Dear readers,
Since the crisis broke out mid 2007 a witch hunt was organized to find the scapegoats who brought us into this. In a discussion like this you always end up with the banks and their financial weapons of mass destruction as Warren Buffet used to call them. It might be wise though to take a step back and leave the emotions aside in this debate. The last thing we want to do is throwing the child with the bath water away.
What most people often forget is that the current crisis goes far beyond the use of derivatives, securitization, CDO’s and Structured Investment Vehicles (SIV’s). The dynamics which created the global imbalances were US consumers who bought goods from Asia and energy from oil exporting countries. The best way to illustrate this trend is by referring to the evolution of the trade balance of the US.
Chart 1 : US Trade Balance : 1968 - 2008
Since the crisis broke out mid 2007 a witch hunt was organized to find the scapegoats who brought us into this. In a discussion like this you always end up with the banks and their financial weapons of mass destruction as Warren Buffet used to call them. It might be wise though to take a step back and leave the emotions aside in this debate. The last thing we want to do is throwing the child with the bath water away.
What most people often forget is that the current crisis goes far beyond the use of derivatives, securitization, CDO’s and Structured Investment Vehicles (SIV’s). The dynamics which created the global imbalances were US consumers who bought goods from Asia and energy from oil exporting countries. The best way to illustrate this trend is by referring to the evolution of the trade balance of the US.
Chart 1 : US Trade Balance : 1968 - 2008
Source : Bloomberg
However, the value of those goods was far much greater then their consumer income. As a result they had to fund this gap with home equity and/or mortgage refinancing. The rising of the US mortgage debt was on its turn repackaged by US investment banks and placed among Asian and oil exporting countries. The major mistake in this model was the assumption of the rating agencies (plus from investors as well) that the value of house assets would never decline, certainly not on a national level (cfr. Newsletter of 5 Dec.)
As with all bubbles is the case, one usually gets an acceleration at the end. This happened when investment banks started their Shadow Banking system, where they decided to set up SIV’s in which they could undertake activities which didn’t need the capital backing which would be required by the regulator if this was applied ‘on balance’ sheet. Under this activity the technique of securitization was (ab)used. For those who are not familiar with this technique, it is best described as bundling a number of individual loans into a reference pool. On its turn one divides this pool up into several tranches of risk. Each investor can pick out a tranche in relation to its risk appetite.
There are two important things to remember though:
this whole process of creating a global imbalance started long before the Shadow Banking System (cfr. Chart 1 : US Trade Balance)
the abuse of a valuable technique called securitization, was driven by pure greed
The question we need to ask: “Does securitization has its benefits and merits?” To answer this we need to look at the journey of globalization and the liberalization of markets over the last 25 years. It goes beyond a doubt that the G-10 countries experienced a remarkable period of rising wealth and falling unemployment during that time. But did globalization contribute to a decline of poverty on a more global scale?
This question was answered by Surjit Bhalla, who used to work for Goldman Sachs and the World Bank. He compared 2 periods, 1950-1980 where the World Bank and other international agencies pumped in billions of dollars of government money in developing countries and the era of globalization starting around the early 1980s. He concluded that poverty even rose during the period of considerable international aid and poverty only started to decline when free trade and liberalization was embraced across the global. This fell together with globalization, when communication, transportation and production costs were considerably reduced.[1]
Also Greenspan came to a similar more intuitive conclusion by arguing that the first who would suffer from a set back of globalization would quite ironically be those in the developing countries.[2] This to the great upset of the anti-globalist movement that is still lingering among left intellectualists.
It is not a coincidence that during the era of globalization we noticed an exponential rise of derivatives products. [3]
However, the value of those goods was far much greater then their consumer income. As a result they had to fund this gap with home equity and/or mortgage refinancing. The rising of the US mortgage debt was on its turn repackaged by US investment banks and placed among Asian and oil exporting countries. The major mistake in this model was the assumption of the rating agencies (plus from investors as well) that the value of house assets would never decline, certainly not on a national level (cfr. Newsletter of 5 Dec.)
As with all bubbles is the case, one usually gets an acceleration at the end. This happened when investment banks started their Shadow Banking system, where they decided to set up SIV’s in which they could undertake activities which didn’t need the capital backing which would be required by the regulator if this was applied ‘on balance’ sheet. Under this activity the technique of securitization was (ab)used. For those who are not familiar with this technique, it is best described as bundling a number of individual loans into a reference pool. On its turn one divides this pool up into several tranches of risk. Each investor can pick out a tranche in relation to its risk appetite.
There are two important things to remember though:
this whole process of creating a global imbalance started long before the Shadow Banking System (cfr. Chart 1 : US Trade Balance)
the abuse of a valuable technique called securitization, was driven by pure greed
The question we need to ask: “Does securitization has its benefits and merits?” To answer this we need to look at the journey of globalization and the liberalization of markets over the last 25 years. It goes beyond a doubt that the G-10 countries experienced a remarkable period of rising wealth and falling unemployment during that time. But did globalization contribute to a decline of poverty on a more global scale?
This question was answered by Surjit Bhalla, who used to work for Goldman Sachs and the World Bank. He compared 2 periods, 1950-1980 where the World Bank and other international agencies pumped in billions of dollars of government money in developing countries and the era of globalization starting around the early 1980s. He concluded that poverty even rose during the period of considerable international aid and poverty only started to decline when free trade and liberalization was embraced across the global. This fell together with globalization, when communication, transportation and production costs were considerably reduced.[1]
Also Greenspan came to a similar more intuitive conclusion by arguing that the first who would suffer from a set back of globalization would quite ironically be those in the developing countries.[2] This to the great upset of the anti-globalist movement that is still lingering among left intellectualists.
It is not a coincidence that during the era of globalization we noticed an exponential rise of derivatives products. [3]
The financial innovation that we knew over the last 25 years was a major contributor to let globalization flourish across the globe. The growth in derivatives reduced barriers and opened up markets to investors who would never been able to enter these initially. Securitization played a major role in this financial innovation process. Due to its characteristics of tranching a pool of loans in different risk categories it enables venture capitalists to participate in funding major projects, and this to the most broadest sense of the word.
A very good example is the securitization programme that Deutsche Bank launched in the microcredit market. Microcredit are very small loans which are extended to the unemployed, and extremely poor who lack collateral or who don’t have a credit history. Microcredit is a financial innovation which originated in Bangladesh where it has successfully enabled extremely impoverished people to engage in self employment projects that allow them to generate an income and, in many cases, begin to build wealth and exit poverty.
By securitizing such a deal Deutsche Bank enabled private and ethical institutional investors to participate in the financing of this and make an effective contribution to the fight against poverty by distributing at least 120,000 very small loans to micro businesses in 15 developing and emerging market countries.
There are many other examples to show that securitization is a valuable tool and has its merits. Chief Investment Officer of Pimco, the largest bond manager in the world, Mohamed El- Erian, described it very well. Securitization broadens the potential group of buyers and sellers due to its characteristics of diversification and customization. As a result it increases liquidity and simultaneously reduces transaction costs. “The combination of greater liquidity, diversification, customization is illustrative of the more general process of integration of financial markets. Like other components of this process, it is subject to excesses, including overproduction and overconsumption, but this need not necessarily derail the phenomenon over the medium term. Indeed, it may even render it more sustainable over the long term.”[4]
Gino Landuyt
[1] Surjit Bhalla in Imagine There’s No Country : Poverty, Inequality and Growth in the Era of Globalization ( Peterson Institute, Oct 2002)
[2] Alan Greenspan in The Age of Turbulence: Adventures in a New World (Penguin Press, 2007)
[3] Bank for International Settlements (BIS) Triennial and regular OTC Derivatives Market Statistics, November 2007
[4] Mohamed El-Erian in “When Markets Collide. Investment Strategies for the Age of Global Economic Change.” (McGraw Hill 2008)
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