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JainNit Its Role and Impact in the Global


Financial Crisis - 2008
Nitin.B.Jain 1011142 5 BBM B Finance 1

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Assignment due date : 25-06-2012 Word count : 2831

TOXIC ASSETS

TOXIC ASSETS Its Role and Impact in the Global Financial Crisis 2008

INTRODUCTION In September 2008, the bankruptcy of the US investment bank Lehman Brothers and the collapse of the worlds largest insurance company AIG triggered a global financial crisis. The result was a global recession which caused the world tens of trillions of dollars, rendered 30 million people unemployed and doubled the national debt of the United States. This crisis was not an accident. It was caused by an out of control industry. Since the 1980s, the rise of the US financial sector led the formation of a new crisis. Each crisis caused more damage than the other but the industry made more and more money. THE BEGINNING After the Great Depression of 1929, the US financial sector was tightly regulated and laws were enacted separating investment banks from commercial banks and they were prohibited from speculating on the savings of the depositors. Investment banks were small in size as only the owners (partners) put their own money and watched it carefully as it was their own but not borrowed. In the 1980s the financial sector exploded with investment banks like Morgan Stanley, Bears Stanley and others went public, borrowing valuable public money as capital. This led to investment bankers getting rich with an increase in their pay compared to other sectors. In 1982, the US government deregulated the savings and loan companies allowing them to make risky investments with the depositors money leading to the bankruptcy of hundreds of such companies which lead to a enormous loss of public money including the life savings of many. Total loss of taxpayers money 124 million USD. By the 1990s the sector had consolidated and had grown so large that their failure could threaten the whole world. In 1999 the CitiCorp and Travellers merged to form the Citi Group which became the largest financial services company in the world. The
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merger violated the Glass-Steagall Act of 1933 which separated the commercial banks from investment banks but the Federal Reserve gave them an exemption for a year and by then a law was passed called the Gramm-Leach-Bliley Act, 1999 clearing way for future mergers. Here one would think why should we have large banks? I think the answer would be that banks love the power and control they have over governments, companies and the industry. It also provides them valuable lobbying power. The next prime mover was the speculation in the dot com stocks in the late 1990s which crashed in the year 2000 2001 leading to a loss of over 5 trillion USD. Accusations went wild that the investment banks promoted those internet firms which they knew would fail and their stock suggestions in public were totally contradictory to those they would have made in private. All those stocks which were highly rated in 1999 were rejected as junk and piece of crap by the same rating agencies in 2000. In December 2002, ten investment banks including the Bear Stearns, Morgan Stanley, Deutsche Bank, Credit Suisse, Lehman Brothers, Citi Group and the rest were fined a total of 1.4 billion USD after which they promised that they would stop these malpractices and fraudulent activities of misleading the innocent investors. Since the deregulation of the 1980s, the worlds largest financial firms have been caught laundering money, defrauding customers and faking their books of accounts multiple times. This also included bribing government officials, laundering money for nuclear projects of Iran in violations of US sanctions and siphoning tax violators money to the UBS for which they were fined a multiple times and had settlement deals with the regulators. In spite of these firms committing such unprecedented crimes they do not directly admit to any of these. Starting from the 1990s deregulation led to the formation of another new and complex creation called Derivatives. These securities made the markets even more unstable as this made the bankers to bet on virtually anything and everything from the rise and fall of oil prices to the weather and the bankruptcy of a firm. To top it all there was no regulation on this USD 50 trillion business. Although there was an attempt to regulate this market in 1998 by the Commodity Future Trading Commission but the Clinton administration slammed it down led by Treasury
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Secretary Larry Summers (who later made USD 20 million in a hedge fund which heavily relied on derivatives) and the other Investment Bankers in Wall Street. In 2000, the Commodities Futures Modernization Act was passed which banned the regulation of derivatives leading to a rallying in innovation of new securities based on derivatives. By 2001 end, the sector was much more profitable and powerful than it ever was. And it was dominated by 5 main investment banks, viz., Goldman Sachs, Morgan Stanley, Lehman Brothers, Merrill Lynch and the Bear Stearns; 2 financial groups, i.e., Citi Group and JP Morgan; 3 insurance companies, namely, AIG, MBIA, AMBAC; and 3 rating agencies, that is, S&P, Moodys and Fitch. SECURITIZATION FOOD CHAIN The birth of toxic assets Toxic assets is a popular term which was coined in the late 2000s during the financial crisis representing those financial assets whose value has fallen significantly and these assets do not have a functioning market wherein they cannot be sold at a price which is satisfactory to the seller. When a product has a buyer and a seller who agree to a mutually satisfying price for the product, it is said that the market clears. It means that the demand and supply of the product is as such that there exists equilibrium in the price of the product which is reached in a free market open from outside interference (regulation). But during the financial crisis of 2007 2009 this did not happen, which was referred to as breaking down of the market. So how did these toxic assets come into the picture and how were they created? Home buyers Lenders Investment banks Investors

Earlier when a home buyer would borrow money he would be expected to pay the mortgage amount back to the lender wherein the money is the own fund of the lender. And since this repayment would decades to complete the lenders were extremely cautious of lending their money. In the new system the lenders sold their mortgages to the investment banks wherein these banks would convert thousands of these loans combining them with other loans
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like commercial mortgages, student loans, car loans, credit card debt, etc. and created complex derivatives called Collateralized Debt Obligations (CDOs). These were then sold to the investors and now when the home buyer pays the mortgages, the money would go to the investors all over the world. The investment banks paid the rating agencies to evaluate these CDOs and many of them were given a AAA rating which is the highest investment grade given to securities which led to become popular among retirement funds which only purchase highly rated securities. This was a big deathtrap for the investors. The lenders now didnt check the repayment capacity of the borrower nor did the investment banks care as the more CDOs they sell, the more profit they make. Furthermore the rating agencies that were paid for this had no liability if their ratings fail. This led to quadrupling of the mortgages between 2000 and 2004. These high risk mortgages loans that were lent were called the Subprime loans and when thousands of such loans were combined leading to the creation of the CDOs which were in high risk of default. They were still rated AAA by the rating agencies. In spite of being such high risk loans, they were preferred by the investment firms due to the very fact that they carried high interest rates. This led to lending money to those borrowers who could not repay them and there was no practice of any background checking due to predatory lending. THE PROGRESSION Suddenly billions of dollars were flowing through this chain and this led to a massive increase in home purchases and housing prices skyrocketed. The overall U.S. homeownership rate increased from 64 percent in 1994 (about where it was since 1980) to a peak in 2004 with an all- time high of 69.2 percent. According to section 121 (U.S.A.), capital gains on housing is excluded on the sale of houses and property for one time for amounts up to USD 500,000 available once every two years. This made housing the only investment which escaped capital gains. These tax laws encouraged people to buy expensive, fully mortgaged homes, as well as invest in second homes and investment properties, as opposed to investing in stocks, bonds, or other assets.

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Between 1986 and 2007 the home prices nearly doubled. And the subprime lending increased from about USD 30 Billion a year to about USD 600 Billion a year. This lead to a formation of a bubble leading to enormous hikes in pays and huge bonuses for the banking sector employees. Lehman Brothers was a top underwriter for subprime lending and the CEO was taking a salary of USD 485 million a year. The Securities and Exchange Commission conducted no enquiry of the investment firms during the bubble. During the bubble, the investment banks were borrowing heavily to create more CDOs. The leverage ratio between the borrowed money and the banks own money was 3:1 in 2002 which was steadily increased to finance these CDOs and by 2007 the leverage ratio had reached levels of 33:1 which was highly dangerous. On the other hand AIG, the worlds largest insurance firm was selling new derivatives called Credit Default Swaps (CDS). For investors who owned CDOs , CDS were like an insurance policy were they paid AIG a quarterly premium. So when the CDOs went bad AIG promised to pay them for their losses. But even here speculators could buy these CDS in order to bet against the CDOs they didnt own. This implied that anybody could insure anybody elses property without actually owning it. But since the CDS market was unregulated, AIG didnt have to create any reserve therefore when it received the premiums; AIG paid it as bonuses to its employees. But if the CDOs go bad AIG would have to pay both the investors and the speculators. Slowly but steadily these CDOs were toxic, that is to say the home buyers defaulted in the repayments of their mortgages leading to a bad CDO which would have no value. Goldman Sachs sold over USD 3.1 billion in the first half of 2006. Henry Paulson, CEO of Goldman Sachs, the highest paid CEO was appointed as the Treasury Secretary soon after. In his last months as CEO, he sold a large amount of these toxic CDOs. Soon after, in 2007, Goldman Sachs not only sold these CDOs but started actively betting against these CDOs on their turning toxic. This meant that it betting against those securities which it was publicly suggesting the investors to buy. So Goldman started purchasing CDS from AIG to the tune of USD 22 billion to bet against the CDOs and when they would default, Goldman would make money out of it. Also they realized that AIG might collapse due to this and so they insured themselves
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against AIGs potential collapse. Later they started purchasing only those CDOs which their customers lost making more money themselves. A similar activity was going on in Morgan Stanley as well. The three rating agencies S&P, Moodys and Fitch made billions of dollars by giving high ratings to these subprime junk securities. Almost all these firms quadrupled their profits between 2000 and 2007 by this activity. This lead to mushrooming of AAA rated securities by just a handful in 2000 to over 4000 in 2007. THE RECESSION the toxic assets release their poisons In 2008 the housing bubble had burst leading to drastic falls in the stock market and the shooting up of home foreclosures. By 2009, the securitization food chain had imploded due to the same reasons and home loan lenders could no longer sell them to the investment banks and as the loans went bad, dozens of lenders failed. The markets for CDOs had collapsed leading to investment banks holding hundreds of billions of dollars in loans, CDOs and real estate (toxic assets) which they could no longer sell. In March 2008, the investment bank, Bear Stearns ran out of cash and was acquired by JP Morgan Chase for 2 dollars a share and the deal was guaranteed by the Federal Reserve with USD 30 billion. This happened when most of its securities were rated between AAA to A2 which are all high investment grades. In September 2008, Fannie Mae and the Freddie Mac, two giant mortgage lenders were taken over on the brink of collapse during a period when they were rated an astounding AAA. Soon after Lehman Brothers announced a record loss of USD 3.2 billion and its stock collapsed from over 20 dollars a share to less than 50 cents. Its securities too were rated A2 days before its collapse. AIG was rated AA a couple of days before being bailed out. Now comes AIG, during all this hungama going around in the US financial market, AIG had to pay over USD 12 billion which it owed towards the owners CDSs and it did not have any money. Soon after, AIG had to be taken over by the government because had AIG failed all planes would have to be stopped from flying. This benefited Goldman Sachs as it had received USD 61 billion in lieu of the CDS it had purchased. Eventually the AIG bailout caused taxpayers USD 150 billion. Bernanke, member of the Federal Reserve asked for USD 700 billion to bailout the banks as the alternative would be a complete breakdown of the US financial sector.
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But this does not arrest the globally plummeting stock markets. Unemployment levels in the USA and the EU rise to over 10%. And the recession spreads globally leading to layoffs and foreclosures. By the end of 2008, two mega firms, General Motors and Chrysler are facing bankruptcy. As US consumers cut back on spending Chinese manufacturers see a massive drop in sales leading to over 10 million job losses in China. Singapore which was buoyantly growing at about 20% p.a. was suddenly in red at -9%. Exports were hit by about 30% a quarter. THE AFTERMATH As these toxic assets that is, CBOs, Subprime loans, Real estate properties were held in large volumes by the large US banks, they started losing value. This resulted in investors losing confidence on the banks and the banks had no money to lend anymore. This was called the Credit Crisis. By 2008, it was clear that the big banks, those considered "too big to fail" had balance sheets full of mortgage-backed securities that were worthless because homeowners were not paying their mortgage payments and banks had foreclosed on their homes. Consumers and businesses couldn't borrow money. When consumers and businesses can't borrow, they can't spend and companies can't sell their products and services. The housing market was oversold and new houses didn't sell. Existing houses up for sell didn't sell because there were so many of them. Companies that can't sell products and services experience a drop in their stock price and have to lay off workers. Unemployment rises and consumers spend even less. It becomes a vicious circle and a recession happens. Finally the government after consulting various institutions passed the Troubled Asset Relief Program in October 2008. This was to address the subprime mortgage crisis by purchasing the assets and equity from financial institutions to strengthen them. Although previously estimated at USD 700 billion it was reduced to about USD 475 billion. It was significantly aimed towards the CDOs issued by the financial institutions. These were later to be auctioned publicly to private investors.

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Another important goal was to encourage lending again to revive the economy. This was achieved by purchasing preference shares of the firms which would infuse cash into the system alleviating the credit crunch. While it is obvious that this has been one of the most disastrous financial events since the Great Depression, and that toxic securities, mortgages, subprime lending, and the credit crunch played a major role in causing the financial crisis; it is still a long way to go for the world to get back to normal.

_____________________________________________________________________ SOURCES AND REFERENCES Movies/Documentaries - Too big to fail Inside Job Knowledge base Search engine Other links Articles - www.wikipedia.org - www.google.com - www.about.com (a New York Times Company) - The financial crisis and its issues (Research in Business and Economics Journal) - Toxic assets Relevant to ACCA qualifications paper P4 (Student Accountant, January 2009, Pg. 54 55)

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