Here's a new explanation of the financial crisis

Jun 11, 2015

- By Vivek Kaul

Vivek Kaul
History when it is initially being written is essentially work in process. And given that it always makes sense to keep in touch with new explanations and reasons that are offered for events that have happened.

A standard explanation for the global financial crisis in the Western economic circles is that the developing countries saved too much. The savings rate in the developing world soared from 23 percent of the GDP in 1999 to 33 percent by 2007.

These excess savings caused the global interest rates to fall during that period. By 2006, long-term interest rates in all developed economies and the major developing economies were in single digits. With long-term interest rates falling, people bought homes and thus pushed up home prices through most of the developed world. Japan, Germany, and Switzerland were the only exceptions. Home prices in the United States rose at the same rate as the global average.

In fact, as is the case in all bubbles, people felt that housing prices would keep going up in the years to come. A survey of home buyers carried out in Los Angeles in 2005, found that the prevailing belief was that prices would keep growing at the rate of 22 percent every year over the next 10 years. This meant that a house, which cost a million dollars in 2005, would cost around $7.3 million by 2015. Such was the belief in the bubble.

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Ben Bernanke called this phenomenon the "global savings glut," in a speech he made in March 2005, when he was a Governor of the Federal Reserve. As he said: "In particular, during the past few years, the key asset-price effects of the global saving glut appear to have occurred in the market for residential investment, as low mortgage rates have supported record levels of home construction and strong gains in housing prices." Bernanke was the Chairman of the Federal Reserve of United States, the American central bank, between 2006 and 2014.

As Barry Eichengreen writes in his new book Hall of Mirrors-Th Great Depression, The Great Recession, And the Uses-And Misuses-Of History: "In the run-up to the crisis, American officials like Governor Bernanke...pointed to a single factor, namely the net flow of capital from the "savings glut countries" of Asia and the Middle East."

The excess savings in Asia and the Middle East found their way into financial securities in the Western markets. A portion of this "excess" flow of money got invested into financial securities issued by governments of Western countries.

With all this money chasing government securities, the returns on offer on government securities were low. These low returns acted as a benchmark for other loans like home loans. Hence, interest on home loans was also low and this encouraged people to buy and speculate in homes, as EMIs were low.

Once the real estate bubble started to fizzle out the financial crisis started. This eventually led to the failure of some big American and European financial institutions, finally leading to the governments coming to their rescue.

This is the story that we have been told up until now. But as it turns out, there might be much more to the entire issue. As Eichengreen writes: "There was no net capital inflow between the United States and Europe. Trade between the two regions was broadly balanced. But there was an immense flow of European funds into the US mortgage-backed securities and their derivatives, matched by an equal and offsetting flow of bank lending from the United States to Europe."

As Eichengreen further explains: "The result was the bizarre situation in which European banks borrowed dollars from US financial institutions in order to buy derivative securities issued...by those same US financial institutions. This was vendor finance with a vengeance."

So what was happening here? Banks and financial institutions pooled together similar kinds of loans, such as home loans or mortgages. Against these loans, they sold bonds to investors. These bonds are referred to as mortgage-backed securities. These bonds paid a rate of interest, which was slightly lower than the interest that the borrower was paying on the home loan.

By selling bonds, the banks and financial institutions got back the money they had loaned out immediately, unlike earlier, when the money was stuck for the period of the loan. This money could be used to give out more loans. When the borrower of the loan repaid it through an EMI, the banks passed on a major portion of this to the investors who had bought the bonds.

The difference between what the borrower paid as interest and what the bond investor got as interest was money the bank made. It also got a commission on selling the mortgaged-backed securities.

The interesting bit here is that the American bank or financial institution giving out the home loan, was also financing the European investors who bought the mortgaged-backed securities issued against the home loans.

Since the loans no longer remained on the bank’s books, it wasn’t interested in checking out the repayment capacity of the borrower any more. In fact, the more loans the bank gave out, the more bonds it could securitize, and hence, the more money it could make.

Gradually, banks started giving out loans to even those who had poor credit ratings. This section of the loans came to be referred to as subprime loans. A prime loan was a loan that a bank gave to its best customers. Investors bought bonds securitized against the subprime loans because rating agencies offered the best AAA-ratings to these bonds.

Once American borrowers started defaulting on their home loans, the European investors who had bought these bonds also got into trouble. And this how a part of the financial crisis from the United States spread to Europe. Europeans also had their own part of the financial crisis to deal with.

To conclude, as Eichengreen writes: "It was this "banking glut" and not Mr Bernanke's "savings glut," and its implications for the housing market...that mattered what followed." And this is clearly something worth knowing about.

Vivek Kaul is the Editor of the Diary and The Vivek Kaul Letter. Vivek is a writer who has worked at senior positions with the Daily News and Analysis (DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. The latest book in the trilogy Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System was published in March 2015. The books were bestsellers on Amazon. His writing has also appeared in The Times of India, The Hindu, The Hindu Business Line, Business World, Business Today, India Today, Business Standard, Forbes India, Deccan Chronicle, The Asian Age, Mutual Fund Insight, Wealth Insight, Swarajya, Bangalore Mirror among others.

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3 Responses to "Here's a new explanation of the financial crisis"

SJ

Jun 24, 2015

There is a tradition in western developed countries to blame third world countries for their own fallacies. The cause of financial crisis in the west is not excessive savings in developing countries, but rather their own greed. However, they are very adept in marketing, whether it is junk bonds, financial instruments or some wierd theory on the reasons of their failure! It is up to the developing world to realize these traps and not to fall into them.

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Rajesh Sutaria

Jun 12, 2015

Interesting, but this situation occured because $ is the reserve currency & US is to blame for crisis because they abolished the gold standard for their currency

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Sai N

Jun 11, 2015

Dear Mr Kaul,

I am surprised that the explanation you have given was not known to many people. This is the ONLY explanation in reality. Let me give you a brief background. I used to work for a large trade processing and risk management firm at the time of the crisis (I don't want to name names here - will be perfectly happy to do so in private). The company was responsible, at the time, for a large number of MBS securities flowing through its innards on behalf of its various clients. The risk management part was very interesting. Many of the mortgage lenders that went bankrupt at the time used the services of the firm where I worked. We got to look very closely at the quality of the securities held by them. Some of them were daily clients. others were monthly clients. Essentially they would give us their holdings at the end of each period and before the next period began, they would have the risk reports. At the time (around 2007/early 2008), I distinctly remember us valuing many of their holdings at almost 30 cents to the dollar. i.e. we believed that the million dollar MBS in their portfolio was actually only worth about 300,000. They could not understand how we could value them so low, when they could find a buyer for 98 or 99 cents on the dollar! So they were already onto the 'greater fool' leg of bubble mania. Once our analytical reps showed them why, they would hate us. We would get fired as their risk reporters. A few months later we would hear of their spectacular failure. This happened more times than I want to remember. As a result of the flameouts, I got laid off too.

These sub prime mortgages are the worst kind of poison that could be developed, with a coating of amrut. Many of the NPAs on the books of Indian banks are these kinds of poisons. Than God securitisation hasn't taken off in India. Because if it had, the NPAs would have long since been packaged off - in search of the 'greater fool'!

Apologies if I have been too obtuse in my email.

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