TWN Info Service on Finance and Development (Nov07/03)

7 November 2007


JUST as the world was recalling the 1997 Asian financial crisis on its 10th anniversary, evidence was accumulating that the global financial system was once again vulnerable. The extent of vulnerability was driven home by the simultaneous collapse of stock indices in the world’s leading financial markets on 27 July, including those in so-called ‘emerging markets’ in developing countries.

The fact that a crisis in the US housing finance market could cause so much chaos to the global financial system is a reflection of the extent of the vulnerability of the whole system. It demonstrates that countries which have a more open and integrated financial system are prone to such contagion effects, however remote the origin of the crisis may be.

Below is an analysis of the cause and global effects of the crisis in the US housing finance markets by economist CP Chandrasekhar. It was published in the Third World Resurgence #203/204 (July/August 2007).

With best wishes
Martin Khor

Financial Entanglement and Emerging Markets
By CP Chandrasekhar

JUST as the world was recalling the 1997 Asian financial crisis on its 10th anniversary, evidence was accumulating that the global financial system was once again vulnerable. The extent of vulnerability was driven home by the simultaneous collapse of stock indices in the world’s leading financial markets on 27 July, including those in so-called ‘emerging markets’ in developing countries. What is disconcerting is that this synchronised collapse of markets was not the result of developments in each of the countries where these markets were located. Rather, the source of the problem was a crisis brewing in the housing finance market in the US, the ripple effects of which encouraged investors to pull out of markets globally.

Underlying these ripple effects is the financial entanglement which results from the layered financial structure, the ‘innovative’ financial products and the inadequate financial regulation associated with the increasingly liberalised and globalised financial system in most countries. Few deny that the sub-prime housing loan market in the US – consisting of loans to borrowers with a poor credit record – is faced with a crisis, reflected in payment defaults and foreclosures. The problem lies in the way in which the preceding boom was triggered and kept going. Housing demand grew rapidly because of easy access to credit, with even borrowers with low creditworthiness scores, who would otherwise be considered incapable of servicing debt, being drawn into the credit net. These sub-prime borrowers were offered credit at higher rates of interest, which were sweetened by special treatment and unusual financing arrangements – little documentation or mere self-certification of income, no or little downpayment, extended repayment periods and structured payment schedules involving low interest rates in the initial phases which were ‘adjustable’ and move sharply upwards when they are ‘reset’ to reflect premia on market interest rates. All of these encouraged or even tempted high-risk borrowers to take on loans they could ill afford, either because they had not fully understood the repayment burden they were taking on or because they chose to conceal their actual incomes and take a bet on building wealth with debt in a market that was booming.

What needs to be understood, however, is that the problem is largely a supply-side creation driven by factors such as easy liquidity and lower interest rates. Utilising these circumstances, mortgage brokers attracted clients by relaxing income documentation requirements or offering grace periods with lower interest rates, on the completion of which higher rates kick in. As a result, the share of such sub-prime loans in all mortgages rose sharply. Estimates vary, but according to one by Inside Mortgage Finance quoted by the New York Times, sub-prime loans touched US$600 billion in 2006, or 20% of the total as compared with just 5% in 2001.

The increase in this type of credit occurred because of the complex nature of current-day finance that allows an array of agents to earn lucrative returns even while transferring the risk associated with the investments that offer those returns. Mortgage brokers seek out and find willing borrowers for a fee, taking on excess risk in search of volumes. Mortgage lenders finance these mortgages not with the intention of garnering the interest and amortisation flows associated with such lending, but because they can sell these mortgages to Wall Street banks.

The Wall Street banks buy these mortgages because they can bundle assets with varying returns to create securities or collateralised debt obligations, involving tranches with differing probabilities of default and differential protection against losses. They charge hefty fees for structuring these products and valuing them with complex mathematical models, before selling them to a range of investors such as banks, mutual funds, pension funds and insurance companies. These entities in turn can then create a portfolio involving varying degrees of risk and different streams of future cash flows linked to the original mortgage. To boot, there are firms like the unregulated hedge funds which make speculative investments in derivatives of various kinds in search of high returns for their high-net-worth investors. Needless to say, institutions at every level are not fully rid of risks but those risks are shared and rest in large measure with the final investors in the chain.

Turning Illiquid

This structure is relatively stable so long as defaults are a small proportion of the total. But as the share of sub-prime mortgages in the total rises and the proportion of defaults increases, the bottom of the barrel gives and all assets turn illiquid. Rising foreclosures affect property prices and saleability adversely as foreclosed assets are put up for sale at a time when credit is squeezed because lenders turn wary. And securities built on these mortgages turn illiquid because there are few buyers for assets whose values are opaque since there is no ready market for them. The net result is a situation of a kind where a leading Wall Street bank like Bear Stearns has to declare that investments in two funds it created linked to mortgage-backed securities were worthless. The investors themselves have to sell off other assets to rebalance their portfolios, sending ripples into markets such as those in developing countries that have little to do with the US sub-prime market.

The problem is not restricted to the Wall Street banks. For example, in early August, the French bank BNP Paribas suspended withdrawals from three of its funds exposed to the mortgage-backed securities market. The bank reportedly attributed its decision to ‘the complete evaporation of liquidity in certain market segments’, which constrained it from meeting withdrawal demands that could have turned into a run on the fund. Other cases included that of Dusseldorf-based IKB bank, which through offshore front company Rhineland Funding had invested as much as $17.5 billion in asset-backed securities. As the value of its assets fell, Rhineland had to call on a _12 billion line of credit that it had negotiated with a group of banks, including Deutsche Bank, besides IKB itself. Deutsche Bank decided to opt out of its promise to lend, resulting in the discovery that the fund had suffered huge losses and needed a bailout led by state-owned KfW. A similar plight reportedly afflicts a number of German Landesbanks as well. In sum, the effects of the sub-prime crisis are weakening distant segments of the global financial system, as a result of financial entanglement.

Entanglement also makes nonsense of the theory that a complex financial system with multiple institutions, securitisation, proliferating instruments and global reach is safer because of the fact that it spreads risk. This was illustrated by the example of IKB referred to above. Banks wanting to reduce the risk they carry, resort to securitisation to transfer this risk. But institutions created by the banks themselves, linked to them in today’s more universalised banking system or leveraged with bank finance, often buy these instruments created to transfer risk. In the event, as The Economist (11 August 2007) recently put it, ‘banks (that) have shown risk out of the front door by selling loans, only... let it return through the back door.’ This, it notes, is what exactly transpires in the relationship between the three major prime broking firms – Goldman Sachs, Morgan Stanley and Bear Stearns – that offer prime broking services, including loans, to highly leveraged institutions like hedge funds. The bailout of Long Term Capital Management in 1998 was necessitated because of entanglement of this kind involving all the leading merchant banks.

Investments by banks, pension funds and mutual funds are driven by the search for high and quick returns in a world of excess liquidity. In deciding to make investments on structured products intermediated at different levels, these institutions, ill-equipped to judge the true value and riskiness of these assets, rely on rating agencies. But these ratings have turned out to be unreliable and pro-cyclical, serving as erroneous and belatedly corrected signals. Noting that ‘in a matter of weeks thousands of portions of sub-prime debt issued as recently as 2005 and 2006 have had their ratings slashed’, The Economist (11 August 2007) argued that investors should not have trusted the original ratings because ‘the rating agencies were earning huge fees for providing favourable judgments’. What is more, even when there is no deception involved, rating agencies themselves are not equipped to assess these products and rely on information and models provided by the creators of the products themselves. Once an asset is rated there is much reluctance to downgrade it, because it would raise doubts about related ratings as well as trigger a sell-off that affects prices of related securities that may warrant further downgrades.

Emerging Market Exposure

The problem is that if these factors result in the accumulation of doubtful assets by investors such as banks, pension funds and mutual funds, any downturn spreads the effects into markets where these institutions have made unrelated investments. In fact, institutions overexposed to complex structured products whose valuation is difficult are saddled with relatively illiquid assets. If any development leads to liquidity problems they are forced to sell off their most liquid assets such as shares bought in booming emerging markets. The effect that this can have on those markets would be all the greater the larger is the exposure of these institutions in these markets.

Unfortunately this is precisely what has been happening in most emerging markets including those in Asia. There has been an acceleration of financial flows to developing countries during recent years when as a group they have been characterised by rising surpluses on their current account. Net private debt and equity flows to developing countries rose from a little less than $170 billion in 2002 to close to $647 billion in 2006, an almost four-fold increase over a four-year period. While net private equity flows, which rose from $163 billion to $419 billion, dominated the surge, net private debt flows too increased rapidly. Bond issues rose from $10.4 billion to $49.3 billion and borrowing from international banks from $2.3 billion to a huge $112.2 billion. And, net short-term debt, outflows of which tend to trigger financial crises, rose from around $0.5 billion in 2002 to $72 billion in 2006.

What is more, there is a high degree of concentration of these flows to developing countries, implying excess exposure in a few countries.  Ten countries (out of 135) accounted for 60% of all borrowing during 2002-04, and that proportion has risen subsequently to touch three-fourths in 2006. In the portfolio equity market, flows to developing countries were directed at acquiring a share in equity either through the secondary market or by buying into initial public offers (IPOs). IPOs dominated in 2006, accounting for $53 billion of the $96 billion inflow. But here too there were signs of concentration. Four of the 10 largest IPOs were by Chinese companies, accounting for two-thirds of total IPO value. Another three of those 10 were by Russian companies, accounting for an additional 22% of IPO value.

Despite this rapid rise in emerging-market exposure, with that exposure being excessively concentrated in a few countries, the market is still overtly optimistic. Ratings upgrades dominate downgrades in the bond market. And bond market spreads are at unusual lows. This optimism indicates that risk assessments are pro-cyclical, underestimating risk when investments are booming, and overestimating risk when markets turn downwards. But two consequences are the herding of investors in developing-country markets and their willingness to invest a larger volume of money in risky, unrated instruments. When liquidity problems arise, even for reasons unrelated to these markets themselves or the countries in which they are located, these investments are quickly unwound precisely because those markets are still liquid, and a collapse of the kind seen in end-July ensues. It hardly bears stating that a collapse that is in the form of a mere ‘correction’ can soon turn into a full-fledged crisis.

There is another reason why such a danger exists. Surges in capital flows to developing countries tend to increase the incentives to invest in these markets. Consider the case of India. Foreign direct investment into India rose sharply between 2005 and 2006 from $6.7 billion to $16.9 billion or by more than $10 billion. Much of this is in the form of new equity inflows, often from private equity firms, that acquire for speculative purposes stock in even unlisted companies that is in excess of 10% of their total share capital. As a result these speculative flows get recorded as foreign direct investment. Moreover, flows defined as portfolio flows (less than 10% of equity) declined only marginally from $12.2 to $10.6 billion.

Another change in recent times seems to be a huge increase in commercial borrowing by private-sector firms. With caps on external commercial borrowing relaxed and interest rates ruling higher in the domestic market, Indian firms seem to be taking the syndicated-loan route to borrow money abroad at relatively lower interest rates to finance their operations, investments and acquisitions. Net medium-term and long-term borrowing increased from $1 billion in 2005 to $13 billion in 2006, or by a huge $12 billion.

A consequence of these flows is excess availability of foreign exchange, since India’s current-account deficit is relatively small because of remittances from overseas workers and exports of software and IT-enabled services. In the event, among the many indicators of India’s post-reform economic success is one that is proving an embarrassment: swelling foreign-exchange reserves. Over the year ending 4 May 2007, these reserves rose by close to $42 billion to touch $204 billion. Two-thirds of this 26% increase in reserves occurred over the first four months of this year.

This galloping rise in reserve levels reflects the effort being made by the Reserve Bank of India (RBI) - India’s central bank - to mop up the large inflow of foreign exchange into the country. By filling the gap between the demand for foreign exchange and its availability within the country, the central bank has in the past ensured a degree of stability of the rupee.

However, more recently the rupee has been gaining in strength, despite the RBI’s efforts as reflected in the sharp increase in reserves. This occurs not because the RBI has not made an effort to prevent such appreciation. The RBI has indeed been intervening vigorously in foreign-exchange markets, resulting in a sharp increase in the reserve of foreign-exchange assets it holds. The problem seems to be that the inflow of foreign exchange into India has been so massive that it has not been matched by even this enhanced intervention by the central bank, resulting in an excess supply of foreign currencies and a consequent appreciation of the rupee.

Rupee appreciation incentivises foreign investment, inasmuch as investors not merely benefit from the high rupee returns available in India’s hitherto booming stock market, but gain in dollar terms because of rupee appreciation, if such appreciation persists till they sell their assets and convert their rupee receipts into foreign exchange for repatriation. This encourages carry trades by speculative investors who borrow in markets characterised by depreciating currencies and invest in markets with appreciating currencies in search of high returns. Conventionally, it was argued that anomalies of this kind would be self-correcting. A country with an appreciating currency would experience a widening of its current-account deficit, increasing the risk of investing in that currency. But in a world where excess liquidity and the proliferation of speculative investors has reduced risk aversion, these corrections do not come soon enough and can be dramatic when they do. There are many examples of this, including, in particular, crisis-prone Turkey.

High Risk

There are a number of implications of these tendencies that have at their core the phenomenon of financial entanglement. To start with, the risk associated with the current surge in capital flows to developing countries can be and is much greater than was true during previous episodes involving a similar surge. Moreover, the surge is accompanied by the growing acquisition of assets in developing countries outside the stock market with objectives that are largely speculative, so that a sell-off, if it occurs, would be far more widespread. And the persistence of the herd instinct has meant that the surge in fixed and portfolio investment flows has resulted in a revival of credit flows that is unbridled since it is accompanied by risk-mitigation techniques that transfer risk to those who are least equipped to assess them. Unfortunately, all of this occurs in an environment in which the target of both investment and debt flows is the private sector, which makes it difficult for governments that have liberalised financial regulation to control such flows.

One consequence of this large and concentrated flow of capital is that when assets have to be retrenched by financial firms because of developments in any component of their portfolio, a few emerging markets can become the sites of that sell-off. This partly explains why stock exchanges in emerging markets have turned bearish and volatile in recent weeks, primarily because of the ripple effects of the sub-prime mortgage crisis in the US. Investors incurring losses in those markets are reordering their global portfolios to meet immediate commitments, resulting in a sell-off that has global repercussions. This is not because all, or even most, of these investors are directly involved in mortgage financing. Rather, it is because of their investments in assets - derivatives or collateralised debt obligations - linked to sub-prime mortgages.

There are many lessons that are once again being driven home by these developments that are of particular significance for developing countries that are rapidly liberalising their financial systems. First, excess liquidity in a loosely controlled financial system provides the basis for speculative and unsound financial practices, such as excessive sub-prime lending that increases fragility.

Second, such practices are encouraged by the ‘financial innovation’ that liberalisation triggers, which increases the number of layers of intermediation and allows firms to transfer risk. As a result, those who create risky ‘products’ in the first instance are less worried about the risk involved than they should be.

Third, as the product moves up the financial chain, investors are less sure about the risk and value of these products than they should be, rendering even low-risk, first-stage tranches prone to value loss. Fourth, this inadequate knowledge appears to be true even of the rating agencies on whose ratings investors rely, resulting in erroneous ratings and belated rating downgrades. This implies that as and when a rating downgrade does occur, the asset turns worthless, since there is nobody willing to buy into the asset.

Fifth, new forms of self-regulation appear to be poor substitutes for more rigorous control, since the current crisis originates in a country whose financial sector is considered the most sophisticated, well regulated and transparent and serves as a model for others reforming their financial sectors. And finally, financial globalisation and entanglement imply that countries that have more open and integrated financial systems are prone to contagion effects, even if the virus originates in remote locations and markets. These are lessons that must inform policy in these so-called emerging markets.

CP Chandrasekhar is a Professor at the Centre for Economic Studies and Planning, Jawaharlal Nehru University, New Delhi.