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WEF 2009: Managing a global crisis
Shafey Danish
The world economic forum 2008 was held amidst considerable economic distress. ‘Subprime’ had turned into a horror word to frighten bankers and finance
ministers with, and the bourses were frequently described in terms (bloodbath, carnage) that are more appropriate for the battlefield.
But if you thought that was bad, then you need to look at the current situation. Nearly 80,000 jobs were lost on a single day on January 27. US is losing
nearly 16,000 jobs per day. Banks, like the Bank of America and Nomura which had served in rescue acts put together by the Fed, are reporting huge losses
themselves.
So if WEF 2008 felt the heat, 2009 finds itself in the inferno.
The edifice of financial capitalism is holding out, for now. But it has received shocks that have placed a question mark on its long term survival. Consider
the statistics: The Eurozone, the US, New Zealand, Singapore, Hong Kong, Ireland and Japan are already in recession. Canada and UK will join them soon.
Global trade, which fell 50%, is poised to contract for the first time in decades. The World Bank has cut its global growth forecast to a mere 0.9% for
2009.
Unemployment in US is above 6% and analysts predict it would go up to 8% by 2009. There are job cuts across the sector, not just in US but in other countries
too. China which had posted double digit growth for years is slowing down, it is predicted that GDP growth may fall below the comfort zone of 8%. Germany’s
economy is expected to contract by 2.7% in 2009.
Dipak Dasgupta, Chief Economist to the World Bank, while speaking at a seminar said that the effects of the drastic fall in world trade is yet to be felt,
and it would darken the already dark picture of meltdown
All of it, of course, had its genesis in the sub prime crisis of 2007, but soon ballooned into a crisis of confidence in financial markets.
Subprime crisis
In 2006, Nobel laureate Paul Krugman wrote that “Nowadays, we make money by two means- by borrowing from China, and by selling houses to each other.”
He was pointing to the bubble that was fast building up in the housing market, which, he said, the Fed, under Alan Greenspan, had created to replace the
Internet bubble that had burst earlier. Americans did really want houses, but in there were others, who saw a quick way to make money on the back of this
demand. They bought houses as investment, confident that they would be able to sell them at a higher price later.
This continued until house prices had become irrationally high. People were buying houses at exorbitant prices on the belief that they would be able to sell
them off. Banks were lending money to those with bad credit records, to those whose incomes were insufficient to pay off the housing loans on the same
belief. These borrowers were ‘subprime’ borrowers. That is, borrowers not qualified for the loans that they were getting.
Next, the banks themselves sold off the debt to other financial institutions after splitting them into small pieces and combining them with slivers of other
financial products. This was supposed to mitigate risks by spreading them around.
The secondary agencies that brought these ‘packages’ further slashed them into small slices and combined them with their other offerings to make new
packages, creating a financial instrument of extreme complexity. Nobody really knew how to evaluate the risks on these products.
These bonds were then insured in the derivatives market. For example, if an agency has a bond which will give it $10 mn at the end of 10 years, it would
insure it with another agency which would pay the entire $10 in case the bond does not deliver, in exchange of a certain share of its annual return. This was
the derivatives market.
On the other hand the public that had taken loans to buy houses (a certain section anyhow), mortgaged them for immediate money. The mortgages were split and
sold by primary agencies in the manner explained above.
So when house prices started their fall, all of the above bonds went bad. The losses were so widely spread that no one knew who really had how much of
debt.
The banks which held the mortgages of these houses could not recover their money even by foreclosing. The type of spiral that had caused the prices to rise
abnormally, now acted downwards. People anxious to recover as much of their investment as possible in a falling house market started panic selling, leading
to a glut of houses in the market, which further pushed down prices.
This sudden collapse in the housing market had wide ranging effects.
Bank failures
Investment banks today are highly leveraged players. For every dollar of actual capital they posses, they borrow up to $30, to $60 dollars. Any big loss
therefore has the potential of wiping out their entire capital base.
It is a risky business. They are insulated in part because of the liquidity in money markets. If they do face losses they could borrow to quickly meet their
obligations and pay off from future profits.
In the wake of the Subprime crisis, banks which had had exposure to the products related to the housing market, faced huge losses.
The market on the other hand was spooked because it did not really know which firm had had how much exposure. If they lent to, say to company A, and it had
these toxic bonds, then it may face a big enough loss to render it unable to payback.
This fear froze the markets all together. No lending was taking place. Liquidity had completely dried up. Banks were also not lending to businesses outside
the financial sector to keep funds in hand to meet emergencies.
In September 2008, Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation), two US government backed
mortgage lenders were placed in conservatorship by the FHFA. The decision was backed by the Secretary of Treasury, Henry Paulson, and Federal Reserve
Chairman Ben Bernanke.
A week later, on September 14 the US financial system was shaken to it very foundation by bankruptcy filing by the Lehman Brothers, one of the big 5 Wall
Street banks. The same day the Merrill Lynch another Wall Street giant was sold off to the Bank of America to avoid bankruptcy. Reports indicated that
Lehman’s collapse was precipitated by JP Morgan Chase which froze the bank’s assets well before it filed for bankruptcy.
A third company, American International Group (AIG), the largest US insurer, suffered a liquidity crisis two days later, and appeared tottering on the brink
of a collapse. The collapse of Lehman had already destabilized the markets.
It was felt that the collapse of AIG could seriously harm the market, the government gave emergency funding amounting to $85 billion to the company in
exchange for a 79.9% stake in the company. Though AIG was saved it was left bruised and battered. Of the big 5 firms on Wall Street only two were left
standing after the crisis. JP Morgan and Goldman Sachs. Goldman Sachs one of the most venerable financial institutions in the world, which only a few years
ago was giving out bonuses to the tune of hundreds of thousands, and millions in some cases, recorded a 53% fall in profit mid 2008. In December the firm
recorded its first quarterly loss since it went public in 1999, around $2.29 bn in the 4th quarter 2008.
Screaming headlines around the globe dubbed it the worst week in the history of Wall Street. Analysts predicted that the era of swashbuckling investment
banking had ended.
More than 500,000 jobs were lost in the US in November alone. In mid September, when the extent of the financial crisis was just becoming apparent, job
losses in the financial sector already stood at 110,000 (computed for 2008). JP Morgan Chase itself announced a cut of 9,200 jobs in December.
Others went so far as to see the mayhem on Wall Street, as the beginning of the end of US’ economic dominance.
The Fed on its part kept aggressively lowering its lending rate; it was to reach near zero by mid December. The Federal Reserve also poured in $105 billion
into the markets on September 18th to stave off an immediate market collapse.
For better or worse (we are still to know the answer) the US government had embarked on an aggressive interventionist policy to prevent financial meltdown,
when it decided to lend to AIG.
The financial crisis was not limited to the US. On October 16, the Swiss government announced a rescue plan for the Swiss banks UBS and Credit
Suisse.
Three days later, the government of the Netherlands rescued ING from imminent collapse with a €10 billion package. Germany’s BayernLB too decided to apply
for funds from the German €500 billion rescue program.
After the forced nationalization of Northern Rock, the UK government decided to inject GBP37 billion in the nation’s three largest banks, Royal Bank of
Scotland (RBS), Lloyds and HBOS. The government would own majority stake in RBS and 40% stake in the other two banks.
France also announced a €10.5 billion rescue plan for six of its largest banks, including Crédit Agricole, BNP and Société Générale
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