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THE CURRENT GLOBAL FINANCIAL CRISES, WILL CAPITALISM RESIST THE TEST OF TIME?


Mustapha Muktar, Ph.D
Department of Economics - Bayero University, Kano P.M.B 3011 kano-Nigeria.

Published August 26th, 2009

 

Introduction

Crises have been a feature of the financial landscape for hundreds of years. They often appear with little warnings as the subprime mortgage crises of 2007-2008 and the Asian crises of 1997-1998 illustrate. It is not always clear what causes crises in the financial sector whether they can be avoided and how their impact can be reduced (Allen & Douglas, 2007). Financial crises are applied broadly to variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and 20th centaury many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crushes and the bursting of other financial bubbles, currency crises and sovereign defaults. A financial asset (stock for example) is said to exhibit a bubble when its price exceeds the value of its future income (interest or dividend) that would be received by owning it to maturity.

The financial crises of 2007-2008 referred to as "credit crunch" or "credit crises" began in August 2007, when a loss of confidence by investors in the value of securitized mortgages in the United States resulted in liquidity crises which prompted a substantial injection of capital into financial markets by the United States Federal Reserve and the European Central Bank. An indicator of perceived credit risk in the general economy was perceived, it spiked up in August 2007, remained volatile for a year, and then spiked even higher in September 2008.

Although America’s housing collapses often cited as having caused the crises, the financial system was vulnerable because of intricate financial contracts known as Credit Default Swap (CDS), which insure debt holders against default. They are fashioned privately, traded over the counter beyond the sight of regulators. The US government seizure of mortgage companies prompted an auction of their debt so that traders who bought and sold default protection (CDS) could settle contracts with cash rather than having physically deliver a bond to their counterparty’s prime.

The initial liquidity crisis can in hindsight be seen to have resulted from the incipient subprime mortgage crisis. Excessive lending under loosened underwriting standards, which was a hallmark of the United States housing bubble, resulted in a very large number of subprime mortgages. These high-risk loans had been perceived to be mitigated by securitization. Rather than mitigating the risk, however, this strategy appears to have had the effect of broadcasting and amplifying it in a domino effect. The damage from these failing securitization schemes eventually cut across a large swath of the housing market and the housing business and led to the subprime mortgage crisis. The accelerating rate of foreclosures caused an ever greater number of homes to be dumped onto the market. This glut of homes decreased the value of other surrounding homes which themselves became subject to foreclosure or abandonment. The resulting spiral underlay a developing financial crisis.

Initially the companies affected were those directly involved in home construction and mortgage lending such as Northern Rock and Countrywide Financial. Financial institutions which had engaged in the securitization of mortgages such as Bear Stearns then fell prey. Later on, Bear Stearns was acquired by JP Morgan Chase through the deliberate assistance from the US government. Its stock price fell from the record high $154 to $3 which was the acquisition price by JP Morgan Chase, subsequently the acquisition price was agreed on $10 between the US government as well as JP Morgan. On July 11, 2008, the largest mortgage lender in the US, Indy Mac Bank, collapsed, and it's assets were seized by federal regulators after the mortgage lender succumbed to the pressures of tighter credit, tumbling home prices and rising foreclosures. That day the financial markets plunged as investors tried to gauge whether the government would attempt to save mortgage lenders Fannie Mae and Freddie Mac, which it did by placing the two companies into federal conservatorship on September 7, 2008 after the crisis further accelerated (The Economist, 2008)

It then began to affect the general availability of credit to non-housing related businesses and to larger financial institutions not directly connected with mortgage lending. At the heart of many of these institution's portfolios were investments whose assets had been derived from bundled home mortgages. Exposure to these mortgage-backed securities, or to the credit derivatives used to insure them against failure, threatened an increasing number of firms such as Lehman Brothers, AIG, Merrill Lynch, and HBOS. Other firms that came under pressure included Washington Mutual, the largest savings and loan association in the United States, and the remaining large investment firms, Morgan Stanley and Goldman Sachs.

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Beginning with bankruptcy of Lehman Brothers on Sunday, September 14, 2008, the financial crisis entered an acute phase marked by failures of prominent American and European banks and efforts by the American and European governments to rescue distressed financial institutions, in the United States by passage of the Emergency Economic Stabilization Act of 2008 and in European countries by infusion of capital into major banks. Afterwards, Iceland almost claimed to go bankrupt. Many financial institutions in Europe also faced the liquidity problem that they needed to raise their capital adequacy ratio. As the crisis developed, stock markets fell worldwide, and global financial regulators attempted to coordinate efforts to contain the crisis. The US government threw the $700 billions plan which was attempted to purchase the un-performing collaterals and assets. Unfortunately, the market sentiment continuously deteriorated and the global financial system almost collapsed. While the market turned extremely pessimistic, the British government launched a 500 billion pounds bailout plan aimed to injecting capital into the financial system. The British government nationalized most of the financial intuitions in trouble. Many European governments followed as well as the US government (Kirkup, 2008)

Some of the consequences of the current crises include;

Credit Got Tighter
With interest rates higher, money just got more expensive to borrow. There are also tighter restrictions for getting loans: you need a higher down payment to qualify for a loan plus you need to have very good credit to get a good mortgage deal these days. A friend of mine who is a real estate investor is not thrilled by these developments at all. He tells me stories of people with perfect credit who are now at the brink of foreclosure due to tighter rules or unlucky circumstance. These people have "upside-down" homes that are now cheaper than their purchase price and are therefore unable to find refinancing for their adjustable rate mortgages due to stricter refinancing terms. Since they are unable to refinance, they become stuck with existing mortgage payments that simply grow larger with interest rate hikes. When payments become prohibitive, they are forced to default (Truman, 2008)

Buying a House get Tougher


If you’re a house bubble sitter happy to wait for lower priced homes, you may be less excited about today’s cheaper housing market. That’s because borrowing to buy a house is now under greater scrutiny. With credit drying up, all those fancy, exotic loans that allowed just about anyone to attain a new house disappeared with a whiff. "Stated-income" loans allowed borrowers to declare but not submit documentation of their income in order to qualify for these loans. These loans used to make it easier to borrow but they are now extinct. There are stricter requirements for purchasing a house today: higher interest rates on jumbo and non-conforming loans (greater than $417,000), better credit scores required, down payments of 10% or more to snag the best loan rates. (Blogger, 2007)

The stock market got scarier
We all know how much this market sucks. I hope you’re keeping your powder dry to buy in on the dips. I’d expect this downturn to work itself out over a period of several months. If this is a summer cyclical swoon, then come November, there could be a recovery.. If you’re well diversified and have a long term view, you need not be too concerned.

Other socioeconomic consequences of the crises include difficulty in borrowing money which makes families to reduce their expenditures. Banks were being forced to write off billions loaned to those who could not afford to make repayments, for example Barclays bad debt hit 1.5 Billion ponds. Banks which specialize in providing home loans to those with poor credit history and the self employed have made dramatic changes recently. While some have dropped mortgages altogether others have raised their rate by as much as 2.5%.

 

The Political Economy of the Current Financial Crises

To fully grasp the politics behind the subprime mortgage crises it will be essential to analyze the US Federal Housing Administration Mortgage Program. In 2002, the President issued America’s Homeownership Challenge to increase first-time minority homeowners by 5.5 million through 2010. The Federal Housing Administration (FHA) mortgage program is an important tool for reaching that goal. In 2006, 31 percent of those using FHA mortgages were minorities purchasing their first home. The 2008 Budget continues administration efforts to modernize FHA by improving its ability to reach traditionally underserved homebuyers (those who do not normally qualify for loans), such as low- and moderate-income families, individuals with blemished credit, and families who have little savings for a down payment. (From Bush Administration’s White House Press Release entitled, "Focusing on the Nation’s Priorities – Meeting America’s Housing Needs").

The Bush administration through, also required Fannie and Freddie (two mortgage giants) to give a higher percentage of their loans to minorities that otherwise would not qualify for the loans. (Blogger, 2007). First of all, government sponsored corporations that help create the mortgage system (Fannie May and Freddie Mac), as well as the federal home loan banks, increased their commitment to minority markets by more than $440 billion.

Fannie Mae’s ten-point plan to help advance the Bush Administration’s homeownership proposals was included in the Blueprint for the American Dream document. The Blueprint for the American Dream unveiled today is the response to the `homeownership challenge’ President Bush issued to increase minority homeownership.Fannie Mae responded to Bush plan by committing $700 billion in home financing to 4.6 million minority households through 2009. This increases by 66 percent the specific pledge Fannie Mae made in 2000 to minority families through its American Dream Commitment plan to provide $420 billion for three million minority families.(Gelpern, 2008)

Bush and the Republican Congress forced Fannie Mae and Freddie Mac to make zero-down loans and adjustable rate 3, 5, and 7 year arms available to the riskiest buyers. Fannie Mae and Freddie Mac were forced to effectively finance 103 percent of the mortgage (including closing costs).

It was between 2001-2005 that most of these loans that have gone bad were made. You can find all of the official documents at the White House, as well as Fannie Mae and Freddie Mac press release websites.

The question here is why did Bush and the Republican Congress push minority and low income loans? They pushed it for two main reasons. First, the economy was facing a recession due to huge debt contracted to finance wars in Iraq Afghanistan and other countries, and they looked to stimulate economy by stimulating the housing market. In fact, the Administration pointed to the huge increase in housing numbers under his "leadership" to show that he stimulated the economy to come out of a recession. Second, there was a huge demand in the securities market for mortgage-backed securities and there were not enough of them to keep up with demand. Mortgage-backed securities were in such demand because it allowed banks and lenders to turn an illiquid asset - mortgages– into a liquid asset by bundling the mortgages and selling them as securities. Also, many thought that they were great securities to buy because they were further secured by collateral (the homes)and if the debt went bad, the collateral could be sold. They also thought that the mortgage-backed securities bundled from loans made through Fannie and Freddie were government guaranteed because they are quasi-government agencies.

In any event, there was a huge demand for these in the market and not enough supply. To increase supply for mortgage-backed securities, more loans had to be made. The only way to get more loans made was to come up with more creative loan products to get people into homes that otherwise would not qualify. So the Bush Administration and Republican Congress aggressively came up with ways to allow individuals who normally could not get loans to get loans.

The problem was the housing "bubble" started to burst and home values started to fall. At the same time, many of the 3 and 5 year arm loans were set to adjust to higher interest rates. Homeowners went to re-finance, but were unable to re-finance their mortgages because their homes were now less than what they owed on their mortgages. Their interest rates shot up incredibly high rates, like 15.9%. Homeowners saw their mortgage payments triple and could no longer afford their homes.

 

The Global Financial Crises and Nigerian Economy

Government economists have asserted that Nigeria is not and will not be in a financial meltdown despite the hiccups in the developed countries their justification is that the recapitalization of Banks is sound and that the respective capital markets of the developed world and that of Nigeria were not connected, however the spill over effects of the crises have started to manifests itself in Nigeria in the following ways;

v The crises has precipitated a reduction in the demand for exports especially oil, its impact have already seen on the oil prices which have fall by more than 50% in the last six months and this has negatively affected the revenue earned as oil is the main source of revenue.

v There is a cut in the foreign capital inflow into Nigeria and other African countries in General as observed the global growth will be a lot slower the sort of flows are going to dry up" and because of the small size in our market even limited withdraws could have significant impact and as the crises deepens it means there will be major capital withdraws. This will affect the rate of economic growth negatively.

v The Nigerian capital market though not linked with foreign capital market have been affected negatively as stock market prices have fallen drastically, this is because investors are fearful and lose confidence. The lost in confidence is mainly due to contagion effects and expectation of same to happen in Nigeria. This lost in confidence can however last for some time.

v It has been observed that remittances by Nigerians who works and stay abroad will be reduced as they are affected by the crises and that will lead to a reduction of welfare of their dependents in Nigeria.

v The post consolidation period has exposed a lot of Nigerian banks to global practices, as they have entered business relationships with some foreign banks that are badly affected by the crises, some of them have booked considerable credits from such embattled financial institutions and with the credit crunch they cannot be able to get the required credit as such are negatively affected.

Conclusion

The current global financial crises is a manifestation of the faulty macroeconomic policies in US coupled with imprudent lending, and weak financial regulations which accelerated asset price bubbles in housing sector. It later spreads to Europe and some Asian countries that has connection with the US capital market. Its effects on the Nigerian economy were however indirect and unavoidable. The Marxian theoretical postulations of the capitalist crises and the collapse of capitalism has been proved, we await the death of capitalism so that after its burial a proletariat government will be formed with no subjugation and exploitation.

 

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