What Triggers a Financial Crisis?

To get at the background of the US (and currently the global) financial crisis one needs to address the following two major issues: First, the prevalence of high stakes in the financial markets under uncertainty with risks involved in holding assets often disproportionately high as compared to their realised returns. Such transactions have been identified in the literature as Minskian 'ponzi' deals, which, as was pointed out by the post-Keynesian economist, Hyman Minsky in 1986 (1), are both unsustainable and hazardous as compared to acts of simple hedging or even speculation on asset prices in markets.

With ponzi finance, the high returns as are offered to entice the new investors to lend and invest are often not realised in the market by the borrower. To avoid an impending default and an interruption of business, it is not only necessary for new investments as above to continue but also these need to be adequate to compensate the losses as are incurred on previous investments. However, as confidence on these assets is gradually eroded, these transactions come to a grinding halt, leading to big holes in the balance-sheets of the concerned parties. The pattern with ponzi finance as above is very different from hedge finance which to some extent keeps the system going as long as hedging offsets the losses against possible gains. Even speculatory finance, which dwells on more risk than under hedging, can be sustained until it becomes ponzi, when borrowings at high rates no longer generates equivalent returns, a situation which is currently on in the US financial markets.

The second factor which contributed to trigger the recent financial crisis relates to financial innovations in de-regulated financial markets. By generating derivative instruments which aimed to protect asset values in uncertain markets, derivatives also made it possible to invest and acquire assets much more easily. Thus, with 'futures', a typical derivative product which arranges a contract towards the sale and purchase of an asset in some future date, the deal can work to the convenience of both the buyers and sellers involved by insuring against the uncertainties in the market, while dispensing with cash transactions at the time of the contract. Thus the buyer contracting a 'long' (buying) position deposits only a fraction of the contracted price as 'margin', with the exchange trading organisation (usually a security exchange). Innovations and instruments as above in the financial sector have opened up vast potentials for expanding financial market transactions which are no more constrained by availabilities of bank credit. However, transactions as above and the agents involved can remain in business as long as the hedging works to minimise the risk under uncertainty and the risk-adjusted returns offered to those with long (buy) positions are realised by those who hold the short (sell) positions on assets. These may not materialise in a typical 'ponzi' situation, as described above.

It now remains to be seen as to how aspects as above are handled in mainstream theory and policy with its advocacy for wide-ranging de-regulations in financial markets. By postulating rational expectations and access to full information for all agents in the market, uncertainty, in terms of these theories, does not get in the way of achieving efficiency when markets are left free. Accordingly, speculation under uncertainty is reduced to arbitrage (in point of space) and hedging (in point of time) and the market is supposed to take care of uncertainty-related concerns by using financial derivatives. From this angle financial markets perform the best when there is no restraint on trading, both in spot markets and in those for derivatives. In case lenders are wary of potential defaults by borrowers which may be due to incomplete or asymmetric information in the market, they resort to credit rationing, as held in the literature. But both borrowers as well as lenders are still viewed as rational beings who decide feely on their lending or borrowing activities in the market.(2) Positions as above, emanating from advanced countries, have continued to dominate policies in financial markets and the financial institutions.

However, the magnitude and the intensity of the latest happenings in the USA and elsewhere seem to have jolted a bit the entrenched positions held by the establishment with efforts to bend the standard rules of monetarism and free markets under capitalism. Otherwise how can one interpret the huge bailout packages from the state in a country (or countries) which always have been strong advocates of free-market capitalism?

Financial Markets - What All have gone Wrong in US Financial Markets?

Back in the 1970s, the US economy was subjected to an unprecedented wave of credit squeeze as the Fed Chairman, Alan Greenspan, launched a series of monetarist strategies to contain inflation. Reacting to above, financial innovations led the way to credit creation beyond the usual banking orbits. Thus a large number of US firms started having access to short-term credit by using, as collaterals, securitised assets like commercial papers.(3) As the wave of securitisation (of assets) caught on, new forms of financial intermediation were provided by investment banks which lent their expertise in re-packaging the securities which were now marketed easily and sold to other banks or non-bank financial units that included the investment banks as well. Since these transactions were outside the orbit of conventional banking channels, the Fed had no regulatory power over these. Instead, these were subject to the jurisdictions of the US Securities and Exchange Commission (SEC). One witnessed, as a consequence, a 50% decline in the proportion of US financial assets as were held by banks between 1950 and 1990. Credit and transactions related to securities were made easy along the non-banking channels, with rates charged at much lower spreads as compared to those along conventional banking channels. Transactions as above facilitated the churning of multiple asset-backed securities (ABS). These were generated on the basis of the original (or underlying) asset, propping up multiple counterparties which held those assets. Leveraging played a major role in the creation of these debt financed assets, which continued as long as there was trust and confidence in the uncertain markets on these newly created financial assets.

Mortgages on property opened up new profit opportunities in the financial sector, by creating a market which targeted the section of US citizens who had so far been financially excluded on grounds of race and/or income, while banks followed credit-rationing which ruled out such loans.(4) Possibilities to securitise the mortgaged assets opened up new channels of investments, for the broker-mortgage firms, the issuers and insurers of asset based securities (ABS), investment banks who readily purchased and repackaged the ABS, and other financial institutions. Each, by acquiring an asset, were able to leverage by obtaining credit against the latter.

As the process continued, a large number of people with low incomes were now endowed with a mortgaged property and a liability to pay monthly instalments, usually to the broker mortgager-cum-bank who organised the deal. These assets were backed by loans which later were discovered as 'sub-prime', with the mortgaged collaterals subject to valuation in a sliding market and with little accountability of the borrowing parties, many of whom were not even bankable in terms of conventional practices. The initial euphoria, fed by the rising property prices on the one hand and the eagerness on part of the financial community to profit by using the securitisation route which temporarily shifted the risk to counterparties, did work as long as the former lasted. The business, as led by investment banks, as mentioned earlier, was outside the purview of the Fed, and the SEC did not find any reason to interfere.

To follow the sequence that led to the recent sub-prime crisis of the US we provide below a rough sketch of the possible links in the system:

Sunanda Sen is a prominent economist from India, who has extensively worked on issues in development, economic history, international trade and finance. She was a professor at the Centre for Economic Studies and Planning at the Jawaharlal Nehru University (1973 to 2000). She is currently a visiting professor at the Academy of Third World Studies, Jamia Millia Islamia, New Delhi. She is also associated with the Institute for Studies in Industrial Development, New Delhi. Her recent works include, Colonies and the Empire: India, 1890-1914 (Calcutta: Orient Longman, 1992), Financial Fragility, Debt and Economic Reforms (London: Macmillan, 1996), Finance and Development: R C Dutt Lectures in Political Economy (Calcutta: Orient Longman, 1998), Trade and Dependence: Essays on the Indian Economy (Delhi: Sage India, 2000), Global Finance at Risk: On Real Stagnation and Instability (London: Palgrave-Macmillan Publishers, 2003) and Globalisation and Development (Delhi: National Book Trust, 2007).

Notes:

(1) Hyman P Minsky, Stabilizing an Unstable Economy, Yale University Press, New Haven (1986).

(2) See for an elaboration, Sunanda Sen, Global Finance at Risk: On Real Stagnation and Instability, Palgrave Macmillan (2003) and Oxford University Press (2004).

(3) L. Randall Wray, "Financial Markets Meltdown: What can we learn from Minsky?", Public Policy Brief No 94, The Levy Economics Institute of Bard College (2008).

(4) Gary Dymski, "Financial Risk and Governance in the Neoliberal Area", University of California Center Sacramento, mimeo (2008).

(5) See for details, Sunanda Sen, "De-regulated Finance and the Indian Economy", in Alternative Economic Survey, India 2007-2008: Decline of the Developmental State, Daanish Books (2008).

(6) Ibid.

(7) This aspect has been discussed in Sunanda Sen, "Labour in De-regulated Financial Markets", in Philip Arestis and Luiz DePaula (ed) Global finance and Emerging Markets,  Elgar (2008).

(8) Berkshire Hathaway 2002 Annual Report, p. 15.

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