Download What is Systemic Risk?

Term 2: Lecture 1
Topic 1: Global Impact of the 2008 Financial Crisis:
Comparing Canada and the Third World Countries
Onaran (2010) argues:
Neoliberalism is an initial attempt to deal with the
1970s stagflation crisis
• After leaving the policies based on the “Keynesian
consensus” and turning away from the capitalism’s
“golden age” (higher spending on social welfare,
strengthening the unions, cooperation between
labour and management) neoliberalist policies were
introduced.
• Profits increased but a greater risk of crisis arose as
a result : investment and wages declined
• To control the crisis, US boosted the economy with
quick financialization- this stimulated debt-credit
and other yields of wealth
Capitalism is facing a major realization crisis:
• An inability to sell the output produced, i.e., to realize, in the
form of profits, the surplus value extracted from workers’ labor.
Why did unemployment grew and labour’s purchasing power
decline?
• Economic growth rates have been low and well below the mark
leading to unemployment
• Labour’s purchasing power declined as a result of
unemployment and lower wages – decline in consumers for
goods produced – capitalists as profit-makers do not spend as
much as workers who earn wages (“a dollar transferred from a
worker to a capitalist reduces total consumption spending”).
The result was
Capitalists played the financial markets for highprofits through financial speculation
This led to unmanageable debt leading to
capitalist crisis: The Financial crisis of 2008
Immanuel Wallerstein (2011) argues:
• Capitalist system requires endless accumulation of capital
• Appropriation of surplus value
• Monopoly of global production with global linkages
• Support of various states
1.AICs rules that shaped global neoliberalism
(slides 6-15 for self-review)
WTO: AICs commercial interests are embodied
in the rules global trade, aid and loan imposed
on the LDCs :
• WTO works on power-based bargaining
• Neoliberal policies
•Washington consensus
•SAP
•Conditionality
• MFN
How does Structural Adjustment Program (SAP) affect
the Developing countries?
Impact:
•Balancing the government budget
•Weakening the Labour
•Deregulating the economy
•Reducing the State
BLeeDS
In the past, IMF’s imposition of SAP on South Asian
countries (e.g., S.Korea, Indonesia, Thailand) created a
financial crisis of economic contraction and depression.
Continued from Lec 4:
WTO: AICs commercial interests are embodied
in the rules global trade, aid and loan imposed
on the LDCs:
• WTO works on power-based bargaining
• Neoliberal policies
•Washington consensus
•SAP
•Conditionality
•MFN
What are the Neoliberal policies? DOPE LD
Liberalize trade
Deregulate finance/currency
Open up for foreign investment,
Privatize economy
Deregulate commercial activity
Ensure property protection
http://www.youtube.com/watch?v=XIUWZnnHz2g&feature=related
neolib as a water balloon 12 min
WTO: AICs commercial interests are embodied
in the rules global trade, aid and loan imposed
on the LDCs :
• WTO works on power-based bargaining
• Neoliberal policies
•Washington consensus
•SAP
•Conditionality
•MFN
WASHINGTON CONSENSUS (1989)
•
Liberalization
•
Austerity
•
Privatization
•
De-regulation
LAPDog
WTO: AICs commercial interests are embodied
in the rules global trade, aid and loan imposed
on the LDCs :
• WTO works on power-based bargaining
• Neoliberal policies
•Washington consensus
•SAP
•Conditionality
•MFN
Conditionality:
• Conditions placed on loans to LDCs
Conditions imposed to make aid effective in
a recipient country – in reality could hurt
the country’s economy or the country’s
political stability
Global Capitalism, Financial Crisis & Developing Countries
1. Origins of the Crisis: USA
2. Impact of the Crisis: Global
Source: Valpy FitzGerald
http://hdr.undp.org/en/media/FitzGerald_Global_Financial_Crisis_edit.ppt
1. What caused the US/EU financial system to fail in
2007-9 that led to a shock to global production and
trade?
2. What has been the impact of the crisis on the US vs.
Canada ?
3. Why has the impact on the Developing countries been
less than that on the AICs?
4. Why has the recovery been quicker in the Developing
countries?
What caused the crisis?
•Market failure?
•Policy failure?
Causes of Market failures
• Lack Information: Markets do not know how to
price systemic risk (hidden by derivatives) and
investors “herd” (risk aversion)
• The Principle-agent: Incentives to traders to take
risks; securitization of loans by banks removes
monitoring
• Deregulations led to Moral hazard/market distortion:
banks “too big to fail” and government underwriting
Assumed
Systemic risk: http://www.youtube.com/watch?v=UM0z6K6NDT0 2 min (watch at home)
Franklin Allen - What is Systemic Risk?
Risk: It’s a risky transaction between parties if one party has not
entered into the contract in good faith – if it has given misleading
information on important elements required for that contract to be
sound: e.g., on assets, liabilities, capacity for credit, or the nature of
its risk.
Is the party misleading the buyer to earn a quick profit?
Deregulation: the reduction or elimination of government power to
regulate how an industry operates – usually to create more
competition within the industry, e.g., financial market (e.g., banking
sector) deregulation led to reckless lending and the housing crisis
2008
Moral hazard can be present any time two parties come into
agreement with one another. Each party in a contract may have the
opportunity to gain from acting contrary to the principles laid out by
the agreement.
Security
•An instrument representing ownership (stocks), a debt
agreement (bonds) or the rights to ownership (derivatives).
•A security is a negotiable instrument representing
financial value. The company or other entity issuing the
security is called the issuer
•A country's regulatory structure determines what qualifies
as a security.
For example, private investment pools may have some
features of securities, but they may not be registered or
regulated as such, if they meet various restrictions.
Derivatives http://www.youtube.com/watch?v=X3nS5kSce_M Derek Banas 8min
• A derivative is an agreement between two parties that is
contingent on a future outcome.
• It is a financial contract with a value linked to the expected
future price movements of the asset it is linked to - such as
a share, currency, commodity or even the weather.
• Derivatives allow risk related to the price of the underlying
asset to be transferred from one party to another. Options,
futures and swaps, including credit default swaps, are
types of derivatives.
• A common misconception is to refer to derivatives as
assets. This is erroneous, since a derivative is incapable of
having value of its own as its value is derived from another
asset.
https://www.youtube.com/watch?v=NPfwUTm1isU
understanding the fin crisis 11 min Mostafa Mourad 2009
CDO CDS, SUBPRIME, INTEREST RATE, EQUITY etc
SayItVisually--US Financial Crisis 4 min 2008
http://www.youtube.com/watch?v=h4Ns4ltUvfw
Derek Banas fin instruments – derivative- CDO –CDSwap – regulated marketderegulation-credit rating agencies 9 min 2011
http://www.youtube.com/watch?v=S3AXHQcXYMk
http://www.youtube.com/watch?v=bYZdKNjTIzY sovereign bonds/debt 10116 min ( you can watch later) 2010
Equity http://www.youtube.com/watch?v=tcpW0mM4OD4 equity 7.5min (watch at home)
A stock or any other security representing an ownership interest.
In finance, equity is ownership in any asset after all debts associated
with that asset are paid off, e.g., a car or house with no outstanding
debt is the owner's equity because he or she can readily sell the item for
cash. Stocks are equity because they represent ownership in a company.
Interest Rate Swap financing involves two parties (MNCs) who agree
to exchange loan payments (cash flows), results in benefits for both
parties. Floating vs. fixed rate exchange
Currency Swap - One party swaps the interest payments of debt
(bonds) denominated in one currency (USD) for the interest payment of
debt (bonds) denominated in another currency (BP), Currency swap is
used for cost savings on debt, or for hedging long term currency risk.
CDS: The buyer of a Credit Default Swap receives
credit protection, whereas the seller of the swap
guarantees the credit worthiness of the product. By
doing this, the risk of default is transferred from the
holder of the fixed income security to the seller of the
swap.
For example, the buyer of a credit swap will be entitled
to the par value of the bond by the seller of the swap,
should the bond default in its coupon payments.
Subprime
Subprime is a classification of borrowers with a
tarnished or limited credit history.
Lenders will use a credit scoring system to determine
which loans a borrower may qualify for.
Subprime loans are usually classified as those where the
borrower has a credit score below 640.
Subprime loans carry more credit risk, and as such, will
carry higher interest rates as well.
Approximately 25% of mortgage originations in US are
classified as subprime.
Subprime lending encompasses a variety of credit types,
including mortgages, auto loans, and credit cards.
Collateralized Debt Obligation (CDO)
•CDOs are a type of structured asset-backed security whose value and
payments are derived from a portfolio of fixed-income underlying
assets.
•CDOs are split into different risk classes, or tranches, whereby
"senior" tranches are considered the safest securities. Interest and
principal payments are made in order of seniority, so that junior
tranches offer higher coupon payments (and interest rates) or lower
prices to compensate for additional default risk.
Note:
•Each CDO is made up of hundreds of individual residential
mortgages.
•CDOs that contained subprime mortgages or mortgages underwritten
because of predatory lending, were at greatest risk of default.
•They are blamed for precipitating the global crisis and have been
called WMD “weapons of mass destruction.”
Credit Default Swap (CDS)
A CDS is an insurance contract in which the buyer of the CDS
makes a series of payments to the protection seller and, in
exchange, receives a payoff if a security (typically a bond or loan
or a collection of loans such as a CDO) goes into default.
NOTE: CDOs are widely thought to have exacerbated the financial
crisis, by allowing investors who did not own a security to purchase
insurance in case of its (CDOs they did not own) default. AIG
(American International Group of insurers) almost collapsed
because of these bets, as it was left on the hook for tens of billions
of dollars in collateral payouts to some of the biggest U.S. and
European financial institutions. AIG paid Goldman Sachs $13
billion in taxpayer money as a result of the CDSs it sold to
Goldman Sachs.
What caused the crisis?
•Market failure?
•Policy failure?
Policy failure
• US and EU government “populism” over-indebts
lower-income groups
• US and EU fiscal low-interest policies fuelled
asset bubble (including commodities)
• Global imbalances generated growing and
unsustainable debts of US, EU, and Japan (G3)
•
•
•
•
Origins of current financial crisis
Since 1990s deregulation of financial markets: risk
pricing replaces prudential supervision. Rise of derivative
“assets” with opaque markets and few players. Bank
loans replaced by bonds, etc.
Huge US fiscal deficit, monetary expansion (“Greenspan
put”), low savings led to a US mortgage boom/bust (non
traded sector) and a huge current account deficit (traded
sector).
Mortgage bubbles (e.g. 1992 in UK) are familiar with
obvious political costs; join recurrent bubbles in past
decade (dotcoms, LTCM, Tequila etc);
But this is by far the most serious systemically because it
threatens the global banking system itself as creditor, and
whole US electorate as debtor.
Sub-prime lending
By 2005, one in five mortgages were sub-prime, and they
were particularly popular among recent immigrants trying
to buy a home for the first time, and the poor.
Subprime
• Repossessions of houses in America as many of
these mortgages reset to higher rates.
• By late 2007, one in ten homes in Cleveland had
been repossessed
• Two million families will be evicted from their
homes as their cases make their way through the
courts.
Scale and Spread
• Collapse of the government backed mortgage system
in the USA (Fannie and Freddie) followed by
meltdown of major investment banks (Lehman, Bear,
Merrill) exposed to mortgage market
• Mark-to-market asset pricing effects on balance
sheets and cumulative liquidity retraction due to
rising risk aversion
• Affecting insurance, e.g., American International
Group, Inc. (AIG) ; and pensions funds
Global mortgage boom and bust
The end of the stock market boom
in U.S., 2007-08
Financial Times, 20 Sept 2008
• “…bank boards and bank executives have failed to
understand complex mortgage-backed banking
products, as have central bankers, regulators and
credit rating agencies.”
• “…a reward system that has granted huge bonuses
to those who peddled toxic mortgage-related
products….”
• “Almost as absurd has been the degree of leverage
racked up by investment banks.”
Policy reactions
• Fannie Mae and Freddie Mac (re)nationalised; Merrill
sold to BankAmerica; Lehman to Barclays; Goldman and
Morgan become banks again; US govt $700bn purchase
of bad debt; G3 central banks support world banking.
• Expansionary monetary policy (to avoid recession like
1930s) and scale of US Govt (and G3) bailouts will have
large repercussions, yet to be evaluated [lessons of
Mexico etc?]
Scale of the potential bailout in Billions (2008)
http://hdr.undp.org/en/media/FitzGerald_Global_Financial_Crisis_edit.ppt
Despite massive trade shock from G3 economies
(US, Euro area & Japan) decline, developing
economies declined less and recovered better
Developing Countries pursued autonomous policies not
dependent on those of IMF strictures:
• Reserve accumulation to insure themselves after
learning form 1990s crises
• Counter-cyclical macro-policies (fiscal, monetary and
exch-rate) to stabilize their output
• More extensive safety nets (universal rather than
targeted) to sustain demand
World International Reserves (USD million)
http://www.nber.org/public_html/confer/2011/GFC11/Dominguez_Hashimoto_Ito.pdf
Pre-crisis accumulation of Financial Reserves in Billions
acts as buffer
Real devaluations of own currencies to accommodate
the shock rebalanced their finances
India in 2009
http://www.youtube.com/watch?v=W5xMujBRvmU
However, income distribution has worsened and poverty
risen in the DW
• Managed exchange rates maintain output/employment
rather than wages/incomes in the formal sector.
• The burden falls on the informal sector – lower wages and
spending by the poor.
•Remittances from abroad declined.
• World Bank estimates poverty rising due to deceleration in
growth
• Decline in job creation while labour force continues to
grow
In AICs employment growth is negative (i.e. unemployment
rises), but not in Emerging economies
Debt Crisis in AICs: Sudden end to a decade-long US and EU
household and corporate credit boom
http://www.economist.com/blogs/buttonwood/2010/06/indebtedness_after_fina
ncial_crisis
Increasing trend in G7 sovereign debt has accelerated
http://www.investopedia.com/video/play/sovereign-debt-overview/ 3 min on sov debt
What Does Sovereign Debt Mean?
A national government issues Bonds in a foreign currency, in
order to finance the issuing country's growth.
Sovereign debt is generally a riskier investment when it
comes from a developing country, and a safer investment
when it comes from a developed country.
The stability of the issuing government is an important factor
to consider, when assessing the risk of investing in sovereign
debt, and sovereign credit ratings help investors weigh this
risk.
Ref: http://www.investopedia.com/terms/s/sovereign-debt.asp#ixzz1d0utu3rA
Lenders were scared when loan defaults began to rise
from 2007 on: Securitized mortgages the most “toxic”
lending to banks in turn became Risky- Total bank losses
exceed $2 trillion: 25% of US & EU securitized mortgages
written off
Rapid (and massive) US & EU government response
•Monetary expansion
• Fiscal expansion
• Bank bailouts
Interest rates in G3 cut to zero (negative in real terms)
Advanced economies’ debt/GDP ratio risen by 35%
2007-14
Though fiscal
stimulus is not the
main cause –
rather automatic
stabilisers,
bailouts and lost
tax base from the
crisis itself
Inflation: In the BRICs only India is alarming
Asia the leading example of large reserves actively managed
Income distribution and poverty
Stabilization and income distribution:
• Output shocks reduce employment; real devaluations
reduce real wages
• Decrease of modern sector wage bill cuts informal
incomes through lack of demand for the informal sector
• Poor urban households (casual labour and petty
services) particularly hard hit
Developing country employment has suffered much
less than in developed
TheWorld Bank Global Monitoring Report 2010: The
Millennium Development Goals (MDGs) after the Crisis
(April 2010)
• WB projects the poverty impact of the crisis
through the effect on growth; also for MDG targets
• “The crisis left an estimated 50 million more
people in extreme poverty in 2009, and some
64 million more will fall into that category by
the end of 2010 relative to a pre-crisis trend”
(p. 102)
• That is 2% of the world population...
http://www.imf.org/external/pubs/ft/gmr/2010/eng/gmr.pdf
http://www.imf.org/external/pubs/ft/gmr/2010/eng/gmr.pdf
Full poverty impact of the crisis will depend upon whether
high growth is achieved (Asia 8%, LAC 4%, SSA 5%) or
not
Is there an equitable stabilization possible?
• the heterodox stabilization policies of EMs have not
protected wages and jobs or contained the impact on
countries’ poverty
Consequences for longer-term inequality and poverty:
• Mainly depends on (a) growth/employment
effects; and (b) fiscal redistribution
• Accelerated industrial shift for some countries
(esp. Asia) creating employment and skills;
commodity export model for others (esp LAC
and SSA), requiring fiscal redistribution
• But greater reliance on domestic investment
and saving would possibly favour Small & medium
Enterprises and thus asset redistribution worldwide?