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The micro origins

By Andrew Sheng (chinadaily.com.cn)
Updated: 2008-11-17 10:27

Special Coverage Exclusive: An Asian view of the global financial crisis

Contents:  Preface  A historical inflexion point  The macro question  The micro origins  Lessons for China and Asia  Back to basics  One world, three paths  Status quo  The rise of regional markets  Romance of the three regions  Conclusion

The above macro-economic question is crucial to understanding the current world financial crisis, because it was the ability to finance external deficits that was the basis for the emergence of the current "originate to distribute" structure of the US banking system.

In other words, the US and European banking system evolved from the traditional retail banking model (accept deposit and lend) to the new wholesale banking model, because they were no longer constrained by limited domestic savings, but could draw upon global savings through the securitization channel.

Unlike the 1997/98 Asian crisis, which was essentially a traditional retail banking crisis together with a currency crisis, the present crisis was truly a wholesale banking crisis with huge derivative amplification effects.

Because the Asian crisis was still a crisis at the periphery, its network effect was limited. But the present crisis is a crisis at the center of global finance and its amplification effect that covered the two dominant powers of US and Europe was therefore significantly larger and deeper.

To understand how the micro fused with the macro environment to create the crisis, we need to understand what the financial engineers did with the derivatives, coupled with what the Western financial regulators allowed them to do.

As indicated earlier, excessive loose monetary policy, low interest rates and carry trades made speculation and "search for yield" the driving motivation for financial innovation. Improvements in telecommunications and computing power had given dynamic trading using real-time information superior advantage over the conservative "buy and hold" retail investors and pension funds.

Hedge funds and investment banks could trade at speed and arbitrage price differentials across markets and products. To satisfy the "search for yield", new securitized products evolved to suit investor tastes.

Four elements of financial innovation and deregulation came together to create the toxic products that were at the root of the current crisis. The first was plain vanilla mortgages that were securitized into mortgage-backed papers by government mortgage institutions such as Fannie Mae and Freddie Mac.

Securitization meant that assets could be moved off-balance sheet into unregulated special investment vehicles (SIVs) that did not require capital. The second was that accounting and regulatory standards permitted such potential liabilities to be moved off the balance sheet so that the banks benefited from "capital efficiency", meaning that leverage could increase using the same level of capital.

The third was the use of insurance companies and the newly evolved credit default swap (CDS) markets to enhance credit quality of the underlying paper. If the underlying assets looked weak, the purchase of credit default swaps sold by triple A insurers such as AIG enhanced their credit quality. The fourth sweetener was the willingness of the credit rating agencies to give these structured products AAA ratings, for a fee.

By slicing the traditional mortgages into different tranches of credit quality, collateralizing each tranche with various guarantees or assets, the financial engineers 'structured' collateralized debt obligations (CDOs) that felt and smelt like very safe AAA products with higher yields than boring government treasury bonds.

What investors did not realize that these products carried embedded leverage that could unravel under certain circumstances. By taking origination fees up front, investment banks, rating agencies and mortgage originators made huge profits without anyone regulating the origination process.

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