Global Financial Crisis : an ongoing menace far from over
By: BongA (published: 12-29-2009)
A collapse of U.S. sub-prime mortgage market and the reversal of the real estate boom in other industrialized countries have had a domino effect throughout the world. The chaos could not have occurred when parties involved were socially responsible and out of greed. Conflicts of interest and the way CEOs are compensated at the center of this financial disaster has wiped out trillions of assets and millions have lost jobs and billions of dollars in market value evaporated. The financial crisis is far from over and has harmful effect and consequences for people around the world.
The losses were the result of unmanaged asset/liability gaps that led to interest rate exposures, speculative investments in junk bonds and service industries, fraud, and – most especially – massive losses from lending to and investing in the US commercial real estate sector. The trigger for the closing shut of this asset/liability trap was the shock rise in oil prices in 1979, pushing up inflation and headline interest rates around the world. By 1980, with interest rates on US government debt hitting 16%, many Savings & Loans had already been fatally wounded.
It is interesting to note that the financial crisis of 2008 did not suddenly appear in just a blink of an eye. Between 1986 and 1995 there was already a warning sign of financial uncertainties in the corporate world. United States of America’s Savings & Loan industry suffered a catastrophic financial setback, which transformed the scale of the disaster into a great threat to the U.S. financial system. The thrift crisis cost an extraordinary $ 153 billion – the most expensive financial sector crises the world has ever seen. Of this, U.S. taxpayers paid $ 124 billion, while paying the thrift industry itself 29 billion U.S. dollars.
The error prompted a revision of the legal framework for U.S. banks and savings institutions, a shake-up in the system of deposit insurance and implied government guarantees and a series of corruption scandals and legal battles waged in the courts. But the financial world ignores this warning. (R1)
A few Years later
A few years later came many large corporate scandals such as Enron Corporation. Enron was one of the world’s leading electricity, natural gas, pulp and paper, and communications companies, with claimed revenues of nearly $ 101 billion in 2000. The company was “America’s Most Innovative Company” for six consecutive years. The end of 2001 it was announced that their financial situation was substantially institutionalized through systematic and creatively planned accounting fraud. Enron has since become a popular symbol of willful corporate fraud and corruption. The scandal also put into question the accounts of many companies in the United States.
In 2002, another corporate scandal broke out resulting convictions in 2005 of the two highest corporate executives of Tyco International Ltd., a highly diversified global manufacturing company in Switzerland with operational headquarters in the USA. Tyco International is composed of five main business segments: ADT Worldwide Fire Protection Services, Safety Products, electricity and electrical and metal products. The two executives were accused of stealing more than 150 million U.S. dollars from the company and they argued that the corporation board of directors authorized it as compensation.
It was then followed by Adelphia Communications Corporation. The company filed bankruptcy that led to its founders John Rigas and son Timothy’s conviction of conspiracy, bank fraud and securities fraud for looting the cable company and deceived its investors. Adelphia was formerly America’s sixth-largest cable operator with nearly 6 million subscribers.
Another bankrupt corporation was the U.S. based Global Crossing Limited, a telecommunications company, which provides computer networking services worldwide and the first global communications provider with IPv6 natively in both their private and public backbone networks throughout the world. Next was the WorldCom, the United States second largest long distance company behind AT & T. It has a further $ 3.3 billion in accounting errors discovered.
Following the Asian Financial Crisis in 1997 and 1998, much of the “world’s hot money” began to flow into high technology stocks. Like the so called dot.com bubble, a different kind of financial crisis, which are driven by irrational spending on Internet stocks. It ended in the spring of Year 2000 as the value of equities in many high technology companies collapsed.
After the dot.com broke, more hot investment capital began to flow into the housing markets fueled the housing bubble in large part by the ready availability of fraudulent mortgages, hot investment capital began to flow into the housing markets not only in U.S. but to other countries of the world. And more and more large corporate accounting scandal around the world had risen.
All of these were the phenomenon that contributed to the 2008 Global Financial Crisis. (R-2)
What is Global Financial Crisis?
When viewed in a global scenario and taking into account the unsteadiness generated by unstable economy of the state or nation, it implicates that the financial crisis are far-reaching. The crisis, however, has by no means reached its peak, it goes down to a level where the reality indeed produced a near impact into the worlds’ economy.
The Center for Research on Globalization admits that “the Global Financial Crisis could possibly disrupt the very foundations of the international monetary system. The effect on people’s lives around the world are dramatic. The crisis is not limited to the meltdown of financial markets, the real economy at the national and international levels, its institutions and its productive structures are also in danger. As stock values collapse, lifelong household savings are eroded, not to mention the insurance and pension funds. The financial meltdown inevitably counterattack on consumer markets, the real estate or housing market, and more broadly on the process of investment in the production of goods and services.”
In general, market failed because of poor corporate governance and incompatible executive remuneration structures. Moreover, the lack of transparency in trading procedures, financial instruments, and balance sheet positions of major financial institutions also exacerbated market failures. In regulatory terms, most countries have weak distinctive rules pertaining to the operation of trading instruments and financial conglomerates or multinationals. Poor capital regulations and accounting rules contributed to excessive risk-taking by banks.
The world has entered a global recession that is causing widespread business contraction, increases in unemployment, and shrinking government revenues. Some of the largest and most venerable banks, investment houses, and insurance companies have either declared bankruptcy or have had to be rescued financially.
The shadows of 2008 Global Financial Crisis
This housing boom coincided with greater popularity of securitization of assets, particularly mortgage debt, into Collateralized Debt Obligations (CDOs). One problem that the mortgage originator was often mortgage-finance companies, whose main purpose was to provide mortgage with funds borrowed from banks and other financial institutions or write. They were originally charged for every mortgage, but had no responsibility for loans gone bad.
In order to cover the risk of defaults on mortgages, the holders of CDO’s purchased Credit Default Swaps (CDSs) and CDSs quickly became more of speculative assets than an insurance policy. Since these were technically not insurance, they did not fall under insurance regulations requiring sufficient capital to pay claims, although credit derivatives requiring collateral became more and more common in recent years. (R-3, R-4)
In 2007 the notional value (face value of underlying assets) of credit default swap (CDSs) had reached $62 trillion, more than the combined gross domestic product of the entire world. ($54 trillion).
By July of 2008, the surface value of CDSs had declined to $54.6 trillion and by October 2008 to an estimated $46.95 trillion. The system of CDSs generated large profits for the companies involved until the default rate, particularly in the subprime mortgages, and the number of bankruptcies began to rise. Soon the leverage that generated outsized profits began to generate outside losses, and in October 2008, the exposures became too great for companies such as AIG.
American International Group, Inc. (AIG) was founded in 1919 in Shanghai, China by Cornelius Vander Starr. Mr. Starr was the first westerner in Shanghai to sell insurance to the Chinese. The firm was successful and expanded its operations to other countries in Europe, Latin America, and the Middle East. In 1962 AIG gave control of the unsuccessful US operations to Maurice Greenberg who changed the company’s focus from personal insurance to high margin corporate coverage.
By 2005 AIG was the subject of a number of fraud investigations by the US Justice Department, the Securities and Exchange Commission, and the New York Attorney General’s office. The investigations resulted in the ousting of Mr. Greenberg, a $1.6 billion dollar fine, and several executives faced criminal charges.
Today, AIG has reportedly changed its plans for restructuring its insurance business and its strategy for paying back the $70 billion it still owes taxpayers.
The troubled insurer is no longer planning to spin off its property-casualty insurance business, recently renamed “Chartis,” through an initial public offering, according to Reuters. AIG had never fully committed to a Chartis IPO, but the troubled insurer put the possibility as a way to raise money to repay government loans. (R-5)
The origins of the financial crisis have three developments that have an increased risk in financial markets. The first was the origin-to-distribute model of mortgage. The second development is the increasing number of perverse incentives and the complexity of the rating agencies. The third development was the unclear boundaries between the issuers of credit default swaps (CDS) and the traditional insurers.
The Downward Slide
The plunge of the global financial crisis did not take long. It was triggered by the bursting of the housing bubble and the resulting subprime crisis in the United States, but also other conditions that contributed to the severity of the situation. Banks, investment firms and consumers take advantage large amount of debt. Some countries create major gaps in international trade and current accounts, especially in USA, while other countries have accumulated large reserves of foreign exchange by surpluses in these accounts. Investors provided ‘hot money’ on the world markets in search of higher returns.
A direct indicator of the speed and spread of the financial crisis has been in the stock market values. As values fell on the American market, which in other countries were swept down in the undertow. By mid-October 2008, the stock indices for the United States, Britain, Japan and Russia had fallen by almost half or more compared to their levels.
Many investors, who not too long ago had heeded financial advisors who were touting the long term returns from investing in the BRICs (Brazil, Russia, India and China), pulled their money out as fast as they had put it in.
Suddenly, the capital base of banks shrank and severely curtailed their ability to make more loans (counted as assets) and still remain within required capital-asset ratios. Insurance companies too found their capital reserves diminished right at the time they had to pay buyers of or post collateral for credit defaults swaps. (R-6)
Conglomerates suffered most:
Every major company/conglomerates/multinationals has been affected in some way or form when the downward slides of the global financial market. The companies that have had the greatest impact are the ones that do business primarily in the financial sector.
The ongoing global financial crisis is a concern for everyone in almost all industries – fear of job loss, foreclosed homes and bankrupt businesses. About 20% to 40% of the revenues of offshore outsourcing companies are tied to the financial services industry. With its collapse, companies have been forced to look to other vertical markets.
In 2008 Global Financial Crisis giant conglomerates in the United States declared bankruptcy to name a few like:
- Lehman Brothers Holdings Inc., a global financial services firm, the largest bankruptcy in the U.S. history holding over $600 billion in assets.
- Merrill Lynch provides capital markets services, investment banking and advisory services, wealth management, asset management, insurance, banking and related financial services worldwide.
- The Federal National Mortgage Association (FNMA) commonly known as Fannie Mae, is a U.S. government sponsored enterprise whose purpose is to purchase and securitize mortgages in order to ensure that funds are consistently available to the institutions that lend money to home buyer.
Given the relative complacency of markets, the federal reserve and other central banks during the period running up to the collapse of Lehman Brothers and even in the midst of the July 2008 crisis involving Fannie Mae and Freddie Mac, it is worth asking what lessons have been learned over the last year and, in particular, as a result of the wrenching dislocations following the collapse of Lehman Brothers.
John H. Makin, author of Three Lessons from the Financial Crisis (September 2009) emphasized that there are three lessons stand out in the present global financial crisis.
First, financial crises produce very powerful effects on the real economy. In a crisis, truly breathtaking dynamic and somewhat unpredictable causal connections, or nonlinearities, involving basic economic relationships come to light that policymakers need to appreciate more fully.
The second lesson is that central banks tend to be slow to react, partly because their models–which broadly exclude a financial sector–are based on linear relationships, not the nonlinearities that emerge after a financial crisis. However, an ancillary lesson is that while central banks may be slow to respond, they possess great power to contain a financial crisis, as witnessed by the experience during the six months following the chaotic market response to the collapse of Lehman Brothers.
Finally, a third lesson that needs to be taken seriously in the current environment is that China has become an even bigger player in the global economy and financial markets than most people have realized. China’s actions–not least the massive fiscal stimulus package announced in November that equals about 14 percent of GDP–can play a big role in helping to stabilize the global economy and financial markets. Of course China has the potential to destabilize as well, but the increasing integration of Chinese policymakers with G7 policymakers over the past year is an encouraging sign that China can, on balance, be a stabilizing force in the global economy. (R-7)
Countries affected most
Argentina, because of its shaky economic and financial position at the outset of the crisis, has been poorly positioned to deal with a protracted downturn compared to most other Latin American countries.
The Russian economy has been hit hard by the global economic crisis and resulting recession, the effects of which have apparent since the last quarter of 2008. Russia has been struggling to uplift the their economic condition when world oil prices tumbled sharply around the middle of 2008.
Iceland’s three largest banks LandsBanki, Glitnir Banki and Kauphting Bank collapsed and sharp depreciation in the exchange value of the Icelandic Krona prompted Iceland to suspend trading on its stock exchange for two days.
South Korea, Asia’s fourth largest economy, was deeply affected by the crisis, with both the South Korean stock market and the won tumbling throughout the months. On October 28, 2008 the won reached its lowest point since 1998.
Pakistan’s economy went into a steady decline in 2008. After several years of strong and comparatively stable growth. Pakistan quickly slid into a severe economic crisis in 2008.
Laos government admitted that six sectors of Laos’ economy, especially the foreign investment, export and tourism sectors, have been gravely affected by the global financial crisis.
The global financial crisis hit United Arab Emirates (UAE) real estate sector. Dubai World, the state-owned holding company whose bail-out plans triggered the current crisis. And many many more. (R-8)
The role of G20 in the Global Financial Crisis
The Group of Twenty Finance Ministers and Central Bank Governors (known as the G-20 and also the G20 or Group of Twenty) is a group of finance ministers and central bank governors from 20 economies: 19 countries, plus the European Union (EU). The G20 has a critical role to play in ensuring global financial and economic stability.
The bloc comprises the European Union, the United States, Britain, France, Germany, Italy, China, Russia, Japan, India, South Korea, Indonesia, Turkey, Saudi Arabia, South Africa, Canada, Australia, Argentina, Brazil and Mexico.
The role of the G-20 in dealing with the global financial crisis began on November 15, 2008, with the G-20 summit on Financial Markets and the World Economy that was held in Washington DC.
The Group of 20 (G20) industrialized and emerging economies agreed that joint action and greater controls were necessary to tackle the international financial crisis and a joint and coordinated action, greater regulation of financial markets and total agreement on policies are required to regain financial stability. They also include other actions like fiscal incentives to enterprises and more international cooperation to identify and rapidly respond to signs of national and international crisis.
The G-20 countries are addressing a number of issues related to correcting abuses in the financial markets particularly those involving non-bank financial institutions and complex financial instruments. Analysts and policy makers generally agree that the lack of regulation of new non-bank financial institutions, such as hedge funds and private equity firms, and the lack of transparency of new complex financial instruments, such as derivatives, were key factors in the current financial crisis.
Nearly all industrialized countries and many emerging and developing nations have announced economic stimulus and/or financial sector rescue packages, such as the American Recovery and Reinvestment Act of 2009 (P.L. 111-5). Several countries have resorted to borrowing from the International Monetary Fund as a last resort. The crisis has exposed fundamental weaknesses in financial systems worldwide, demonstrated how interconnected and interdependent economies are today, and has posed vexing policy dilemmas.
The process for coping with the crisis by countries across the globe has been manifest in four basic phases. The first has been intervention to contain the contagion and restore confidence in the system. This has required extraordinary measures both in scope, cost, and extent of government reach. The second has been coping with the secondary effects of the crisis, particularly the global recession and flight of capital from countries in emerging markets and elsewhere that have been affected by the crisis. The third phase of this process is to make changes in the financial system to reduce risk and prevent future crises. In order to give these proposals political backing, world leaders have called for international meetings to address changes in policy, regulations, oversight, and enforcement.
On April 2, 2009, heads of the G-20 nations met in the Leaders’ London Summit and announced measures to bolster international financial institutions, stabilize the world economy, and reform and improve the financial regulatory system.
Yet the global financial crisis is still an ongoing menace far from over.
R-1 : The cost of the Savings and Loan Crisis by: Timothy Curry and Lyn Shibut
R-2 : Notable Accounting Scandal taken from Wikipedia
R-3: Journal, “Containing Financial Crisis” By: Mark Jickling, U.S. Joint Economic Committee
R-4: Credit Default Swaps, Frequently Ask Questions FAQ (http://digital.library.unt.edu/govdocs/crs/permalink/meta-crs-10780:1 )
R-5: AIG Bailout and its meaning
R-6: Risk “Global Financial Crisis: Analysis and Policy Implications by: Dick Nanto (Page 34,35 & 36)
R-7 John H. Makin, author of Three Lessons from the Financial Crisis (September 2009) (http://www.aei.org/outlook/100067 )
R-8 The Global Financial Crisis: Analysis and Policy Implications (http://www.acrobatplanet.com/non-fictions-ebook/ebook-global-financial-crisis-analysis-and-policy-implications.html)