Stock market and economic meltdown
K Abeywickrama
The globe is facing an economic tsunami with
the heavy credit crunch. Even the multi-millionaire companies hardly can
entertain hopes of any bailout.
Up until 2001, loans given out by financial institutions were
generally secured against loss by bank guarantees. Bank guarantees are
comparatively expensive and have stricter security requirements.
After that date, these institutions were allowed to insure the
transactions with insurance companies, a much cheaper avenue as
insurance premiums are less expensive. Hence the massive involvement of
AIG and the two major quasi-government housing loan guarantors, Freddie
Mac and Fanny Mae, who were helping to propel the house market in the
USA. Loans given out in this market, whether housing or car loans or
credit card debt, are not retained by the lender. Within days, the loans
are repackaged and sold as Credit Deposit Swaps (CDS) to other financial
institutions who in turn sell it to others, creating a chain of CDS
holders around the world.
The total value of US sub-prime housing mortgages which were at
around US$ 500 billion in 2005 rose to US$ 3.0 trillion by 2008. The
national value of the chain of CDSs set off by this amounted to US$ 64
trillion, a staggering sum that exceeds the GDP of the whole world which
stands at US$ 56 trillion.
Business risks
CDSs are a form of unregulated derivatives. Inordinate business risks
can be taken today because these can be leveraged through the use of
derivatives. Derivatives are used for all manner of speculative business
decisions involving future scenarios that can range from the price of
commodities in the commodity exchanges, stocks, currency exchange rates,
interest rates, inflation levels or even the weather conditions.
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Will economic meltdown burst out? |
Basically there are three categories of derivatives: futures, options
and swaps. Credit derivatives derived from loans, bonds and other credit
issues are swaps. While most futures and options are traded through
formal Trade Exchanges which act as trading houses and are subject to
some regulation, swaps are over-the-counter derivatives that are
privately negotiated and unregulated.
The Bank of International Settlements in Basle, Switzerland, that is
the window for arranging settlement of these transactions, estimates
that the national value of the total derivatives market is now over $
700 trillion of which about 8 per cent are swaps.
The operation of derivatives is not easily understood by the
uninitiated as the Sri Lanka petroleum Corporation has learnt the hard,
brutal way. The world’s richest man and perhaps the biggest
philanthropist today, Warren Buffet, wrote to the shareholders of his
immensely successful company, Berkshire Hathaway, in 2002 as follows:
“We try to be alert to any sort of mega-catastrophe risk, and that
posture may make us unduly appreciative about the burgeoning quantities
of long-term derivatives contracts and the massive amount of
uncollateralised receivables that are growing alongside. In our view,
however, derivatives are financial instruments of mass destruction,
carrying dangers that, while latent, are potentially lethal.”
The high price of de-regulation
The reader may wonder why there should be risks if the housing loans
were secured against real estate. The problem was that the increased
demand for housing in the USA accused by easy credit resulted in a giant
escalation of house prices and corresponding loans.
House prices that usually rose annually by 2-3 per cent increased by
50-100 per cent within a few years. Since houses are the main asset held
by many US households, increasing housing values had encouraged people
to take additional secondary or even tertiary mortgages on their houses
and indulge in more extravagant spending.
When millions of sub-prime mortgage borrowers began defaulting in
large numbers, lenders began restricting credit and even calling upon
borrowers to double their monthly payments to make up for losses created
by defaulting borrowers. Housing prices declined sharply and the value
of the collateral then fell below the value of the loans. The sheer
volume of losses in such a short time, amounting to around $ 3.0
trillion, set in motion a train of defaulting CDSs around the financial
world. These had now become toxic assets.
Financial institutions
Again we may ask why financial institutions worldwide bought these
CDSs based on high risk sub-prime mortgages, hoping to make a long-term
profit. The answer is that risk assessment agencies in the USA like
Moody’s and Standard & Poor classified these junk bonds as Triple A
securities, giving assurance to institutions around the world looking
for good investments. The financial world implicitly trusted these
agencies to tell them the truth and were cheated and lost their
investments. The Chinese and Japanese economists and bankers have
described this as ‘the financial tsunami unleashed by the USA on the
whole world’.
The housing bubble accompanied a stock market bubble in Wall Street.
Speculative trading in stocks was the fashion with day traders and short
sellers for several decades. |
