This article aims at providing a simple explanation of what’s happening to international finance for those unfamiliar with finance and economics
Let’s start by saying that the American economy has been on the verge of recession for several years. This fact was kept hidden for a long time, but now it has exploded like a bomb and obviously in a single, globalized world market it also involves the economies of other nations.
The origins of this crisis go all the way back to 2001, when the American system was forced to reckon with the end of enthusiasm for the so-called new internet-based economy (otherwise known as the dot.com bubble). To tackle the difficulties encountered by web operators after the fall of their expected future incomes the Bush administration took a number of steps.
First it acted on the currencies market, so that the greenback depreciated with respect to other currencies. This partly explains the exceptional quotation reached by the “supereuro”. The aim was to add requests from Europe to the weak internal demand and thus to fuel US exports.
Then the American government implemented a strong tax cut (which actually favored only the richest part of the population) in an attempt to raise the economy from the recession it had sunken into (as we have already said) following the fall of the New Economy.
More difficulties arose after the terrorist attacks of September 11. Indeed, following the political decisions made by the administration, the US became involved in various military scenarios. Subsequently a war economy prevailed which, by definition, is an economy of full employment. It has, in fact, been suggested that the decision to declare war on Iraq, in which a large part of the army contingent was deployed, was one of the measures undertaken by the administration to extricate the American system from the economic crisis. However, the fact that the economy does not seem to have benefited from the large commissions originating from the military presence abroad (both Iraq and Afghanistan) certainly does not support this position.
The policy of the Bush administration that should have had the greatest impact on the American production system was the lax monetary policy, which was adopted based on the advice of Alan Greenspan who headed the Federal Reserve at that time, aimed at reducing nominal interest rates. This was, in fact, the only way to sustain employment and growth in the US.
This decision produced results in that Americans experienced a period of very low nominal interest rates (in fact, in 2003 they were at 1%). However, this policy only postponed the inevitable. This brings us to the events of this summer for which the former chief of the FED, Alan Greenspan, until recently regarded as one of the leading experts in the field of monetary policy, is largely to blame.
Joseph E. Stiglitz, Nobel Prize winner for economics and professor at Columbia University, pointed out that the monetary policy developed by Greenspan worked differently from what was predicted by the scholastic model. Instead of stimulating firms to borrow more in order to increase investments, decreasing interest rates induced families to take on very large debts (or to restructure previous debts) with adjustable-rate mortgagees, which actually led to an increase in consumption and thus economic growth.
Furthermore, in a situation characterized by decreasing interest rates it was in the interest of the banks to encourage people to take on these mortgagees, among other things by reducing solvency parameters and offering new retail products, which actually financed close to 100% of the value of houses.
This type of market led to the subprime boom, the so-called B series loans that were offered to less well-to-do clients, which had no guarantees and thus constituted a risky asset for banks.
However, the mechanism functioned only until interest rates hit the bottom and began to rise. In the mean time the price of real estate continued to increase more than proportionally with respect to the rising cost of the mortgages for their acquisition. At this time, the borrowers who had gullibly accepted the variability of interest rates in order to obtain very favorable initial terms (which is why this type of financing is called a “teaser” in the USA) realized that they were unable to make their mortgage payments because the latter had increased excessively with respect to the initial amount borrowed.
Very simply, this is what has been happening in recent months and is why those working in the financial markets have been holding their breath. What is surprising in this series of events is that they could have been foreseen, yet nothing was done to prevent them. It was evident that once the interest rates reached the minimum they would rise and it was also evident that the families who had taken on mortgage debts would have serious difficulties finding the money to pay the ever-increasing rates. This, in fact, was Greenspan’s big error. He continued to exhort American families to take out mortgages “with adjustable rather than fixed rates” as if he expected interest rates would always remain at 1%. Nevertheless, the debacle of the American subprime mortgages cannot entirely explain the financial catastrophe experienced by stock markets around the world.
According to a reliable estimate, subprimes are only worth 10% of the American loan market and because the feeling is that the credit difficulties are not limited to the subprime sector, further considerations are needed to explain why the crisis triggered by the mortgages moved horizontally across the entire panorama of world finance. In other words, why is everyone is talking about a generalized crisis of the financial sector when this crisis should have actually been limited to mortgage holders who were unable to reimburse their loans and to credit institutions which, due to superficial lending, do not have sufficient assets to foreclose in order to recuperate the initial nominal value of their credit?
The link between the American mortgage market, the poorest families and the large international financial organizations can be found in the typical functioning of derived finance, which tends to transform any instrument that becomes available into a credit security. In this way, many credit institutions that had subprimes in their portfolios transformed them into securities, which they then sold on the market.
These new financial instruments, called “Asset Locked Securities”, are characterized by a patrimonial guarantee: they are freely offered on the market, but without any guarantee of reimbursement because they essentially depend on the regular payment of the original subprime mortgage they derive from (which is why they are called “derivatives”).
Nevertheless, it doesn’t end here because these derived securities undergo a further regrouping with other asset guaranteed securities; the latter originate from ordinary commercial transactions and from real obligations, thus becoming CDO’s (Collateralized Debt Obligations) or in technical jargon, “sausage securities”.
Like all derivatives, they have a life of their own and therefore are acquired as such not only by hedge funds (speculative funds) limited to institutional investors, but also by multinationals and various types of institutions that wish to diversify their financial investments. The problem is that after all the transfers described above, the contents, the consequences, and the degree of risk of these sausage securities is no longer apparent; indeed, they are covered with a patina of credibility and safety when, instead, the debtor in the last resort remains the bank client without means who bought a house, got himself up to his neck in debts, without adequate availability of capital.
It is precisely this passage from the American subprimes to the international financial markets that has alarmed economists and governments around the world; indeed, the major central banks have decided, without precedent, to simultaneously lower reference interest rates by a half percentage point. Legislative measures were also adopted by almost all countries, including Italy, to protect savings and bank deposits from any defaults by the credit institutions.
The word that most clearly describes the world economy today is “infection”. The illness originated in a specific part of the body (the particular behaviour of mortgages in the United States) and then, little by little, it infected other parts of the body (countries and economic sectors) very far away but also linked to and functioning in a unique organism (the international financial system). Now antibiotics are being injected (liquidity and lower interest rates) to cure the various organs infected and, as in the field of medicine, we have to wait until the illness takes its course and the treatments have their effect. We can only hope that this happens as soon as possible.
According to the analysts, the crisis will last at least until mid-2009; the turning point will, in fact, be reached only at the end of that year. In any case, it is the Government’s responsibility to adopt economic policies aimed at strongly supporting consumption and investments in order to avoid entering into a deep recession.