The 2007-2008 financial crisis- causes,consequences and implications
„Structured Finance and the 2007-2008 Financial Crisis -
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leverage was pro-cyclical among financial institutions.148 Furthermore when balance
sheets were highly leveraged, minimum capital adequacy requirements (Basel II) and
maximum leverage conditions (hair cuts on repurchase agreements)
149 tended to
exacerbate the deleveraging process. An example of the deleveraging effect prevalent
among investment banks through hair cuts on repurchase agreements is discussed in
appendix figure 3. This condition of the minimum capital adequacy requirements (Basel
II) and maximum leverage conditions (hair cuts on repurchase agreements) exemplifies
the actions of Northern Rock‟s creditors.
As depicted in Figure 58, Northern Rock had a steadily increasing leverage ratio, with
ratios surging from 22.8% in 1998 to 58.2% in 2007. Furthermore they possessed long
term securitized notes financed through short term debt. Consequent to the turmoil short
term funding dried up and the long term securitized notes turned illiquid.
90
Northern Rock's Leverage
80
70
60
Leverage on common equity
50
40
30
20
10
0
Jun 98 Dez 98
Jun 99 Dez 99
Jun 00
Dez 00 Jun 01
Dez 01 Jun 02
Dez 02
Figure 58: Northern Rock‟s leverage
(Northern Rock)
Jun 03 Dez 03
Jun 04 Dez 04
Jun 05 Dez 05
Jun 06 Dez 06
Jun 07 Dez 07
Thus Northern Rock was a victim to deleveraging actions of their creditors within the
financial system exacerbated by pro-cyclicality. The following example should help to
further clarify the deleveraging actions by Northern Rock‟s creditors (refer to: Figure 59)
Bank 1 is the creditor to Northern Rock,
Bank 2 is Northern Rock
Figure 59: Northern Rock vs. Their creditors
(Northern Rock case study)
148
(Shin, Reflections on Modern Bank Runs:A Case Study of Northern Rock, 2008)
149
Many investment banks engaged in short term repurchase agreements for their financing purposes. The
maximum leverage conditions are controlled through haircuts on repurchase agreement, imposed by
financial regulators
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Northern Rock borrows from their creditors and alternatively the creditors undergo credit
losses on their loans, consequent to turbulent economic conditions. However Northern
Rock‟s creditworthiness remains unchanged. The loss undergone by Northern Rock‟s
creditors must be met with a reduction in the size of their exposure. For the shrinking of
the balance sheet size of the creditors, lending to Northern Rock is cut. Northern Rock is
encountered with withdrawal in funding and needs to find an alternative source of lending
to facilitate this loss. In a disturbed environment finding alternative funding is not easy
and thus Northern Rock has to either curb lending or sell off its assets.
As such, there were three occurring incidents that are evident:
1. The creditor‟s withdrawal of lending was severe
2. Northern Rock did not have access to alternative sources of funding and
3. The assets held by Northern Rock were illiquid and could only be sold at fire sale rates.
In summary; the cut in exposures by Northern Rock‟s creditors was the predominant
grounding behind their crash.150
5.2.4 Summary
In summary Northern Rock‟s creditors were subject to external restraints and need to react
accordingly which may not adhere to the typical principal agent affiliation with the bank.
Northern Rock‟s previous success paved the way for their downfall. The soft credit
prevalent on a global sphere contributed towards the growth in Northern Rocks balance
sheets. Leverage grew with the increase in the propensity of total assets, however when
the economic cycle alternated the maturity mismatch inherent within Northern Rock‟s
balance sheet contributed as a predominant feature to their downfall. The Northern Rock
case opened doors and illustrates economic rationale behind the mismatch of balance
sheets and the profound role of pro-cyclicality prevalent during the financial crisis of
2007-2008. Furthermore the traditional view of regulation is challenged, and the market
based bank model tends to misallocate the externalities inherent within the financial
system. The role of the regulators was also subdued and they did not act accordingly to
diminish the propensity of the externalities. In conclusion, the curtailment of exposures by
the creditors of Northern Rock resulted in the failure.
150
(Shin, Reflections on Modern Bank Runs:A Case Study of Northern Rock, 2008, p.13-p.17)
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6 A POST-CRISIS OUTLOOK AND POLICY IMPLICATIONS
Chapter 6 concludes with policy implications that need to be adhered to in order to avoid a
recurrence of pro-cyclicality and unintentional consequences within the financial
spectrum. Over the recent years, the conversion of the financial system into a heavily
market oriented system coupled with regulatory stringencies (Basel accords and mark to
market accounting regulations) have proliferated pro-cyclicality throughout the system. In
a modern financial system (market based) pro-cyclicality is foreseeable and thus countercyclical
elements need to be integrated into the system to reduce damaging effects,
without deteriorating the fundamental motives of the regulations. The following section
recommends three remedies for regulators in the areas of monetary policy, fair value
accounting and capital adequacy requirements, in order to combat the excesses of Procyclical
behavior.
6.1 Pro-active Monetary Policy
Bubbles and busts in the financial system dictate stability, which have disproportionate
affects on asset prices. Furthermore if the severity of the bubbles causes dislocation in the
system, the normal behavior of monetary policy will be affected. Thus central banks need
to take a more holistic approach towards their decisions. The tools that are used to control
monetary policy should introduce as a component, where the progressions of asset prices
are integrated into the process, as a remedy to absorb financial shocks. This will foster the
market dynamics and reduce the pro-cyclical tendencies in financial markets. The actions
taken by the central banks and warnings of upcoming asset price bubbles should be openly
communicated among the rest of the financial sphere. Thus unwanted speculation that
results in the spurring of asset bubbles will be contained. 151
However, analysts argue that the role of political organizations and bureaucratic
institutions should not be trusted anymore. The majority of economists involved within
these institutions were erroneous in their proposals and predictions in respects of the
severity of the crunch. Many economists lacked the institutional knowledge which
involved the complexities of the structured finance product lines. 152
The implementation of a body where the experts consist of different fields of expertise
such as financial theorists, micro- and macro- economists, accountants and (most
importantly) practitioners has been subject to aggressive debate.153 This body collectively
151
(Walter, 2009)
152
(Shiller, J, 2008)
153
(Soros, G. 2008)
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will exploit the theoretical assumptions in markets and predict the resilience of their
implications. However, it is argued that these experts should not discuss solutions in a
group. Moreover this method should take the form of individual reports dispersed among
the financial system to facilitate individualism among financial participants and less
reliance on decisions and opinions from bureaucratic institutions.
A compromise of the two approaches would be a prudent remedy. If pro-active
methodologies are introduced into monetary policy and a body of experts work
independently of political organizations and bureaucratic institutions, it would enable less
probability for misjudgement and deficient warnings. This approach should facilitate a
greater degree of security among the financial spectrum and most importantly the
opportunity for each market participant to perform their own due diligence. 154
6.2 Fair Value Accounting: Current Value Measurement Method
Assets “held for trading” purposes were mark to market under fair value accounting
(illustrated in the previous chapter), holding assets for the intention to trade, incorporate
risks, thus these risks should be illustrated in earnings and valued at the market. However
assets “held for sale” were also treated at mark to market under fair value accounting.
Assets “held for sale” should not be treated under the fair value accounting approach, even
if there is a given market for these assets, the author proposes that the disclosure of
holding assets for sale needs reconsideration.
The main counterparty associated with assets held for sale is the investor. A means of
valuation that shows the investor all sufficient information that is needed by valuing these
assets through a discounted cash flow method using a prudent discount rate is more
valuable than the assets being valued at the market rate. The frequency of change
incorporated with cash flow valuations is less significant than with mark to market
valuations. Moreover the propagation of asset bubbles will be subdued with the cash flow
approach relative to the mark to market valuation method.
Financial institutions tend to manipulate their accounts by holding assets under „held to
maturity‟ (at amortised cost) with motives to either increase their earnings or reduce their
losses. Thus further regulation was implemented under FAS 115 to prevent such
154
(Sibert, 2009)
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manipulative actions. Nevertheless this regulation was relatively stringent and triggered
false interpretations. The disasters that occurred during the financial crisis of 2007-2008
have proven that preventing asset bubbles in the financial system need to be considered
with greater priority rather than averting manipulation. The concept of manipulation could
be combated by institutions disclosing (in the footnotes of their financial statements) the
reason and the effect of the transfer of financial instruments among the three categories. 155
The International Accounting Standards Board (IASB) and the Financial Accounting
Standards Boards (FASB) sat together on the 5th and 6
th of May, 2009 and collaboratively
discussed the implementation of the current value measurement method for financial
institutions (the concept is however still under discussion)
156. This approach bases its
calculation on the present value of expected future cash flows of financial assets and
liabilities. The cash flows that are embedded in the instrument are analyzed and a value
based on the prepayment and the collection of the cash flows with the counterparty, rather
than be based on an exchange price. However it is an important aspect to note that fair
value accounting should not be replaced; the valuation of certain instrument that are
subject to negative biases associated with fair value accounting could use this alternative
method to ascertain more accurate valuation results.
Two methods can be used, the present value method or the expected cash flow method.
The first method uses the traditional discount rate adjusted method where the discount rate
can be adjusted during the course of the assets life. The second method is the expected
cash flow method where probability weighted cash flows discounted at the risk free rate is
used to determine the present value of financial instruments (refer to appendix figure 6).
Both methods integrate the amount and timing of the cash flows. This can be done by
adjusting the discount rate in the first method and altering the probabilities and the future
cash flows in the latter method. The volatility and the vibes in financial markets have
proven that an alternative form of measurement was well overdue to overcome the procyclicality
and the formation of asset bubbles. This method not only grants investors
information on the timing, amount and uncertainty of future cash flows, but it has
overcome the exit notion found in fair value accounting. Under the exit notion the cash
155
(Wallison, 2008; p.7 )
156
(IASB, 2009; P.2)
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flow estimates will be derived through a market participant‟s assumption of liabilities.157
The „exit notion‟ correlated with fair value accounting tends to report a certain value in the
balance sheet which reflects the market condition associated with the asset at the present
moment in time. Nevertheless the value of the asset beyond the time period of the negative
environment is not captured. This was evident among many firms during the 2007-2008
financial crisis, financial institutions were valued based on short term horizons and thus in
many occasion forced to write down exposures even though their long term motives
looked promising. The current value measurement method overcomes the disadvantages
associated with the exit notion and moreover conquering the limitations concerning the
valuation of instruments at amortized cost. The main shortcoming of valuing assets at
amortized costs is that changes in valuations are not reported in the financial statement,
only impairment of the assets are represented in the statements and thus impairment loan
loss reserve guidance is usually required. The current value measurement method
considers the changes in value as well as the cash flows of the financial instrument and
thus overcomes the shortcomings associated with valuing assets at amortised cost.
Short calculations of the two methods are presented in appendix figure 6.158
6.3 An Alternative Approach to the Market Based Basel II Models
The upcoming section illustrates a remedy for Basel II. Integrating capital adequate
requirements that are correlated with the changes in banks lending as well as the changes
in different asset prices in applicable sectors, will foster motives to encourage the build-up
of reserves during an upturn and release adequate reserves during a downturn.
Furthermore the implementation of liquidity regulations which pose restrictions on the
composition of assets rather than mere quantitative restrictions will enable greater balance
sheet matches within the financial sector.
6.3.1 Less Reliance on Risk Sensitive Market Based Models
The bank for international settlements (BIS) observed the under pricing of risks and
during many occasions and warned that a turnaround of the business cycle was evident.
Even though regulatory authorities were warned on the shortcomings, countercyclical
instruments were in short supply. The market based models (as discussed above) and
157
(Ernst & young 2009, p.2)
158
(IASB, 2009; P.2)
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approaches adopted by regulators have largely based their defence strategies on market
prices.
The question is hence obvious why- if market prices act prudently towards preventing
crashes, they are still evident?
Risk sensitive models used by regulators that are strongly founded on market prices,
signalize to banks that risk- are low during booms and that adequate capital reserves
prevail to increase the propensity of risk taking. Alternatively during downturns risk
taking becomes subdued and capital reserves signalize that economic activity should be
curbed. Thus market prices are not the solution upon which regulators should base their
decisions. Capital adequate requirements should be correlated with the changes in banks
lending as well as the changes in different asset prices in applicable sectors. (e.g. changes
in house prices and mortgage lending should be correlated to ascertain capital adequacy
requirements for mortgage lending and property lending should be related with price
increases in commercial property sectors).
The purpose of this implementation is to encourage the build-up of reserves during an
economic upturn and release adequate reserves during an economic downturn. This move
does not intend to terminate the economic cycle, but rather acts as a forward thinking
remedy to avoid the reoccurrence of previous mistakes. The minimum capital adequacy
requirement of 8% is rather high; thus the risk sensitivity should be aligned according to
the asset prices in the relevant sector together with the bank‟s lending propensity.
Furthermore the loan to value ratios need to be determined on a risk weighting system for
residential and commercial mortgages to prevent the propagation of real estate bubbles.159
If the loan to value ratios were integrated under Basel II with a time varying maximum
limit, the growth in the mortgage industry would have been distributed globally, rather
than being concentrated in the US.
Finally, by these countercyclical measures into the Basel II accord, in time the pressure at
central banks to act as the only body to regulate monetary policy during distressed
economic conditions would be reduced. This will then enable the responsibilities among
159
(Soros, 2009)
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the financial spectrum to be proliferated among regulators which in turn will avoid
concentration of decision making by a few institutional individuals. 160
6.3.2 The Imposition of a Liquidity Regulation
The implementation of liquidity regulations which pose restrictions on the composition of
assets rather than mere quantitative restrictions needs to be executed. Stringencies on the
magnitude of the total assets relativity to equity will enable firms to combat liquidity
restraints and foster a greater balance sheet mismatch during turbulent times (the
mismatch of balance sheets was underpinned by the Northern Rock scenario which
resulted in solvency problems). In a depressed environment, a bank has the eligibility to
survive given the possession of liquid assets and cash or stable liabilities (long term debt).
The mismatch of balance sheets widely evident among financial institutions during the
2007-2008 financial crises can be contained with the implementation of liquidity
regulations which pose restrictions on the composition of assets rather than mere
quantitative restrictions. 161
In summary, counter-cyclical measurement techniques need to be integrated into the
financial system to avoid asset bubbles during lucrative economic conditions and hider
severe crunches during deteriorating economic situations. Firstly, monetary tools that
absorbs the progression of asset bubbles and a body of experts who work independently of
political organizations and bureaucratic institutions need to be established. Secondly, the
fair value accounting valuation method should additionally integrate a component where
the calculation is based on the present value of the expected future cash flows. The cash
flows that are embedded in the instrument are analyzed on a value based relative to the
prepayment and the collection of the cash flows with the counterparty, rather than be
based on an exchange price. Finally an alternation to the Basel II needs to be integrated.
Capital adequate requirements should be correlated with the changes in banks lending as
well as the changes in different asset prices in applicable sectors rather than be overly
reliant on market prices. Moreover the implementation of liquidity regulations that poses
restrictions on the composition of assets needs to additionally be considered rather than
mere quantitative restrictions on the magnitude of the total assets to equity. The
countercyclical mechanisms prevalent within the financial system need to be prudently
implemented without distorting the objectives of already existing regulations.
160
(Goodhart & Persaud, 2008)
161
(Shin, 2008, p.20)
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CONCLUSION
This study‟s aim was to reveal and clarify the catalysts that transformed the sub-prime
crisis of 2007 into a global crunch. Thus, an analysis was conducted via three avenues of
dissection, the instruments involved, the parties concerned and the channels exacerbating
the crunch.
Research by the author revealed the immense complexity associated with financial
systems, the cause of the dereliction of information and transparency, which climaxed in
the financial crisis. The valuation and ratings concerning structured products, together
with the immense losses that have been evident in the subprime sector are fundamental to
this statement.
Based on the author‟s findings the second stage of the “originate to distribute” model,
namely re-securitization instruments (predominantly ABS CDOs) contributed as the most
venomous catalyst, which can be held responsible for this catastrophic outcome.
Furthermore CDSs, who protected these re-securitized exposures, also played a vital role
in the exacerbation of the write downs.
Many players were involved in the channels that propagated the crisis. The mortgage
brokers were undaunted by the credit quality of their loans. Borrowers took advantage of
the soft macro-economic environment in the United States and acquired loans they were
not able to repay while lenders carelessly underwrote counterparties in the subprime
sector. Even financial experts were preoccupied exploiting the loop holes within the
system by creating complex high yielding structured finance instruments, while investors
trusted the rating agencies and neglected to perform their own due diligence.
Even though additional counterparties contributed directly and indirectly to the
propagation of this financial turmoil, the author gravitates on three main counterparties:
namely the rating agencies, banks and financial regulators.
The author revealed that amongst the three participants involved, the financial regulators
and supervisory institutions were a critical interceptive throughout the entire financial
system. On many occasions they failed to adhere to their tasks and often enshrined
reversed motives. The regulators themselves encouraged the securitization process and
off-balance sheet transfers. Taking the example of the daunting success inherent within the
“originate to distribute” banking model, the regulatory authorities assumed that
securitisation enables the diversification of risks among a multitude of investors
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throughout the global financial system and thus chances would be rare that these
exposures would fail to pay off. The Basel II minimum capital adequacy requisite for
mortgage backed securities (MBS) underpins this statement. MBSs required the minimal
(8%) capital adequacy requirement for investing in such exposures. Hence the heavy
reliance of the regulators on risk weighting models, determined by market forces
underpinned this outcome. This in turn, inflicted false perceptions among the rest of the
financial system and illustrated the vulnerability inherent within the role of the regulators
in the propagation of the crisis.
Using the metaphor of the house “built of hay” in Chapter Four, the failure of the
financial system became evident. As illustrated in the example the house was built on
muddy ground lacking a firm foundation, symbolising the dependency of regulators and
supervisory institutions towards the achievement of a firm base within the financial
system. The foundation was the core ingredient that was required to keep the house
standing in the event of a catastrophe. Similarly, adequate policies and supervisory
institutions need to foster methodologies to dampen the proliferation of bubbles during
booms, and store adequate reserve capacity to overcome a bust. The supervisory
institutions during this turmoil were flawed, and failed to fulfil these prerequisites.
Pro-cyclicality is clearly evident during the 2007-2008 financial crises. It has contributed
as a prime feature in the exacerbation of business cycles and increased the severity of the
crunch. A bubble is often followed by a bust and the pro-cyclicality associated with fair
value accounting and Basel II is an unintended consequence. However, it is foreseen and
considered as failure in human perceptions. The lack of adequate counter-cyclical
mechanisms, which forced the deleveraging process, was a prime element in the
proliferation of the crunch.
The Northern Rock Case Study reveals the primary reason of the insolvency being the
curbed lending activity by Northern Rock‟s creditors induced by pro-cyclicality. Thus,
exacerbated through Basel II, Northern Rock‟s lenders engaged in excessive curbing of
their lending exposures to Northern Rock, which was a primary cause behind their run.
Looking to the future to mitigate a similar crisis, pro-active methodologies need to be
introduced into monetary policy, where a body of experts works independently of political
organizations and bureaucratic institutions. This should leave less probability for
misjudgement and deficient warnings and facilitates a greater degree of security among
the financial spectrum and most importantly the opportunity for each market participant to
perform their own due diligence.
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