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Víctor Isidro Luna.

On the financial crisis

by Víctor Isidro Luna.

26 November 2008

On the financial crisis .
Interview a Dr. Cihan Bilginson .
By Victor Isidro.

Victor Isidro: 1) I think since even more than a year ago some economists were discussing a possible crisis, but for the majority I think it is something new or surprising?

Dr. Cihan Bilginsoy: In retrospect, it is obviously not a surprise, after Bear Stearns’ failure back in March. Starting from that point on, the financial markets were in a decline, but politically this did not attract any attention. I don’ t think politicians were willing to talk about either because talking about it would raise the question of regulation, and given the political atmosphere back then I don’ t think any politician was willing to raise the question. They talked about the problems of Fannie Mae, for instance, but this was in obtuse terms, the people in the street not heard it. The more important thing Ithink is that real economy had not been greatly effected by the crisis at that time., Since there was not a sharp increasing in unempleyoment and the life of the people was not effected, people in the street didn’t pay much attention either. People on Wall Street they knew what was going on and I don’t think that it was a surprise for them but I don’t think they knew what to do about it, it was beyond their control. So they were in the state of denial.

Victor Isidro: But since a year ago, for example liquidity has been incresing in United States and in Europe, so they knew about it.

Dr. Cihan Bilginsoy: Yes, the Federal Reserve reduced the Federal Fund Rate in surprising ways over a weekend. It reduced the Federal Fund Rate by 0.75. I think it was unprecedented, there was something wrong going on. It was not followed by the Europeans. The European central Bank did not reduce the interest rate, so it was not commonly accepted accross the central banks the need for incresing liquidity., But even then Bernanke was talking about the issue of inflation, the European Central Bank was talking about the issue of inflation, so they were talking about inflation being a problem and they were no willing to act in a bold fashion.

Victor Isidro: What is in your opinion the source of this crisis?

Dr. Cihan Bilginsoy: Deregulation and market ideology which started back in in 1980s and continued until now.

Victor Isidro: There were changes in the way to concede credits in the United States and other European countries over the last 30 years. As the IMF says “...Until the 1980s, mortgage markets in general were highly regulated...” Why did these chages happen and what was the role played for the financial instituions?

Dr. Cihan Bilginsoy: After the 1930s’ depression a new regulatory system was introduced, Glass-Steagall Act in 1933. There were two kinds of banks, commercials banks and investments banks. Commercial banks generated loans for retail customers, households, small bussinesses, etc., They collected deposits and retail made loans. They were strictly regulated by the Federal Reserve., So Federal Reserve kept a close eye on how prudently these banks were behaving, if they have sufficient capital, sufficient reserves, etc,.

On the other side, we have investment banks and these make money by advising companies on mergers on loans and collecting fees, and underwriting initial public offerings when companies went public. That was the source and they were regulated very lightly by the Securities and Exchange Commission. Once we come back to 1970s, commercial banks were complaining about strict regulation. They were saying thay they could not make enough profits, that they could not be competitive because their action were stritctly regulated by the Federal Reserve,.

At the same time in Europe there was no such distinction between commercial and investments banks, so what was heard from the finacial circles in the US was that they cannot compete with the europen banks. So they wanted banks to be deregulated so they could make more loans. That is the situation at the beginning of 1980s, but some other things hapenned in 1980s.

First, there was Ronald Reagan and Margaret Tatcher in the US and England respectively and they came with free market platforms and they started to argue that regulation inhibits econonomic grow., During the 1970s stagflation had made people skeptical about the intervention of governments in macroeconomics, so people were receptive to this idea of free markets.

At the same time within the economics profession the idea of efficient markets gained more strength., Efficient markets, rational expectations, and the drift to the economic profession to the rigth, towards the free markets system created the ideological framework to make the free market argument. The effiecient market hypothesis essensially states that is not necessary to regulate the financial markets, because the financial markets are going to regualte themselves. Lenders (banks) are not going to make excessively risky loans because if they make excessive risky loans they will be asking for a higher interest rate (in order to be cover for the risk), so the borrower is going to be less willing to borrow. So the price mechanism, in this case the interest rate, is going to ensure that loans are not going to be excessively risky. The other side of the coin is that efficient market hypothesis also states is that if you regulate the financial markets the outcome would be sub -optimal., The interest rate mechanism is going to bring together people who are willing to borrow at a high interest rate and people that are willing to lend. If markets works in these fashion then there is no need for regulation, furthermore regulation distorts the markets, inhibits the growth of markets.

The important point is the following, efficient market hypothesis would work - the interest rate mechanism would work - if lenders know the riskiness of the projects., In other words according to the efficient markets hypothesis lenders know the expected yield of loans and also know the varience of returns., They know the probability distribution of returns.In other words there must be information, on the riskiness of assets. What happened was in 1980s and 1990s gradually, regulation on commercial banks were removed, and as they were removed commercial banks found other ways of making loans. One specific thing that they did is the following. They started collecting these mortgage loans and securitizing them. They started to issue bonds against these mortgages and they started selling these bonds (mortgages backed bonds) in the market. These are the bonds that started to be sold in Wall Street and there were a lot of buyers for these bonds across the world. These bonds were attractive for these buyers because they were mortgage backed and the USA’s home price was continuing to rise. People who were buying these bonds said these bonds cannot fail because home prices in the USA are rising. The peculiar thing about these bonds is that when banks created these bonds they put all kind the mortgages together (risky mortages, less risky mortgages, big or small mortagages whatever). No one was able to see how risky these bonds were. Furthermore when they sold these mortgages they started cutting and slicing them. They were able to sell the risky part of the mortgage package to some one and less risky part to some one else,. For instance, some body wants to buy a bond, that is linked to the principal component of the mortgage, someone else wants to buy a bond linked to the interest component of the mortgage. Banks were not only putting thousands of mortgage together but they were selling each slice of mortgage at different interest rates to different people . What this created was extreme opacity, no one was able to see what is in these packages, how risky these packages are., Remember that in order for efficient market hypothesis to work you need to know the probability distribution of returns., In this case no one was able to se the probability distribution. In the mid - time these mortgages became increasingly more risky because as home prices continued to rise, mortgages lenders were making irresponsible mortgage loans. They were selling a million dollar home to somebody who has a hundred thousand dollar income, to someone that is not going able to pay this mortgage. They didn’t care about this because they were collecting their fees and selling the mortgage to some one else. There were pervasive incentives in the system that created more and more risky mortgages.

Victor Isidro: What did hapenned to the borrower? I don’ t know well the case of the USA but in Spain for example people got two or three mortgages, not to buy a house in order to live but to be richer?

Dr. Cihan Bilginsoy: The same thing happened in the US as well. People took second and third mortgages on the same house and with those mortgages they were able to go undertake home renovation, to take cruises, to enjoy a higher standard of living on borrowed money. They believed as long as housing prices increased they would be able to pay these mortgages. This continued until 2006, after 2006 home’s prices started coming down in the USA.
One key point is that, interest rate was also very low and that was another incentive for people to go ahead and borrow funds.

Victor Isidro: What are the social and economic implications of this situation?

Dr. Cihan Bilginsoy: Economic implication is that you are facing the greatest threat since the Great depression, the whole financial system may experience a total meltdown and there could be a huge run on the banks. That is the biggest danger. Whether if it happens or not, there will be a deep recession, that is for sure., Unemployment rate is going to be at the highest level since the great depression., The highest has been in 1982’s recession (around ten percent) and probably we are going to exceed that figure. The problem in the financial markets today is the following, it is not a liquidity crisis it is solvency crisis. These banks made those bad loans (packaged mortgages), but these loans are not limited to mortgage loans., These loans are also made on commercial property, credit cards, auto loans., All kind of loans are packaged and sold in the same fashion., In that sense the typical mortgage loan the is the tip of the iceberg., Now each bank knows that other banks made these loans and also knows that they may not able to collect these back., They don’ t know who is going to survive and who is going to fail in this crisis. If that is the case, .if one company doesn’t know if other company is solvent or not, do you think that they will make a loan at that company? They won’t. Bank A is not going to make any loan to bank B or corporation X, becasuse they do not know who is going to survive.

Victor Isidro: Is it true that only big banks are going to survive, the same is going to happen with big companies?

Dr. Cihan Bilginsoy: That is not necessary true, Wachovia was a big bank., At this point I do not think any bank is safe. Some of the bigesst banks made these loans. Probably it is true that bigger banks are safer than smaller banks but what matters is that if ratio of the capital of the bank relative to the toxic waste that it has in its balance sheet., It depends on how much risk it has been undertaken.

Victor Isidro: After the World war II a new finalcial system was set, even World Bank and IMF was the result of that, Now do you consider we need a new one, under what basis should it be founded?

Dr. Cihan Bilginsoy: There must be a new financial system coming after all of this. First, before the Second World War the Internationally Monetary System collapsed, because gold standar did not work. The Bretton Woods system was created. It broke down in 1970s as well and another financial sytem came. Obviously in this current situation the system has collapsed, domestically and on the internationally scale as well., What is going to replace it we don’t know yet. Nobody knows yet. At this point what all people are trying to figure out is how to overcome this crisis, with the less damage, so what we have now is not a creation of a new arquitecture. But when a new system is created regulation is going to be a big part of it, this move towards free markets and deregulated financial markets will come to an end

Victor Isidro: Considerer a new financial arquitecture, what will be the role played for the underdevolep countries? For example it is said that countries like China and Brazil now have a good situation due to the quantity of their reserves and the price of the raw material?

Dr. Cihan Bilginsoy: In the case of China the reserves have been higher for a long time., What is important from derveloping countries perspective is the unregulated inflow and outflow of hot money, and liberalization of their financial markets. If less develop countries become more and more open to hot money flows from the first world they are going to be hit badly by the crisis. International capital is a big player in the stock markets of some developing countries. As soon as a crisis hits, this money will move out, and thus you will see the collapse in many stock markets in China, in Brazil, in Turkey. They will not be able to get any loans any more, so countries that used to live from international borrowing they cannot borrow any more. They are in difficult situation, especially if they need short term loans. I don’t know if they are in a better position now.

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