World Financial Services Essay
“Gentlemen, I have had men watching you for a long time, and I am convinced that you have used the funds of the bank to speculate in the breadstuffs of the country. When you won, you divided the profits amongst you, and when you lost, you charged it to the bank. You tell me that if I take the deposits from the bank and annul its charter, I shall ruin ten thousand families. That may be true, gentlemen, but that is your sin! Should I let you go on, you will ruin fifty thousand families, and that would be my sin! You are a den of vipers and thieves.
I intend to rout you out, and by the eternal God, I will rout you out. ” (President Andrew Jackson 1832) (James Quinn Our Coming Depression, June 2008) The statement by President Andrew Jackson in 1832 just reflects that history has become present or we may agree that at present the bankers have gone one step ahead by presenting inflated profits, misguiding investors globally and bring the doom of financial world across the globe. If we look historically The Panic of 1907, Wall Street Crash of 1929 which led to Great Depression,
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Dot Com Bubble (2000), California Electricity Crisis(2001) created by Enron followed by Sub Prime Mortgage and Credit Crisis(2007-) at present the greed of bankers have been growing. They have stretched a common man’s money in investing in weapons of mass destruction i. e. derivatives as described by Warren Buffet that not only investment banks like Lehman Brothers, Morgan Stanely, Goldman Sachs, have become things of past, but also biggest insurance company globally- AIG, world biggest financial service Citi Group and several other banks and asset management company spread across globe have
drowned in this financial tsunami. Before going any further we have to understand how such a tsunami was created and the role of bankers and other financial institution in it. The Creation of Financial Crisis First Stage With the end of DotCom Bubble in USA a different and a bigger bubble started building up called the housing bubble. Speculative investments in housing property increased many folds and availability of housing loan in USA became the easiest thing on the earth. To avail a housing loan all a person would require is zero credit worthiness. Thus the term sub prime came into the picture.
The sub prime products were based on interest rate like- ? Adjustable-Rate Mortgage (ARMs) which was based on variable interest rate. ? Moratorium Interest where the buyer has to pay only interest. ? Negative Amortization loan (NegAm) which let the borrower pay a portion of the monthly payment irrespective of interest and the due amount would be added back to principal would increase the amount of the loan. The financial institutions were giving loans against the properties i. e. in case of default they would take back the property on which loan was given and as property rates were increasing the loan looked secured.
The sub prime loans accounted for 15% of the USA mortgage market in 2006vs 3% in 2002 (Source: Danske Bank. March 30, 2008). To compete with private lenders, Fannie Mae and Freddie Mac lowered lending standards and provided mortgage loan to sub prime borrowers. This fuelled an unprecedented bubble in property prices Second Stage Then at second stage came a theory of to lever the already leveraged market called securitization. In simple terms securitization is mixing of different financial products with different risk category and trying to generate more than market return with less risk.
Securitization of sub prime loans can be termed as cooking meal where spice was the sub prime loans which would add flavor to the food or make it non eatable. Securitization process started with Freddie Mac, Fannie Mae and 12 Federal Home Loan Banks pooled together mortgages and bundled them up into asset-backed securities (ABSs) and sold the securitized product to generate more capital for providing more home loans. The sub prime loans had different categories of risk which were also taken care by financial institutions.
The ABSs were pooled together to create Collateralized Debt Obligations (CDOs) and mix it with pension funds (the safest financial instrument across globe/across countries) and increase its credit rating. The credit rating are provided by rating agencies like Moody’s and S&P who rated such risky financial instruments as AAA – the safest rating for a financial instrument. As a result trillions of dollars of ASBs and CDOs were distributed through out the financial system. As the properties prices started to increase the numbers on the banks and financial institution showed huge profit and executives took a handsome incentives back home.
But the numbers did not reflect the actual scenario. There was no actual profit, as there were derivative and securitized instrument which are based on future cash flows the rise in their prices only reflected increase in mark to market prices which were transferred to books of financial institutes as actual profits. 3rd Stage The 3rd Stage of financial crisis was when the defaults of sub prime loan started to rise and the down turn effect started and it resulted in drop in housing prices as the equation between demand and supply got changed.
The banks which were considering their housing loan as secured loans, those loans became unsecured. The effect then passed on to investment banks, commercial banks, hedge funds and private equity who had borrowed money to invest in ABSs, CDOs and structured products related to it. The market for ABSs and CDOs dried up and companies found that their holdings of ABSs and CDOs were worth far less than what they had paid. The rise in devaluation of MBSs prices market called for Credit-default Swap (or CDS) which in simple terms is insurance on debt i. e.
banks buy CDS to protect against the company’s defaulting on its bond payments, In case of a default, the bank go to the insurer and cash in its CDS which took AIG down. And the financial tsunami across the globe started with commercial banks across USA and Europe got drowned in. (Jim Stanford -The Global Financial Crisis for Beginners, June 2008. ) In Europe the scenario was no different than USA. Europe’s largest bank was recapitalized by British government. The UK government injected capital in HBOS & LLyods TSB. Northern Rock and Bradford & Bingley – two of the UK’s largest mortgage lenders became involvement and were nationalized.
France and Belgium bailed out Fortis and Dexia. ( Effect of Inflated figures & High compensation to Executives. If we analyze the above said events we would conclude that banks were living in Disney land. The financial wizards flawed basic rules of lending and demand and supply law. Easy loans were pushed in housing market which made everyone buy a house irrespective of whether they could afford to pay the interest or not of the loan. The Negative Amortization was also introduced which results in that the loan which is already not affordable becomes bigger and more unaffordable.
Not only were private banks pushing the easy loans but also government bodies such as Fannie Mae and Freddie Mac whose mission was of promoting affordable homes and apartments ballooned the property prices. This resulted in increase in value of al the instruments related to it which were being sold numerous times in the market. The banks believed that as the housing prices rise there collateral value would rise and there would be no risk. Therefore there was no proper provisioning and marks to market gains were treated as actual gains.
As the defaulters list started to increase the demand and supply law came into effect. There were more properties available and less buyers resulting in fall in price of properties and instruments attached to it. The inflated figures by banks shown in 2000 started to deflate in 2006 onwards. The fall in property prices made the instruments fall much faster. A snapshot of market capitalization presented below would reflect the magnitude of inflated numbers presented by banks . (Bloomberg Oct 2008) The market capitalization is calculated on stock prices multiplied by volume of stocks.
Stock prices rise on the basis of profits which were inflated. The drastic change in market capitalization in one year reflects the inflated profits of bank. This clearly reflects that banks ALM and risk management practices were not in place. The banks were just doing number crunching by mark to market gains but it was not actual gains. The inflated numbers also reflect lack of provisioning from the banks side. Moment the stock exchanges got the hint of such a crisis the reduction in market capitalization of different banks shows the condition of financial statement of bank.
The other part of the deepening of such crisis is the executive pay packages provided by the banks. For example Lehman Brothers steered millions to departing executives even while pleading for a federal rescue. Richard S Fuld Jr, chief executive officer of Lehman Brothers took more than ? 172 million since 2000. To add on Bonuses totaling over ? 10million were paid to three departing Lehman Brothers executives just days before the investment bank collapsed. Lehman Brothers compensation spending rose 9. 5% to $9. 5 billion in 2007 and a bonus pool worth $2.
5 billion was set aside for 10,000 staff at Lehman Brothers New York office. $5. 7 billion worth of bonuses were paid in 2007 by Lehman Brothers, a year before it filed for the biggest bankruptcy in history. (David Gardener http://www. dailymail. co. uk/news/article-1070650/Disgraced-chief-failed-bank-Lehman-Brothers-pocketed-172million-collapse. html ,October 2008) Another example for the same point lies in Europe – Switzerland’s Bank -UBS. The former CEO of Switzerland’s biggest UBS, Marcel Ospel has received total payment of 70 million pound since 2000.
The bank is paying a total of SFr93. 6m in salary, deferred pay and consulting fees from 2007 to 2009 to its former chief executive, Peter Wuffli; Clive Standish, the former finance director; and Huw Jenkins, the ex-head of investment banking. (Sean Farrell http://www. independent. co. uk/news/business/news /ubs-executives-urged-to-pay-back-bonuses-995068. html, November 2008. ) Both the example shows the same story about sky high pay packages to the bank executives and it acting as a catalyst in current financial crisis.
The compensation to executives is made out of banks operating revenue and operating profit. As the operating profit where all inflated numbers i. e. virtual pay -in and the sky high actual pay out to executives of banks caused two defects in financial statements of bank. First of all the revenue side had imaginary numbers – no real gains only mark to market gains as the same kind of instruments were still with the bank but the compensation and high bonuses where being decided on these imaginary numbers which were actual very high pay out on the expenditure side.
The compensation increases as the imaginary profits increased bringing in more stress on the funds of the banks which were shrinking without the knowledge of bankers, investors and the government.. This kept on denting the financial statements of the bank from revenue as well as expenditure side and at the time of crisis the executives were rich and banks were defaulters. A resignation from executives released them from all their responsibilities and no question was asked about the rationalization of their investment strategies and mortgages.
In short an executive has got a high pay to destroy funds of a common man who did not understood the markets , financial instruments and was happy to invest is hard earned money in pension funds. Conclusion We can conclude from the above presentation that the current financial crisis happened due to chain of events. The base for the chain of events was originated from the inflated profits by banks.
The ballooning of property prices inflated the profits of bank and resulted in creation of complex financial instrument which were sold across globe again and again and when the balloon busted it brought every one down – the related and the unrelated one’s. The inflated figure made the banks looks look good and the banker’s compensation much better and heftier. At one end banks had lend or invested around 30 times its capital and other end heftier pay packages increase there expenditure side.
They believed credit creation would take care itself but failed to notice that to create credit one needs cash at the starting point. This reminds of the poem “Humpty Dump sat on a wall .. to have a great fall.. and all the king horses and men could not get Humpty Dumpty back again!! ” All we can hope that the lesson has been learnt but history shows that the learning gets unlearned very soon. Bibliography ? Paul Muolo and Mathew Padilla (2008)Chain of Blame ? Richard Bitner (2008) Confessions of a Subprime Lender ? David Gardener (8th October 2008), http://www.
dailymail. co. uk/news/article-1070650/Disgraced-chief-failed-bank-Lehman-Brothers-pocketed-172million-collapse. html ? Sean Farrell(6th November 2008), http://www. independent. co. uk/news/business/news /ubs-executives-urged-to-pay-back-bonuses-995068. html ? Jim Stanford (19th June 2008), The Global Financial Crisis for Beginners ? HSBC Global Research (2008), Global Economics Q4 ? James Quinn (27th June 2008), Our Coming Depression ? Shah Gilani (18th September 2008), The Real Reason for the Global Financial Crisis…the Story No One’s Talking About