13771 PL30895 - essay - Grade: 68 PDF

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Department of Politics, Languages and International Studies Undergraduate Coursework Submission Form

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13771 PL30895

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Dr Maria Garcia

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PoLIS

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What role did financial innovation play in the 2008financial crisis?

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What role did financial innovation play in the 2008- financial crisis? The 2008 crisis has been one of the most researched topics in the academic field of economics as it had effects so severe, that even now a full recovery has not been achieved (IMF – World Economic Outlook, 2017). Furthermore, while it shared many similarities with past global crisis it was unique in that it revolved around the “the most sophisticated financial system in the world” (Rajan, 2001:5). While many turn to the US sub-prime mortgage market as one of the prime causers of the crisis, its spread around the world and its complexity lead us to the role finance played. More specifically, the boom in financial innovation and activity in the sector in the period leading up to 2008 (Beck et al., 2012) draws attention to its contribution to the severity of the crisis. The main innovations that the literature considers is the rise of securitization and the subsequent change in the business model of the financial sector (Rajan, 2011; Lo, 2012; Dwyer, 2012). The logic behind securitization is one meant to hedge against risk, with banks offloading the bad credits off its books and transferring it to long-term investors, while also reducing its interest rates for new borrowers (Rajan, 2011)- if thousands of debt assets are bundled together in a single product, then the overall risk of default reduces because of a low probability of all of them defaulting simultaneously, with the assumption being that those probabilities were independent of each other. As we now know, they were not, due to the systemic risk running in the system – they were not independent because of factors common for the debt bundle, like the house price bubble bursting was going to lead to a default on all sub-prime mortgages. Many of the financial products offered were based on that logic however, and had sophisticated and complicated names like mortgage backed securities, collaterised debt obligations (CDOs) or Asset backed Commercial Papers (ABCP). The period leading up to the crisis saw an immense increase in the value and volume of such asset-backed securities globally, from $300 billion in 2002 to $750 in 2007 and 2008 (SIFMA, 2010). This led to a change in the business model of financial institutions from a simpler relationship between creditor and borrower to the originate-to-distribute model, which involved a complex chain of mediators, actors and institutions (Pesic, 2011; Jacobides, 2014). This skewed the incentives of bankers and other actors and misaligned them with the interests of the investors, making financial bonuses the main motivation, an issue Rajan (2006) has been pointing towards some time before the crisis itself. Innovation however, is still regarded by many as a driver for real economy growth, and debates in the economic literature on the matter are still inconclusive. Beck et al. (2012), for instance, found empirical evidence that while it is indeed related to GDP growth, it is also 4

contributing to fragility, and that the more financial innovation is introduced in a country, the greater the fall in profits after the crisis hit. In order to evaluate the role of financial innovation in the crisis, it is important to understand the complexity and variety of actors and factors that led to it, hence, the next section of this essay is going to provide some background to strengthen our understanding and is then going to examine the role of financial innovation in the 2008 crisis. I will then argue that the increased financial innovation did exacerbate the crisis by concealing risk along the securitisation chain, distorting incentives, and making what was a US mortgage crisis into a severe global financial one. The roots of the crisis can be traced to the US sub-prime mortgage market. An expansionary fiscal policy along with a continuing policy for expanding home ownership was led by the Bush and then Clinton administration, who specifically encouraged the financial sector to innovate and find a way to get people into houses and pressured them to expand credit by beginning to enforce the Community Reinvestment Act of 1977 (Rajan, 2011). The Federal Housing Association was also promoting that mandate by guaranteeing riskier loans private institutions would consider bad investment, and during Clinton, decreasing the minimum down payment dramatically to just 3% while increasing the number of mortgages it could guarantee. Many trace this as one of the root causes of the crisis, as the guarantee from the US government forced a change in private incentives, and led to overinvestment and price distortion (Thompson, 2009; Rajan, 2011; Allen & Yago, 2010). They used the government-sponsored enterprises with a public mandate – the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) to buy enormous amount of subprime mortgage-backed securities to meet the government's quota, and were also pushed to do so quickly, which put further pressure on the system and made diligence harder (Rajan, 2011). By 2008 the two enterprises were holding half of the outstanding mortgages in the US and were guaranteeing trillions of dollars more (Rajan, 2011). As house prices were rising, households could later refinance at lower rates when the house is worth more, which meant that as long as house prices were going up everything was sound. In reality the market was not satisfying a real demand for housing, but it was rather the product of speculation – people believed house prices would continue rising and saw this as a good investment. This led to what some refer to as “irrational exuberance”, the belief that they would not go down, reinforced by the government’s continued stimulus to pour more money into the housing sector (Rajan, 2011). Meanwhile, bank competition in the financial sector led to the invention of increasingly complex forms of risk taking, which made evaluation of financial products even harder. Increased deregulation after the introduction of the Gramm-Leach-Bliley Act of 1999 repealed 5

provisions that were separating investment banks from high street deposit ones, which meant that there was no longer a firewall protecting ordinary people and the banks who deal with them and the ones which dealt with securitisation (Delivorias, 2016). The securitised bundles of assets did contain some toxic debt, but even the institutions holding them were not fully aware of the extent of their exposure. In addition, systemic risk was affecting the whole system as the assets weren’t as heterogenous as they were meant to be: many of the packages were not properly diversified and were instead sharing common links along the intermediaries’ chain and most of the originating mortgages in those packages were of the same low quality (Rajan, 2011). As we now know, the bubble burst, households defaulted on their credits, as the house prices started plummeting by the end of 2006. The fact that most, if not all, of the actors were holding the same packages meant that when this occurred they all individually responded in a homogenous manner – cutting back lending – which only exacerbated the problem (Rajan, 2011). In 2008 Lehman Brothers filed for Chapter 11 bankruptcy and the interbank lending rates (LIBOR) went up as banks lost confidence in each other’s viability and the liquidity crunch set in, which forced the US government had to go out on a bailout campaign. The following section is going to look at what was the role of financial innovation in those events. The nature of the financial sector and its ability to constantly innovate and evolve as the regulatory context changes led to the emergence of the “shadow banking system”. After Basel II was introduced, it made liquid assets unprofitable and thus banks were forced to invent securitisation techniques that moved the riskier assets away from their balance sheets and expand their activities in close relationships with complex financial institutions that allowed them to grow (Nesvetailova, 2014). Thus many of their activities were taken outside of the government safety net regulating capital requirements and such, which made financial institutions more exposed to liquidity risk (Delivorias, 2016; Sobreira, 2010). This was one of the purposes of the new securitisation products. As we already established, there was a boom in issuing and trading complex products that were the fruit of securitization. I argue that those products were of extreme importance in contributing to the severity of the crisis as they concealed and concentrated risk by lengthening the intermediation chain and making external risk assessment harder because of the complexity of the products. There were so many intermediaries between the borrower and lenders that financial institutions themselves were not aware of the level of risk they were exposed to. While normally banks would take household deposits and then lend them to business borrowers or other households, with securitisation, the banks would now sell the mortgages to SSPEs who would package them into ABS’s, who 6

would pool them and issue CDOs, with all of this being financed at the end by commercial banks selling short-term liabilities to households or funds (Delivorias, 2016:14-15). A.I.G for instance was one of the biggest swallowers of risk as an insurance company, via its credit default swaps, that was also one of the major scapegoats of public wrath and media attention when the crisis started to unfold, and it received bailout from the US government while also awarding millions in bonuses (Lewis, 2009). During the crisis A.I.G FP was a major player that never sold quite the same product that it had bought, always adding a slight difference, thus increasing the complexity of its products, but also giving them triple A ratings because the firm would guarantee them and A.I.G itself did have AAA rating (Jacobides, 2014). The widely circulated opinion that the traders in financial institutions were simply greedy and short-sighted was prevalent in public opinion, but in A.I.G FP for example, its employees had more than half its bonuses within the company, thus leaving them personally invested in the future success of the company. Joe Cassano, who ran A.I.G FP had $36.75 mil out of a total of $38 mil in earnings inside the firm (Lewis, 2009). It is simply the case that the nature of the financial products was so complicated that the mathematical models used to evaluate them could not provide true assessment and the traders themselves were not aware of their exposure to toxic debt and how much of the consumer debt in its CDS’s were actually subprime mortgages (Lewis, 2009). While we could argue that the banks that offloaded the risk to A.I.G did become aware of the toxicity of their assets despite the AAA rating they got by the rating agencies, they still held onto the risk or continued lending even when insurance enterprises refused to take on the risk. Acharya & Richardson (2009a), for instance, assert that although banks used SIV’s to offload bad loans and thus lower their capital requirements, they actually held onto the risk by committing to pay the debt on case of a default. They conclude that this only concentrated risk further, instead of dispersing it, which was the original promise of securitization, while simultaneously also lowering banks’ capital requirements. UBS for instance, held onto the securitised packages they produced – the “supersenior”, supposedly perfectly safe, and AAA CDO’s (Jacobides, 2014). As those risks become neglected the economy overheats with excessive issuance and overinvestment, but as it became clear that there is a high interdependence of the possibilities of default, the investors would all withdraw to traditional products simultaneously, which made the system incredibly susceptible and vulnerable to crisis, or in other words become fragile (Gennaioli e al., 2010). As Nesvetailova (2014) asserts, a system relying on innovations is bound to be illiquid by its very nature – many global actors were performing homogenous actions with complex tradable securities that led them to believe that the underlying assets were liquid when, in reality, they were not. 7

This innovation eventually led to a change in the way financial institutions were making money – their business model. As we said earlier the originate-to-distribute model became quite prevalent in the industry, with the majority of actors in the securitisation chain of intermediaries not holding onto the risk, but instead altering the original product and then selling it on. The main issue created by this model was the lack of incentive to preform due diligence, with many of the originators weakening their evaluation and screening practices (Delivorias, 2016). Financial innovation introduced another vulnerability in the system – the move from an investor paid evaluation of risk to one paid by the originator (Delivorias, 2016). As credit rating agencies are being paid by the same banks (originators) that are going to then sell them and pass on the risk, they face little motivation to provide critical ratings because if their rating does not work in the bank’s favour they would not bring more business to them, which creates obvious distortion in the credit agencies’ incentives (Lewis, 2009). Standard and Poor’s and Moody’s were evidently extremely generous in their rating in the period building up to the financial crisis (Rajan, 2011). Gorton and Metrick (2010) examined the securitisation machine in their attempt to establish the best way to regulate the shadow banking sectors, and argued that the outcome of it was to significantly reduce transparency and produce asymmetrical information throughout that same chain and that by the time it reaches the investment bank as a CDO the brokers are likely to be unaware of the quality of the credit in it. They also contended that in reality, there was not an overexposure to the subprime market and that they actually constituted a fraction of the structured investment holdings (Gorton and Metrick, 2010), which does support the thesis that the subprime mortgage market was just the trigger for the wider crisis that ensued, and that financial innovation and complexity had a key role in those events. In this regard, Thankor (2008) argues that this was a purposeful move from financial institutions, in order to differentiate from the competition in the absence of patents in the sector. They had to make them more complex and unfamiliar, so the competition cannot agree on their profitability, but that made them extremely exposed and vulnerable to losing investor confidence because the more unfamiliar the product the easier can they decide to withdraw which can easily snowball and lead to crashes like the one that happened. Another role of financial innovation was that it turned what was essentially a US subprime mortgage crisis into a devastating global financial one (Rajan, 2011). The US government’s signal that it would guarantee investments in its housing sector led to a global influx of investors. Securitization packages, like Collaterised Debt Obligations (CDO’s) and Asset backed Commercial Papers (ABCP’s), tended to hold mortgages with ambiguous quality 8

that were held by banks globally and traded in large volumes. Thus, products of securitisation were spreading globally, with foreign investors that are removed from local realities being further unable to evaluate the risk they are exposed to (Rajan, 2011). It also resulted in a clash of different types of capitalism. The export-led growth model of the East-Asian “tiger” economies eventually translated into accumulation of savings that were invested in financial products overseas, which unfolded into overinvestment with the risk of default lying largely on the US government, which led an expansionary fiscal policy fuelled by foreign debt (Rajan, 2011; Thompson, 2009). A scenario much too reminiscent to the 1997 Asian financial crisis (Rajan, 2011). The clash of different types of capitalism was problematic in the crisis because foreign investors were much less sensitive to risk, as they are used to not have much information unless they have a long-term relationship with the financial institution, unlike more developed arm’s length systems where information is supposed to be widely available and the risk is falling entirely on them (Rajan, 2011). The sources of financing for the mortgaged backed securities is highly concerning according to Rajan (2011) as they were the US government and by foreign private and government investors, both of which are insensitive to risk, the former because of its social mandate and the, other because of the underlying differences in the capitalist system. It is important to also consider the other side of the token, as innovation in any sector is generally considered to be an important driver for real growth, and evidence is present that the case of financial innovation is no different. As Beck et al. (2012) found, countries where financial innovation occurs are enjoying substantially higher GDP growth rates. Hence, many proponents argue that it was complexity, rather than true innovation that caused the crisis. In an excellent account, Allen and Yago (2010) give the example of Spain and Ireland, which were among the countries in the EU that were hit the hardest by the crisis, had developed a housing bubble of their own despite financial innovation being absent as a factor in their economies. They argue that at the time the loan to value ratio of securitised mortgages was 80% and the only changes in the financial sector was the lengthening of mortgage periods in Ireland (Allen and Yago, 2010). Therefore, they argue that it was the complex products, many of which were designed specifically to mislead people, that aided the crisis and that true innovation is more likely to solve the issues currently plaguing the sector. A similar view is expressed by Jacobides (2014), who assert...