CREDIT PROBLEMS IN THE FINANCIAL MARKETS

Recent Credit Problems in the Financial Markets

Recent Credit Problems in the Financial Markets

Introduction

It is now clear that the global economy is facing the worst economic and financial credit problems since the Second World War (Datamonitor 2008). We don't know where this credit problems might lead if it is not dealt with quickly and aggressively. We do know, however, what happened to political systems in Europe in the course of the depression in the 1930s. And we know that even the new head of national security in the UK has recently testified to Congress that the security threat from terrorism has been overtaken by the threat posed by the worsening economic situation around the world (Ahamed 2009). Clearly understanding this credit problems and the fundamental risks that it poses, and taking bold action to deal with it, must be the highest priority of the world leaders.

There is now some clarity and broad agreement on the origin of this credit problems. It has its roots:

1. in the 'search for yield' and a weakening of—and lack of understanding of—risk management during the expansion phase of the credit cycle from 2002 to 2006;

2. in the international fragmentation and lack of harmonisation of financial supervision and regulation in the face of rapid innovation in the financial markets—a phenomenon that gave rise to regulatory arbitrage by the global financial institutions; and

3. in weaknesses in certain aspects of surveillance conducted by the IMF.

The credit problems manifested itself initially in the sub-prime mortgage market in the UK, but quickly spread to Europe. It was also evident in the breakdown in the market for credit default swaps—a huge, unregulated and thoroughly opaque market; and in the general collapse of the markets for securitised instruments across the global financial system (Attwood 2008). It was aggravated, most analysts agree, by the initial policy mis-steps in handling the credit problems, including in dealing with the problems at Lehman Brothers, which effectively froze the inter-bank market.

Taking the example of the sub-prime mortgage market:

* Mortgage originators held virtually none of the debt they created; they sold it off as fast as possible after the mortgage was signed and got their fee. As a result, they had little interest in the quality of the credit; they had, as it is said, 'no skin in the game'

* The mortgages were then quickly sold to Wall Street to be bundled with other mortgages into securitised instruments to be sold to investors. Those doing the bundling received their fee and like the originators, had little interest in the quality of the credit. Wall Street profited enormously from this business and quickly developed a voracious appetite for mortgages to slice and dice into more and more exotic instruments, putting further pressure on the originators to deliver more and more mortgages (Brummer 2008).

* The compensation structure in the banks and other institutions was based on the short term payoff to activities such as this. It was divorced from the longer term risks that the ...