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Environment Policy
A Perspective Report
GENESIS
What began as a bursting of the U.S. housing market bubble and a rise in
foreclosures has ballooned into a global financial and economic crisis. Some of
the largest and most venerable banks, investment houses, and insurance
companies have either declared bankruptcy or have had to be rescued
financially. In October 2008, credit flows froze, lender confidence dropped, and
one after another, the economies of countries around the world dipped toward
recession. The crisis exposed fundamental weaknesses in financial systems
worldwide, and despite coordinated easing of monetary policy by governments,
trillions of dollars in intervention by central banks and governments, and large
fiscal stimulus packages, the crisis seems far from over.
2001 Global
15 China
Recession Financial
Crisis
10
0
U.S.
Japan
Germ any
-5 S. Korea
Mexico
Brazil
U.K.
-10
United States Mexico Germany United Kingdom Russia
China Japan South Korea Brazil
-15
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Year (4th quarter)
Source: Congressional Research Service. Data and forecasts (August 15) by Global Insight.
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GLOBAL FINANCIAL CRISIS - USA NOT RESPONSIBLE
The global crisis now seems to be played out on two levels. The first is
among the industrialized nations of the world where most of the losses
from subprime mortgage debt, excessive leveraging of investments, and
inadequate capital backing credit default swaps (insurance against defaults and
bankruptcy) have occurred. The second level of the crisis is among
emerging market and other economies who may be “innocent bystanders”
to the crisis but who also may have less resilient economic systems that can
often be whipsawed by actions in global markets. Most industrialized countries
(except for Iceland) have been able to finance their own rescue packages by
borrowing domestically and in international capital markets, but many emerging
market and developing economies have insufficient sources of capital and have
turned to help from the International Monetary Fund (IMF), World Bank, or from
capital surplus nations, such as Japan, and the European Union.
The first of these was a belief that modern capital markets had become so much
more advanced than their predecessors that banks would always be able to
trade debt securities. This encouraged banks to keep lowering lending standards,
since they assumed they could sell the risk on. “Abundant market liquidity
led some firms to overestimate the market’s capacity to absorb risk,”
says the Institute of International Finance, a Washington-based lobby group, in a
recent report. “The same buoyant environment resulted in market pressure for
high returns ... and high levels of competition among financial firms.”
Second, many investors assumed that the credit rating agencies offered an easy
and cost-effective compass with which to navigate this ever more complex world.
Thus many continued to purchase complex securities through out the first half of
2007 – even though most investors barely understood these products.
But third, and perhaps most crucially, there was a widespread assumption that
the process of “slicing and dicing” debt had made the financial system more
stable. Policymakers thought that because the pain of any potential credit
defaults was spread among millions of investors, rather than concentrated in
particular banks, it would be much easier for the system to absorb shocks than in
the past. “People had looked at what had happened to the Japanese banks and
said, ‘this simply cannot happen here’, because the banks were no longer
holding all the credit risk,” one senior European policymaker recalls.
The present financial crisis afflicting the global economy should not be
seen from the narrow focus of the credit crunch and its relationship to the
subprime mortgage crisis in the Western countries, especially the US. The crisis
goes to the very foundations of the global capitalist system and it should be
analysed from that angle. What is at the core of the crisis is the over-extension
of credit on a narrow material production base. This is in a situation in which
money has become increasingly detached from its material base of a money
commodity that can measure its value such as gold.
The expansion of the world economy from 1945 onwards was based on the US
providing some kind of link between money and the gold standard, which the US
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tried to maintain until its collapse in the 1970s. Increasingly the dollar became
the global currency but without a backing to its currency from a money
commodity. The over-expansion of credit that has taken place since then,
especially with the globalisation of the world economy, has meant that a lot of
paper money and monetary instruments in the form of derivatives and ‘future
options’ have lost any relationship to the ‘fundamentals’ in the material
production of the world economy.
That is why there has been a growing outcry that the growth of ‘speculative
capital’ has over-run the growth of ‘productive capital’ with large amounts of
money and credit circulating without the backing of any production at all. That is
also why the relationship between the ‘fundamentals’ in the economy and the
new credit instruments created on a daily basis in many cases from speculative
‘short-selling’ have become narrower and narrower over time. This is also why
the present financial crisis is also a reflection of the energy and food crisis,
because oil and food products such as wheat, rice and other commodities have
been subjected to speculative trading to back up paper money many years in the
future
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The value of U.S. subprime mortgages was estimated at $1.3 trillion as of March
2007. Subprime loans can offer an
opportunity for borrowers with a less-than- Subprime lending (near-prime, non-prime,
or second-chance lending) in finance means
ideal credit record to become a home making loans that are in the riskiest category
owner. The standards for determining risk of consumer loans. The term subprime refers
to the credit quality of particular borrowers,
categories refer to the size of the loan,
who have weakened credit histories and a
"traditional" or "nontraditional" structure of greater risk of loan default than prime
the loan, borrower credit rating, ratio of borrowers.
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As financial assets became more and more complex, and harder and harder to
value, investors were reassured by the fact that both the international bond
rating agencies and bank regulators, who came to rely on them, accepted as
valid some complex mathematical models which theoretically showed the
risks were much smaller than they actually proved to be in practice.
"The super-boom got out of hand when the new products became so
complicated that the authorities could no longer calculate the risks and
started relying on the risk management methods of the banks
themselves. Similarly, the rating agencies relied on the information provided by
the originators of synthetic products. It was a shocking abdication of
responsibility."
1. GREED
Housing boom coincided with greater popularity of the securitization of assets,
particularly mortgage debt (including subprime mortgages), into collateralized debt
obligations (CDOs). A problem was that the mortgage originators often were
mortgage finance companies whose main purpose was to write mortgages using
funds provided by banks and other financial institutions or borrowed. They were
paid, for each mortgage originated, but had no responsibility for loans
gone bad. Of course, the incentive for them was to maximize the number
of loans concluded. This coincided with political pressures to enable more
Americans to buy homes, although it appears that Fannie Mae and Freddie Mac
were not directly complicit in the loosening of lending standards and the rise of
sub-prime mortgages.
The sellers of the CDSs that protected against defaults often covered their risk
by turning around and buying CDSs that paid in case of default. As the risk of
defaults rose, the cost of the CDS protection rose. Investors, therefore, could
arbitrage between the lower and higher risk CDSs and generate large income
streams with what was perceived to be minimal risk. In 2007, the notional value
(face value of underlying assets) of credit default swaps had reached $62 trillion,
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more than the combined gross domestic product of the entire world ($54 trillion),
although the actual amount at risk was only a fraction of that amount
(approximately 3.5%). By July 2008, the notional 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 on subprime mortgages, and the number of
bankruptcies began to rise. Soon the leverage that generated outsized
profits began to generate outsized losses, and in October 2008, the
exposures became too great for companies such as AIG.
2. Risk
The origins of the financial crisis point toward three developments that increased
risk in financial markets. The first was the originate-to-distribute model for
mortgages. The originator of mortgages passed them on to the provider of funds
or to a bundler who then securitized them and sold the collateralized debt
obligation to investors. This recycled funds back to the mortgage market and
made mortgages more available. However, the originator was not penalized, for
example, for not ensuring that the borrower was actually qualified for the loan,
and the buyer of the securitized debt had little detailed information about the
underlying quality of the loans. Investors depended heavily on ratings by credit
agencies. The second development was a rise of perverse incentives and
complexity for credit rating agencies. Credit rating firms received fees to rate
securities based on information provided by the issuing firm using their models
for determining risk. Credit raters, however, had little experience with credit
default swaps at the “systemic failure” tail of the probability distribution. The
models seemed to work under normal economic conditions but had not been
tested in crisis conditions. Credit rating agencies also may have advised clients
on how to structure securities in order to receive higher ratings. In addition, the
large fees offered to credit rating firms for providing credit ratings were difficult
for them to refuse in spite of doubts they might have had about the underlying
quality of the securities. The perception existed that if one credit rating agency
did not do it, another would. The third development was the blurring of lines
between issuers of credit default swaps and traditional insurers. In essence,
financial entities were writing a type of insurance contract without regard for
insurance regulations and requirements for capital adequacy (hence, the use of
the term “credit default swaps” instead of “credit default insurance”). Much risk
was hedged rather than backed by sufficient capital to pay claims in case
of default. Under a systemic crisis, hedges also may fail. However, although the
CDS market was largely unregulated by government, more than 850
institutions in 56 countries that deal in derivatives and swaps belong to the
ISDA (International Swaps and Derivatives Association).
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and risky assets. This meant that disruptions in credit markets would make
them subject to rapid deleveraging, selling their long-term assets at depressed
prices. He described the significance of these entities: "In early 2007, asset-
backed commercial paper conduits, in structured investment vehicles, in auction-
rate preferred securities, tender option bonds and variable rate demand notes,
had a combined asset size of roughly $2.2 trillion. Assets financed overnight in
tri-party repo grew to $2.5 trillion. Assets held in hedge funds grew to roughly
$1.8 trillion. The combined balance sheets of the then five major investment
banks totalled $4 trillion. In comparison, the total assets of the top five bank
holding companies in the United States at that point were just over $6 trillion,
and total assets of the entire banking system were about $10 trillion." He stated
that the "combined effect of these factors was a financial system vulnerable to
self-reinforcing asset price and credit cycles."
Nobel laureate Paul Krugman described the run on the shadow banking
system as the "core of what happened" to cause the crisis.
"As the shadow banking system expanded to rival or even surpass conventional
banking in importance, politicians and government officials should have realized
that they were re-creating the kind of financial vulnerability that made the Great
Depression possible—and they should have responded by extending regulations
and the financial safety net to cover these new institutions. Influential figures
should have proclaimed a simple rule: anything that does what a bank does,
anything that has to be rescued in crises the way banks are, should be regulated
like a bank."
Economist Paul Krugman and U.S. Treasury Secretary Timothy Geithner explain
the credit crisis via the implosion of the shadow banking system, which had
grown to nearly equal the importance of the traditional commercial banking
sector as described above. Without the ability to obtain investor funds in
exchange for most types of mortgage-backed securities or asset-backed
commercial paper, investment banks and other entities in the shadow banking
system could not provide funds to mortgage firms and other corporations.
This meant that nearly one-third of the U.S. lending mechanism was frozen and
continued to be frozen into June 2009. According to the Brookings Institution, the
traditional banking system does not have the capital to close this gap as of June
2009: "It would take a number of years of strong profits to generate sufficient
capital to support that additional lending volume." The authors also indicate that
some forms of securitization are "likely to vanish forever, having been an artifact
of excessively loose credit conditions." While traditional banks have raised their
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lending standards, it was the collapse of the shadow banking system that is the
primary cause of the reduction in funds available for borrowing.
Additional downward pressure on interest rates was created by the USA's high
and rising current account (trade) deficit, which peaked along with the housing
bubble in 2006. Ben Bernanke explained how trade deficits required the U.S. to
borrow money from abroad, which bid up bond prices and lowered interest rates.
Bernanke explained that between 1996 and 2004, the USA current account
deficit increased by $650 billion, from 1.5% to 5.8% of GDP. Financing
these deficits required the USA to borrow large sums from abroad,
much of it from countries running trade surpluses, mainly the emerging
economies in Asia and oil-exporting nations. The balance of payments
identity requires that a country (such as the USA) running a current account
deficit also have a capital account (investment) surplus of the same amount.
Hence large and growing amounts of foreign funds (capital) flowed into the USA
to finance its imports. This created demand for various types of financial assets,
raising the prices of those assets while lowering interest rates. Foreign investors
had these funds to lend, either because they had very high personal savings
rates (as high as 40% in China), or because of high oil prices. Bernanke referred
to this as a "saving glut. A "flood" of funds (capital or liquidity) reached
the USA financial markets. Foreign governments supplied funds by
purchasing USA Treasury bonds and thus avoided much of the direct impact of
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the crisis. USA households, on the other hand, used funds borrowed from
foreigners to finance consumption or to bid up the prices of housing and financial
assets. Financial institutions invested foreign funds in mortgage-backed
securities.
%
spending too much and
borrowing too much for
years and the rest of the
world depended on the U.S.
consumer as a source of
6.0
global demand." With a
recession in the U.S. and the
increased savings rate of U.S. consumers, declines in growth elsewhere have
been dramatic. For the first quarter of 2009, the annualized rate of decline in
GDP was 14.4% in Germany, 15.2% in Japan, 7.4% in the UK, 18% in Latvia, 9.8%
in the Euro area and 21.5% for Mexico.
The fact of the matter is that the U.S. needs a weak dollar to generate export-led
Current
growth and to re-orient its economy away from rampant personal consumption.
With the U.S. consumer saving more and spending less, dollar weakness has
4.0
never come at a better time to America, boosting exports and the foreign
earnings of U.S. multinationals. Washington policy makers know this and are not
about to fiddle with success.
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Hence, the “strong dollar” mantra of the Obama administration does not carry
much weight. It has become a phrase with little currency.
The economies of the world have failed in their task of Risk Assessment &
mitigation by not diversifying their assets allocation like investing in
alternate asset classes eg Gold which would have de-risked their portfolio
which then would have withstood the financial tsunami like GLOBAL
FINANCIAL CRISIS.
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United States still has the largest Reserves of GOLD by far, countries like
China have blindly stashed their monies in instruments like US treasury
bonds. Had the Chinese Govt been less than willing to invest in US Bonds
then the US housing bubble would not have grown that big resulting in the
meltdown that followed the crisis.
All this futuristic thought clearly indicates the fact that the world economic
system and not the USA alone was responsible for the lack of financial stability
leading to collapse.
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NANJING, China — The head of the European Central Bank said that a revaluation
of the Yuan currency would be "appropriate" after talks with China's Premier
Wen Jiabao. "We discussed the exchange rate policy, the de facto peg of the
Yuan," Jean-Claude Trichet told reporters at a briefing after talks between EU
officials and Wen in the eastern city of Nanjing.
He said officials encouraged Beijing to take "a more flexible policy," adding "it
seems it would be appropriate."
The Chinese currency has been effectively pegged to the dollar since the
summer of 2008, and Europe fears the euro's rise against the Yuan will hurt EU
exports to China and eventually slow the continent's economic recovery.
But Beijing, which faces complaints from both the United States and Europe that
it is manipulating its currency to gain an unfair trade edge, says it wants to take
its time and reform its exchange rate system.
Once again the USA appears to be the victim rather than the reason for financial
crisis and its mitigation as China is influencing the World economy.
CONCLUSION
The United States of America cannot be held responsible for the Global
Financial Crisis and that too solely. As the term “Global” conveys; the
crisis was a global one rather than being only American, albeit the
crisis started from the American shores. The firms that went down like
Lehman brothers, Goldman Sachs, Merrill lynch, Bear Stearns etc might be
US registered but were Multinationals, they employed countless nationals
of all countries, even the shareholding of these corporations was spread
the world over.
Principally, Greed was the major factor behind the crisis whereby
all norms of financial propriety were laid by the way side in
pursuit of insatiable thirst for profit globally.
One thing this crisis has made amply clear is that the balance of
economic power has shifted from the Atlantic Ocean to the Asia-
pacific region.
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