laissez-faire that used to be the prevalent norm for governance. This meant that Govt. either started framing rules/regulation for industries, course followed by USA which led in terms of these regulations or Govt take over of industries itself, mostly in Europe which saw a vast public sector emerge especially in defence and health.
This pro-regulation (which sometime is also inferred as anti-business) environment continued in USA until late 1970's when with the troubles of stagflation (aggravated by oil crisis) in 1970's West began to turn towards more pro-market, deregulation philosophy whose political proponent Republicans in USA and Conservatives in UK came to occupy seat of power simultaneously.
Thus, began an era, especially in finance, which over next 25 year would turn the industry upside down and pendulum of regulation swung to other side completely. This did not happen over-night but regulations were dis-mantled slowly over a period of time, this was helped in not so small means by a secular growth in stock market which provided a tremendous increase in wealth as more and more public came to own stock (this period saw the assets of mutual funds and stocks overtake bank deposits as repository of public savings in US). The change in social attitude and almost religious belief in market forces is a far wider topic that needs to be studied separately but suffice to say that it provided a perfect platform in which post depression financial regulations were dismantled and in some cases new industries without any regulations or minimal regulations were allowed to flourish.
During this period from 1980's onward it wasn't as if there were no crises some of the prominent one in chronological order is:
- Savings and Loans USA - 1986
- Japan Banking 1991
- Asian banking crisis 1997
- Long Term Capital Bank (LTCM) USA 1998
- Enron/Accounting 2002
As each of the crisis unfolded and were resolved they were all explained away with some specific/local issues and not anything systemic that could be applicable for modern capitalist system with its pro market and deregulation gospel. Thus, Asian banking crisis due to "crony capitalism" and nepotism of Asians (someday it would be a good topic for modern racism/white supremacy/oriental-ism discussion). LTCM was made out to be a case of a one large bet going wrong or rather one institutions risk management system not being upto the scratch.
But ignorance of Japanese banking crisis has been the worst egregious behavior for system regulators and industry especially in USA (West typically follows USA in terms of financial regulation). This was a crisis which originated in asset price bubble of 1980's led by stock market and real estate sector (at its peak total Japan real estate was valued more than that of USA!). Unfortunately as the bubble bust in 1991 it was not just case of re-adjusting quickly to demand shock for few years but instead due to presence of large non-performing assets on financial institutions which could not be written off without causing further damage to economy. Thus, this was termed "balance-sheet" recession where all economic stake-holder corporations and household spent an entire decade or more in De-leveraging i.e. reducing their overall debts and Govt has to assume fiscal deficits to prop up the economy (Public and private sector cannot run deficit simultaneously). Many economists in USA have been student of this crisis and have generally blamed Japanese Central Bank and/or Govt for being "too little too late" but looks like boot is on the other foot!.
Now with advantage of hindsight for handling of crisis during 2007-2011 it can be safely said that West had ignored the political economy part of decision making or had not properly accounted for its impact. It seriously underestimated the effort require to reach a majority consensus in democratic setup where significant and powerful section have their vested interest that are diametrically opposite to society at large.
Origin of crisis in USA Mortgage Industry
It is common knowledge now that the first sign of asset bubble were noticed in US mortgage industry which has over the last decade seen a major change in financing due to securitization of Mortgage Assets by industry. The securitization, which was hailed initially as a risk dispersal/management mechanism by regulators, was thus encouraged wholeheartedly with minimal regulations. This provided a means of spreading the risk into other parts of global financial sector (risks never disappears it just gets transferred with loss of information, Lesson learnt!). Thus, the traditional mortgage which had only two actors i.e. customer and mortgage holder typically a bank which held the same to its maturity, now the same had been transformed where multiple actors/institutions participated in various roles:
1. Mortgage Originator/Financier: Institution that does the original due-diligence and provides the mortgage to customer. These are primarily commercial banks or specialize mortgage financial companies (Country wide Financial)
2. Investment Bank: Organization responsible for converting the loan portfolio into securitized debt consisting of alphabet soups of acronyms MBS, CDO, CLO, CDO- squared etc. They were the originator and backer for all financial engineering that went into creation of these financial products.
3. Rating Agencies: Provide standardized and ‘independent’ rating of various securities
4. Govt. Sponsored Enterprises (GSE): Organization with mandate to provide liquidity in specific areas like mortgage, student loan, etc.
5. Investors: End buyers of financial security basically the organization who carry the risk on their balance sheets and could be Pension/Mutual/Hedge/Sovereign funds spread all over the globe.
6. Mortgage Servicer & Trust: Organization which manages the cash-flow from customer to investors and especially non-payment, default fore-closure process
7. Debt Insurance: Organization under-writing CDS contracts on the securities,
Due to dismantling of restrictions there was trend world-wide of huge growth of all-in-one shop “global bank” like Citi, BoA playing all the roles mentioned above thus creating a huge inter-connected networks which were not visible to regulators but would cause financial contagion at the time of financial stress.
Once the asset growth started slowing down the signs of stress started becoming visible interconnected financial system (in fact some market participant committed fraud by selling their naive clients mortgage based securities that they knew were dud, many of these are getting sorted in legal system). These stresses initially showed up in illiquid Inter Bank credit market in summer of 2007 and reached its peak with the bankruptcy of Lehman Brothers', in between causing either bankruptcy/seriously harming such global institutions as Bear Stern, Fannie Mae/Freddie Mac, AIG, RBS (UK) etc.
In the end this crisis has impacted all of financial sectors globally, each of these sectors were affected in their own way and have posed systemic risk that need to be delve in detail by its regulators. But the most prominent of all these are the Banks (Commercial and Investment) as they are fundamental to functioning of modern economy by providing the plumbing for Payment/Saving functionality to majority of population, hence need to be protected which implies an implicit Govt. subsidy in their activities. The other side of this coin would indicate since Banks cannot be allowed to fail hence they need to be regulated carefully.