16
Jun

REASONS AND AFTERMATH OF THE FINANCIAL CRISIS

Escrito el 16 Junio 2008 por Alumni en Functional Area


The 13th of March 2008 IE Finance Club presented a conference held by Mr. Ignacio de la Torre, Executive Director of Investment Banking at UBS’ Madrid office. He is currently the academic Director for the Master’s Program in Financial Management and for the Executive Master in Finance Management at IE Business School, as well as professor of finance, economy and accounting.

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The event took place at IE Business School with the attendance of 50 students from the school’s diverse programs. The presentation was titled “Reasons and Aftermath of the Financial Crisis”, and provided an overview of the current global financial and economic situation, the causes of the recent circumstances and predictions for the future.
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As a starting point, Mr. de la Torre said that the German people have been significant net savers in recent years. Germans have poured large sums of capital in the Chinese market, which is a major reason why the Chinese have had so much money to invest around the world, and specifically in the USA and its bond market.

Let´s briefly cover the circumstances surrounding the current financial situation, particularly the lack of control in the financial market. Hyman P. Minsky, a Wall Street economist developed a theory in the 60´s that was launched by him in the 80s when the markets were deregulated and the state encouraged investors to take greater risks in hopes of spurring innovation. Minsky believed that Wall Street encouraged businesses and individuals to take on too much risk,, generating ruinous boom-and-bust cycles. The only way to break this pattern was for the government to step in and regulate the lending practices. A few months ago, at the beginning of the crisis, we could see a similar lack of control in financial markets and how the US government announced the creation of new regulatory measures. This included giving more authority to the Federal Reserve, as Minsky’s theory recommended.

We also need to know what a Credit Default Swap is. A simple explanation: passing the debt to a third party. In the case of firms or banks, the debt holders sell loans from their customers to an outside investor. A public debate ensued between two famous figures, one in favour and the other against the wisdom of such a policy. Alan Greenspan believed it was good for the economy as the risks were diversified between more people and more countries. On the other hand, Warren Buffet opposed it because it generated overly risky decision-making.

How does it work?

A person in (e.g) Tulsa, Oklahoma, without a job or future expectations of income wants to buy a house. The real estate agencies have two types of clients: Prime and No-Prime (subprime), this person would be SUBPRIME. When agencies have too many subprime mortgages, they make a pooled instrument known as a structured investment vehicle (SIV) and sell it to banks or other entities, so it is the new owner who has the right to collect the debt from clients.

Banks securitize the mortgage packages and create a bond with three ratings:

1)     Good. AAA rating.

2)     Medium.

3)     Bad. This one will have a 3% default. S&P will give them AAA rating.

As a result, an unemployed mortgage holder at high risk of default is inadvertently folded into the AAA rating category. In fact, SIV buyers oftentimes had no means of properly assessing solvency or liquidity risks underlying such debt.

When the credit crisis began to explode, banks and other entities did not have the possibility to recover the debt and suffered from major losses. These unrecoverable holes were as big as $7 billion at Merrill-Lynch, and $8 billion at UBS, and led to a series of announcements that banks would write down large amounts of assets from their balance sheets.

As the banks could not recover their money, lost liquidity, and could not continue lending. This impacted the overall credit market when consumers who had to pay down debts (e.g. a car purchase) could not obtain additional credit lines from banks.

The banks will have to wait until they recover some cash before they resume lending, which will eventually help jumpstart the economy again. But the question is: How much time will it take to recover from such big write downs?

This liquidity crisis also affects the inter-bank lending markets. Previously, banks with more liquidity would loan money to others at a small premium. Now, however, banks are reluctant to or cannot lend, and no lending means no income to expand the credit market. A vicious cycle results.

In summary, the economy must wait until banks recover sufficient liquidity to restart lending (more safely). This should fuel real economic growth once again.

To this we have to add the impact of much higher crude oil prices, which makes all goods much more expensive at a moment when families are already struggling with mortgage interest payments. These two factors will lower consumption and may cause the economy to stagnate or even contract for several terms.

In Spain, the subprime crisis did not affect the banks as much as in other countries due to the limits established by regulators that mandated that the amount of subprime lending could not pass a specified limit.

On behalf of the IE Finance Club we would like to thank Mr. De la Torre for his excellent seminar on the reasons behind the crisis and we hope to count on him again in the future for another outstanding seminar.

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