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Global Financial Crisis

Important revision....

These were the economists who predicted the global financial crisis and the US housing bubble. So what lessons should we heed for the immediate future?

Nouriel Roubini, chairman of Roubini Global Economics

Once derided as Dr Doom, the New York University professor has become a media star on the back of his predictions in 2006 of a looming credit and housing bubble crisis in the US. That year, in an address to the International Monetary Fund, Roubini warned of the risk of a deep recession that would reverberate around the world.

The professor cites his early 2008 paper, The Rising Risk of a Systemic Financial Meltdown: The 12 Steps to Financial Disaster, as proof that he got it right. It includes a suggestion that “one or two large and systemically important broker dealers” could go “belly-up” (months later Bear Stearns and Lehman Brothers imploded).

As early as August 2006, Roubini had commented that slumping house prices were “enough to trigger a US recession” and, also that month, that “sub-prime lending institutions may thus be the proverbial canary in the mine” signalling an ugly housing bust that “will be associated with a broader economic recession”.

Warning signs: Lessons Roubini preaches to this day include the perils of a lack of market discipline, internal mismanagement and conflicts of interest within financial institutions.

Ann Pettifor, director of Policy Research in Macroeconomics (PRIME)

Pettifor’s 2006 publication – The Coming First World Debt Crisis – bombed on its release, but became a bestseller after the GFC. The then little-known British economist claimed levels of private debt were unsustainable and that the debt crisis “will hurt millions of ordinary borrowers, and will inflict prolonged dislocation and economic, social and personal pain on those largely ignorant of the causes of the crisis, and innocent of responsibility for it.”

In the book, Pettifor blames the US Federal Reserve, politicians and mainstream economists for endorsing a framework to support unsustainably high levels of borrowing and consumption under the guise of propping up the economy. Continuing the theme in her most recent writing, Pettifor attacks the “small elite that controls the global finance sector” and suggests government bailouts protecting speculative private wealth holders mean “we are no longer dealing with anything resembling a free market system”.

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Power shift: Pettifor, in her most recent book Just Money: How Society Can Break the Despotic Power of Finance, calls for greater public understanding of finance so the monetary system can be managed for the public good. She notes that society seized back control of the monetary system from the wealthy elite after the 1929 crash.

Steve Keen, head of the School of Economics, History and Politics, Kingston University

Keen, an Australian, is widely regarded as one of the first economists to make the call on an impending financial crisis and later won the inaugural Revere Award for Economics for his foresight.

In December 2005, when markets seemed buoyant, Keen set up the website debtdeflation.com as a platform to discuss the “global debt bubble”. Then teaching at the University of Western Sydney, he attracted considerable attention, much of it negative, for his views that an exponential rise in private debt in Australia, and in the US, was unsustainable and would lead to a collapse in asset prices.

“This is how bubbles grow and burst and ignoring debt in this way is one of the great fallacies of modern economics.”

In November 2006, he started publishing monthly DebtWatch reports warning of high debt levels. His first report was called “The Recession We Can’t Avoid?” (PDF). As the global economy plummeted in 2008, Keen’s star would rise on the back of such reports.

Debt wish: Keen opposes debt-dependent economics and over-investment in speculative assets such as property or shares. Commenting in BRW magazine, he argued: “This is how bubbles grow and burst and ignoring debt in this way is one of the great fallacies of modern economics.”

Dean Baker, co-director of the Centre for Economic and Policy Research

In the years leading up to the GFC, Baker wrote numerous columns tipping an American housing price bubble and a subsequent burst. In 2004, in an article in The Nation titled “Bush’s house of cards”, he wrote: “The crash of the housing market will not be pretty. It is virtually certain to lead to a second dip to the recession. Even worse, millions of families will see the bulk of their savings disappear as homes in some of the bubble areas lose 30 per cent, or more, of their value.”

In November 2006, Baker published his paper Recession Looms for the US Economy in 2007, in which he predicted a “downturn in consumption spending, which together with plunging housing investment, will likely push the economy into recession.”

Policy rethink: Since the GFC, Baker has warned against the incompetence of financial policymakers. In his 2010 book, False Profits: Recovering from the Bubble Economy, he states that the US needs to “rein in a financial sector that has grown out of control”.

Raghuram Rajan, governor of the Reserve Bank of India

As an economic counsellor at the International Monetary Fund in 2005, Raghuram Rajan drew disapproving looks from an audience of economists and bankers in Jackson Hole, Wyoming when he questioned the “worrisome” actions of the banks. He said the rollout of complicated instruments such as credit-default swaps and mortgage-backed securities made the global financial system a riskier place. Indeed, he argued that such developments “may also create a greater – albeit still small – probability of a catastrophic meltdown”.

Given that investments markets were revelling in high growth at the time, Rajan was an easy target for criticism. By 2008, his concerns had been justified. Now the head of India’s central bank, Rajan is again worried – he is warning that “super-easy” money from the world’s central banks, including the US Federal Reserve, to combat recession is inflating assets and encouraging bad investments.

Market meddling: Rajan fears long-term low interest rates and unorthodox programs to stimulate economies, such as quantitative easing, may lead to more turmoil in financial markets.

“My sense is that monetary policy can only do so much and beyond a certain point if you try to use monetary policy it does more damage than good,” he told Time magazine in August 2014.

Peter Schiff, CEO and chief policy strategist at Euro Pacific Capital

Famously appearing in debates on Fox News in 2006, Schiff was ridiculed by his fellow commentators for his bearish views. In August 2006, the stockbroker and author declared: “The United States is like the Titanic and I am here with the lifeboat trying to get people to leave the ship ... I see a real financial crisis coming for the United States.” In later debates, he predicted crashing real estate prices in 2007 and a looming “credit crunch”.

The title of Schiff’s 2007 book, Crash Proof: How to Profit from the Coming Economic Collapse, further justifies his selection as one of the few to predict the financial crisis. In his book he described the US as a “house of cards: impressive on the outside, but a disaster waiting to happen beneath the surface”. Schiff practised what he preached – for years he had been helping his clients restructure their portfolios to ride out what he views as the negative aspects of the economy.

False dawn: Claims of a US recovery in recent years are largely an “illusion”, Schiff says, created by the effects of zero per cent interest rates, quantitative easing and deficit spending. These policies have primarily benefited rich owners of stocks and real estate at the expense of creating good-paying jobs and purchasing power for the average Joe.

Minsky

Hyman Philip Minsky (September 23, 1919 – October 24, 1996) was an American economist, a professor of economics at Washington University in St. Louis, and a distinguished scholar at the Levy Economics Institute of Bard College. His research attempted to provide an understanding and explanation of the characteristics of financial crises, which he attributed to swings in a potentially fragile financial system. Minsky is sometimes described as a post-Keynesian economist because, in the Keynesian tradition, he supported some government intervention in financial markets, opposed some of the financial deregulation policies popular in the 1980s, stressed the importance of the Federal Reserve as a lender of last resort and argued against the over-accumulation of private debt in the financial markets.^[1]

Minsky's economic theories were largely ignored for decades, until the subprime mortgage crisis of 2008 caused a renewed interest in them.

Minsky proposed theories linking financial market fragility, in the normal life cycle of an economy, with speculative investment bubbles endogenous to financial markets. Minsky claimed that in prosperous times, when corporate cash flow rises beyond what is needed to pay off debt, a speculative euphoria develops, and soon thereafter debts exceed what borrowers can pay off from their incoming revenues, which in turn produces a financial crisis. As a result of such speculative borrowing bubbles, banks and lenders tighten credit availability, even to companies that can afford loans, and the economy subsequently contracts.

This slow movement of the financial system from stability to fragility, followed by crisis, is something for which Minsky is best known, and the phrase "Minsky moment" refers to this aspect of Minsky's academic work.

"He offered very good insights in the '60s and '70s when linkages between the financial markets and the economy were not as well understood as they are now," said Henry Kaufman, a Wall Street money manager and economist. "He showed us that financial markets could move frequently to excess. And he underscored the importance of the Federal Reserve as a lender of last resort."^[4]

Minsky's model of the credit system, which he dubbed the "financial instability hypothesis" (FIH),^[5] incorporated many ideas already circulated by John Stuart Mill, Alfred Marshall, Knut Wicksell and Irving Fisher.^[6] "A fundamental characteristic of our economy," Minsky wrote in 1974, "is that the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles."^[7]

Disagreeing with many mainstream economists of the day, he argued that these swings, and the booms and busts that can accompany them, are inevitable in a so-called free market economy – unless government steps in to control them, through regulation, central bank action and other tools. Such mechanisms did in fact come into existence in response to crises such as the Panic of 1907 and the Great Depression. Minsky opposed the deregulation that characterized the 1980s.

It was at the University of California, Berkeley that seminars attended by Bank of America executives helped him to develop his theories about lending and economic activity, views he laid out in two books, John Maynard Keynes (1975), a classic study of the economist and his contributions, and Stabilizing an Unstable Economy (1986), and more than a hundred professional articles.

Minsky

American economist Hyman Minsky, who died in 1996, grew up during the Great Depression, an event which shaped his views and set him on a crusade to explain how it happened and how a repeat could be prevented, writes Duncan Weldon.

Minsky spent his life on the margins of economics but his ideas suddenly gained currency with the 2007-08 financial crisis. To many, it seemed to offer one of the most plausible accounts of why it had happened.

His long out-of-print books were suddenly in high demand with copies changing hands for hundreds of dollars - not bad for densely written tomes with titles like Stabilizing an Unstable Economy.

Senior central bankers including current US Federal Reserve chair Janet Yellen and the Bank of England's Mervyn King began quoting his insights. Nobel Prize-winning economist Paul Krugman named a high profile talk about the financial crisis The Night They Re-read Minsky.

Financial instruments - 1 : CDO

CDO stands for Collateralized Debt Obligation and it involves the pooling of debt to reduce risk and raise returns. CDOs have been widely blamed for the 2008 financial crisis, but most people do not know what they are. When a lot of debt (such as home mortgages) is pooled together, bonds can be issued on this debt. The debt is split into different tranches, and each tranche is assigned a different payment priority and interest rate. This process is known as securitization.

When there is a lack of debt to securitize, it is possible to create a synthetic product by pooling all of the lowest tranches (highest interest payments, highest risk) to create a new product known as a CDO. The theory behind this is that even though the assets behind the bonds are risky, by pooling large amounts together it is possible to minimize risk whilst still receiving the high interest rates.

The problem with CDOs is that although they are split into tranches with the top tranche being rated AAA (i.e. no risk) and the bottom tranche being rated as junk, they are all based on the same asset - the worst subprime mortgages from a large mortgage pool.

A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS).^[1] Originally developed for the corporate debt markets, over time CDOs evolved to encompass the mortgage and mortgage-backed security ("MBS") markets.^[2]

Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. The CDO is "sliced" into "tranches", which "catch" the cash flow of interest and principal payments in sequence based on seniority.^[3] If some loans default and the cash collected by the CDO is insufficient to pay all of its investors, those in the lowest, most "junior" tranches suffer losses first. The last to lose payment from default are the safest, most senior tranches.

Consequently, coupon payments (and interest rates) vary by tranche with the safest/most senior tranches receiving the lowest rates and the lowest tranches receiving the highest rates to compensate for higher default risk. As an example, a CDO might issue the following tranches in order of safeness: Senior AAA (sometimes known as "super senior"); Junior AAA; AA; A; BBB; Residual.^[4]

Separate special purpose entities—rather than the parent investment bank—issue the CDOs and pay interest to investors. As CDOs developed, some sponsors repackaged tranches into yet another iteration, known as "CDO-squared", "CDOs of CDOs" or "synthetic CDOs".^[4]

In the early 2000s, CDOs were generally diversified,^[5] but by 2006–2007—when the CDO market grew to hundreds of billions of dollars—this changed. CDO collateral became dominated not by loans, but by lower level (BBB or A) tranches recycled from other asset-backed securities, whose assets were usually sub-prime mortgages,^[6] and are known as a synthetic CDO. These CDOs have been called "the engine that powered the mortgage supply chain" for sub-prime mortgages,^[7] and are credited with giving lenders greater incentive to make sub-prime loans^[8] leading up to the 2007-9 subprime mortgage crisis.

CDOs might lead to another financial crisis....

Collateralized debt obligations (CDOs), the bad boys of the financial crisis of 2008, are coming back.

CDOs are securities that hold different types of debt, such as mortgage-backed securities and corporate bonds, which are then sliced into varying levels of risk and sold to investors. With the Federal Reserve committed to keeping interest rates low, investors — such as pension funds seeking higher returns — are driving demand once again for these structured securities, which are riskier but provide more bang for the buck than safer bets such as Treasuries and investment-grade corporate bonds.

This year, Deutsche Bank launched an $8.7 billion CDO in two tranches with payments ranging from 8% to 14.6%, garnering strong interest from investors, according to a January 24 story in Bloomberg News. In the U.S., firms such as Redwood Trust have started selling CDOs backed by commercial real estate for the first time since the credit crunch, Bloomberg reported in a January 14 article.

Financial instruments - 2

Payment protection insurance (PPI), also known as credit insurance, credit protection insurance, or loan repayment insurance, is an insurance product that enables consumers to ensure repayment of credit if the borrower dies, becomes ill or disabled, loses a job, or faces other circumstances that may prevent them from earning income to service the debt. It is not to be confused with income protection insurance, which is not specific to a debt but covers any income. PPI was widely sold by banks and other credit providers as an add-on to the loan or overdraft product.^[1]

Credit insurance can be purchased to insure all kinds of consumer loans including car loans, loans from finance companies, and home mortgage borrowing. Credit card agreements may include a form of PPI cover as standard. Policies are also available to cover specific categories of risk, e.g. credit life insurance, credit disability insurance, and credit accident insurance.^[2]

PPI usually covers payments for a finite period (typically 12 months). For loans or mortgages this may be the entire monthly payment, for credit cards it is typically the minimum monthly payment. After this point the borrower must find other means to repay the debt, although some policies repay the debt in full if you are unable to return to work or are diagnosed with a critical illness. The period covered by insurance is typically long enough for most people to start working again and earn enough to service their debt.^[3] PPI is different from other types of insurance such as home insurance, in that it can be quite difficult to determine if it is right for a person or not. Careful assessment of what would happen if a person became unemployed would need to be considered, as payments in lieu of notice (for example) may render a claim ineligible despite the insured person being genuinely unemployed. In this case, the approach taken by PPI insurers is consistent with that taken by the Benefits Agency in respect of unemployment benefits.

Most PPI policies are not sought out by consumers. In some cases, consumers claim to be unaware that they even have the insurance. In sales connected to loans, products were often promoted by commission based telesales departments. Fear of losing the loan was exploited, as the product was effectively cited as an element of underwriting. Any attention to suitability was likely to be minimal, if it existed at all. In all types of insurance some claims are accepted and some are rejected. Notably, in the case of PPI, the number of rejected claims is high compared to other types of insurance. In the rare cases where the customer is not prompted or pushed towards a policy,but seek it out,may have little recourse if and when a policy does not benefit them. ^[4]

As PPI is designed to cover repayments on loans and credit cards, most loan and credit card companies sell the product at the same time as they sell the credit product. By May 2008, 20 million PPI policies existed in the UK with a further increase of 7 million policies a year being purchased thereafter^{[citation needed]}. Surveys show that 40% of policyholders claim to be unaware that they had a policy^{[citation needed]}.

"PPI was mis-sold and complaints about it mishandled on an industrial scale for well over a decade."^[5] with this mis-selling being carried out by not only the banks or providers, but also by third party brokers. The sale of such policies was typically encouraged by large commissions,^[6] as the insurance would commonly make the bank/provider more money than the interest on the original loan, such that many mainstream personal loan providers made little or no profit on the loans themselves; all or almost all profit was derived from PPI commission and profit share. Certain companies developed sales scripts which guided salespeople to say only that the loan was “protected” without mentioning the nature or cost of the insurance. When challenged by the customer, they sometimes incorrectly stated that this insurance improved the borrower's chances of getting the loan or that it was mandatory.^[7] A consumer in financial difficulty is unlikely to further question the policy and risk the loan being refused.

Several high-profile companies have now been fined by the Financial Conduct Authority for the widespread mis-selling of Payment Protection Insurance. Alliance and Leicester were fined £7m for their part in the mis-selling controversy, several others including Capital One, HFC and Egg were fined up to £1.1m. Claims against mis-sold PPI have been slowly increasing, and may approach the levels seen during the 2006-07 period, when thousands of bank customers made claims relating to allegedly unfair bank charges. In their 2009/2010 annual report, the Financial Ombudsman Service stated that 30% of new cases referred to payment protection insurance. A customer who purchases a PPI policy may initiate a claim for mis-sold PPI by complaining to the bank, lender, or broker who sold the policy.^[8]

Slightly before that, on 6 April 2011, the Competition Commission released their investigation order^[9] designed to prevent mis-selling in the future. Key rules in the order, designed to enable the customer to shop around and make an informed decision, include: provision of adequate information when selling payment protection and providing a personal quote; obligation to provide an annual review; prohibition of selling payment protection at the same time the credit agreement is entered into. Most rules came into force in October 2011, with some following in April 2012.

The Central Bank of Ireland in April 2014 was described as having "arbitrarily excluded the majority of consumers" from getting compensation for mis-sold Payment Protection Insurance, by setting a cutoff date of 2007 when it introduced its Consumer Protection Code. UK banks provided over £22bn for PPI misselling costs – which, if scaled on a pro-rata basis, is many multiples of the compensation the Irish banks were asked to repay. The offending banks were also not fined which was in sharp contrast to the regime imposed on UK banks.^[10] Lawyers were appalled at the "reckless" advice the Irish Central Bank gave consumers who were missold PPI policies, which "will play into the hands of the financial institution."^[11]

Source: Wikipedia

How to reclaim PPI for free....

How to find out if you’ve been mis-sold PPI

If you’ve had a mortgage, credit card or loan you might have been mis-sold PPI.

Until recently, PPI was sold at the time you took out a loan, credit card, mortgage or car finance deal.

The idea being that PPI would cover the monthly payments on your credit agreement if you became ill or lost your job.

However, the policies often didn’t pay out when people needed help. Sales staff often didn’t explain the policies properly.

For example, to people who were self-employed or with pre-existing medical conditions.

Policies were often sold to people in these groups when they weren’t eligible for cover.

If you remember any such conversation, there’s a chance you were mis-sold PPI and can claim.

There’s also a chance that you could have been sold PPI without realising it.

In some cases the salesperson didn’t explain the PPI policy at all when you bought it, or said you had to take out PPI or that you had a better chance of getting the loan if you took it out. In these cases you were mis-sold.

It’s well worth checking any mortgage, credit card and loan agreements.

If you can see any of the following terms or similar, you’ve probably been sold PPI:

ASU
Loan care
Payment cover
Protection plan
Loan protection

Even if you can’t find the documents, it’s still worth claiming if you think you were mis-sold PPI.

How we can predict the next....

...financial crisis....

Are we about to have another financial crisis?

In the decades prior to the financial crisis, the U.S. underwent a period of financial deregulation under the assumption that market forces would prevent financial institutions from taking excessive risk. In particular, the shadow banking system -- financial institutions that don’t operate as traditional banks -- was lightly regulated.

However, as Alan Greenspan admitted in testimony on Capital Hill after the financial crisis, that assumption turned out to be wrong. The traditional banking sector, which is highly regulated, weathered the storm fairly well, but the shadow banking system came crashing down -- and brought the economy with it.

Nevertheless, Republicans are determined to roll back financial regulation, particularly measures implemented under the Dodd-Frank financial reform package passed in the aftermath of the financial crisis. I believe that’s a mistake.

Deregulation would increase the risk of another financial crisis and, should a crisis occur, make it more likely that the consequences for the nation’s economy would be severe. If anything, regulation of the financial sector should be strengthened rather than dismantled, as promised on Donald Trump’s transition website.

Is Trump....

...about to cause another financial crisis?

Could a financial crisis happen again?

Read and make notes:

The City of London’s most vocal “bear” has warned that the world is heading for a financial crisis as severe as the crash of 2008-09 that could prompt the collapse of the eurozone.

Albert Edwards, strategist at the bank Société Générale, said the west was about to be hit by a wave of deflation from emerging market economies and that central banks were unaware of the disaster about to hit them. His comments came as analysts at Royal Bank of Scotland urged investors to “sell everything” ahead of an imminent stock market crash.

Sources of risk

Liquidity – Whether enhanced capital and liquidity requirements, and the ban on proprietary trading by banks, have suppressed market maker inventories in relation to the outstanding amount of corporate bonds.
Non-banks – Whether the next contagion will originate in asset managers and fintech companies who are subject to less prudential regulation but compete with banks in credit intermediation.
TBTF – Whether post-crisis regulations have encouraged oligopolistic behavior by reinforcing market concentration and creating barriers to entry in banking, clearing, and ratings.
Securitization – Whether risk retention/other regulations designed primarily to respond to the subprime mortgage crisis are optimized to reduce systemic risk without suppressing systemic benefits in other asset classes.
Hyper-risk – The impact of quantitative easing and ultra-low interest rates on risk-pricing mechanisms, and whether these policies have encouraged excessive risk-taking by investors seeking to harvest capital gains in a low yield environment, and by banks seeking to bolster profits by lending to riskier borrowers.
Mercantilism – Whether aggressive monetary stimulus, which tends to devalue a country’s currency and make its exports more competitive, will trigger competitive currency devaluation and other trade barriers by other countries seeking to manage their trade deficits.
Central bank divergence – Whether divergent policies (loosening in Europe/Asia versus tightening in the U.S.) will encourage speculation in the bond and currency markets.
Dollar-denominated credit – Whether emerging market companies who have borrowed heavily in U.S. dollars can manage any credit squeeze wrought by local currency depreciation.
“Drug-resistant” recessions – Whether central bankers have innovations, besides slashing interest rates below the “zero lower bound” and printing money, that will stimulate the economy without destroying government balance sheets.
Zero lower bound – The consequences of negative nominal interest rates (where depositors pay rather than receive interest to maintain accounts, but borrowers pay less the longer they take to repay their loans) on perceptions of lending risk, incentives to make loans to riskier borrowers (rather than pay to hold excess cash at the central bank), and on the stability of insurance companies, pension funds and other organizations with long- term liabilities and demographic risk.
China – Whether the government can command a soft landing of its economy, including managing its debt crisis and dwindling reserves.
Sovereign wealth – Whether funds run by natural resource revenue-dependent countries can manage the rapid liquidation of assets to cut budget deficits resulting from falling commodity (especially oil) prices.
Populism – Whether populist sentiment (left or right) will trigger decisions (such as Britain’s potential Brexit from the EU) that might hinder free trade.
Non-correlated risk? – Whether insurance-linked securities, which purport to offer diversification based on low correlation to other markets, pose a contagion risk in the event of a large-scale natural catastrophe and sentiment-based volatility.
Bailouts – Whether contingent convertible debt securities that automatically convert to equity (or are written down) when a bank crashes will obviate the need for taxpayer bailouts without inducing a panic that contaminates the entire financial system.