Financial deregulation and the sub-prime crisis

One of the central tenets of the Washington consensus - pursued remorselessly by the International Monetary Fund (IMF) - has been the neoliberal view of the ostensible benefits that financial deregulation would bestow. Throughout the 1980s and 1990s, most countries reduced or abolished restrictions on capital movements and enacted policies of domestic financial deregulation.

These policies inevitably led to the rise of highly liquid, speculative short-term flows of capital, mostly emanating from offshore financial centres, which began to have a destabilising impact on international financial markets and hastened a whole series of financial-economic crises in Latin America, East Asia and Russia.

In the US itself, regulations that had limited domestic banks to the role of financial intermediaries were relaxed to allow commercial banks to engage in more speculative activities through the creation of banking affiliates. These transactions could be made outside the balance sheets of the banking system and allowed commercial banks to engage in the trading of securities, and in the underwriting of debt.

Financial deregulation witnessed a decoupling of the functions performed by financial intermediation, as commercial banks were no longer obliged to evaluate risk and the creditworthiness of borrowers since the loans which were originated could be sold to the secondary bond markets in the form of collateralised assets. This implied that the traditional role of banks in the evaluation of risk was transferred to the powerful credit agencies.

The primary concern of banks was the ability to sell these collateralised assets in order to earn a fee or a commission. These assets, in turn, were selected on the basis of their investment yield rather than by the past credit profile of the borrower. In other words, financial deregulation allowed banks to issue loans and sell these assets into secondary markets, which were then re-packaged and blended into other classes of yield bearing financial assets.

The whole logic of "securitisation" was aimed at overcoming financial regulations, which had prevented formerly illiquid assets held in banks' own portfolios from being transferred into banking affiliates and sold into secondary bond markets.

Consequently, the secondary bond markets assimilated these collateralised assets into mortgage-backed securities (MBSs) - which were issued on the basis of their yield - calculated in terms of the expected streams of income in the form of interest and principal payments from the underlying pool of mortgage debt. As banks moved their securitised loans off their books, there was a proliferation of mortgage companies and real estate developers entering the market, which had the effect of accentuating the gulf between the ownership of assets and the risks incurred.

The whole process led to the downgrading of credit risk, outright fraudulent practices and the alarming growth of Ponzi schemes. Indeed, in the aftermath of financial deregulation, MBSs emerged as one of the largest pools of financial assets traded in the US capital markets. It was the rapid growth of these new classes of engineered financial assets, known as collateralised debt obligations (CDOs), which acted as the trigger for the sub-prime crisis as defaults began to escalate.

The value of CDOs issued had tripled between 2004 and 2006, from US$125 billion to US$350 billion per year. As defaults mounted, the entire structure of debt began to collapse and the contagion effect soon spread to safer assets as investors lost confidence. Widespread panic led to a stampede out of these markets, which hastened a crash and the ultimate termination of funding for CDOs.

In the decade 1997-2007, real estate values more than doubled - from about US$10 trillion to over US$20 trillion. Home mortgage liabilities rose even faster during this period - from US$2 trillion to over US$10 trillion. The ratio of the median house price to median household income increased from about three to one in 2000, which reflected a relatively stable ratio over the previous three decades, to a historically unprecedented ratio of five to one in 2006. Indeed, between 1995 and 2007, house prices rose by more than 70 per cent in real terms (adjusting for the general rate of inflation). This represented an additional US$8 trillion generated by the housing wealth effect.

 The housing boom was doubtless fuelled by the easing of monetary policy as the interest rate on mortgages fell to a 30-year low - from 8.29 per cent in June 2000 to 5.23 per cent in June 2003. In this speculative frenzy, the proportion of Ponzi financial units was on the ascendant. Sub-prime mortgages accounted for 20 per cent of total mortgages issued in 2006. These loans grew by almost five-fold between 2001 and 2005, estimated at an average of US$625 billion annually.

Household debt in the US rose from around 93 per cent of disposable income in 2000 to exceed 130 per cent by the end of 2006. This dramatic upsurge in household indebtedness appeared to coincide with the end of the "new economy" bubble and was instrumental in providing a major catalyst for the recovery from the mild recession of 2001-02. By mid-2006, household debt service payments reached a record high of 14.5 per cent of disposable income.

Much of this debt was incurred during the housing boom of 2002-05; for instance, between 2000 and 2004, household wealth based on the ownership of real estate increased by more than 50 per cent. Indeed, as the US Federal Reserve eased interest rates after the bursting of the dot.com bubble, real estate was perceived as a relatively safe haven by investors.

The subsequent housing boom created a new plethora of exotic mortgages, the so-called sub-prime market, which offered low income earners "interest-only" and "option adjustable rates" mortgages. These new Ponzi schemes soon became a ticking time bomb as the original low interest payments were later adjusted upwards, which dramatically increased the debt burden. Needless to say, mortgage defaults exploded.

The entire debt pyramid generated by these parasitical forms of financial were governed to a large extent by a deregulated banking system in which banks were not obliged to report how many of these sub-prime mortgages had been incurred. The risk was essentially diversified by re-packaging these financial units to the large hedge funds in Wall Street. Such funds are among the institutions that are relied most heavily in issuing commercial paper in the past few years.

As recently as the end of 2006, Wall St banks lent liberally to such funds, and much of that borrowed money was used to invest in huge packages of mortgages. However, when it became increasingly clear that large numbers of homeowners could not repay their mortgage obligations, the cash flowing to hedge funds dried up, and fund managers found themselves sitting on enormous losses.

Sooner or later however, the "Minsky moment" was imminent as these inflated market values retreated to their historical averages. Furthermore, the home mortgage debt had increased faster than the market value of these assets as households had indulged in a hyper-credit binge, financed to some degree by leveraging their home equity.

It has been estimated that the propensity to consume out of each additional dollar of housing wealth is between 4.5 and 16 cents. Every dollar of home equity which is leveraged represents 10 to 50 cents of additional consumer spending. As house prices began to fall from early 2006 onwards, the reverse wealth effect led to a severe retrenchment of private spending. It has been estimated that a 20 per cent fall in house prices is equivalent to a US$2 trillion destruction of asset wealth. At the same time, mortgage debt as a share of disposable income had increased from 60.9 per cent on average during the 1990s to over 75 per cent in 2007.

By the beginning of 2008, an estimated 8.8 million households, or a tenth of the total, had experienced negative equity. Real estate prices fell on average by 10.2 per cent between January 2007 and February 2008; the largest fall in the Case-Shiller home price index in over20 years. Defaults on mortgages increased from early 2007 onwards and, by February 2008, more than 24 per cent of sub-prime mortgages were in foreclosure. This represented more than 1.3 million households that were facing foreclosure; an increase of 79 per cent from the previous year.

By mid-2008, the number of monthly foreclosures reached levels not witnessed since 1929, on the eve of the Great Depression. The inevitable retrenchment of household wealth will doubtless lead to cascading declines in consumer spending and a dampening of the level of effective demand. The system thus seems poised for a Minsky-Fisher style debt deflation that further interest rate reductions will be powerless to stop.

The initial shock waves of the sub-prime crisis occurred in July 2007 when two Bear Sterns hedge funds, which held about US$10 billion in MBSs, went into liquidation and were later sold at a fraction of their market value to JP Morgan, supported by a US$30 billion credit line from the US Federal Reserve Bank.

This crash was soon followed by the failure of the British mortgage lender, Northern Rock, which was eventually bailed out and nationalised by the government. In response to the emerging credit crunch, the US Federal Reserve Board injected liquidity into the financial system and drastically cut the prime rate from 4.75 per cent in September 2007 to 3 per cent in January 2008. In addition, the US Congress convened to announce a fiscal stimulus package of US$150 billion in tax cuts. In March 2008, the world's central banks co-ordinated an emergency line of credit of US$200 billion to distressed banks.

At about the same time, the US Federal Reserve Bank injected an additional US$400 billion into the financial system. Interest rates were cut yet again - by 0.75 per cent to 2.25 per cent in March. By early September, the US Treasury intervened to bail out mortgage insurers and lenders, Fannie May and Freddie Mac, which had incurred over US$15 billion in losses, had shed about 80 per cent of their shareholder value over the previous year. These two government-sponsored mortgage companies own or guarantee about half of the US$12 trillion mortgages in the US.

 For the first time in over 50 years, the reserves of US banks held by the US Federal Reserve, were negative. If the crisis spreads to defaults in other debt markets, the entire US banking system could be imperilled.

By mid-2008, these sub-prime defaults have threatened the very citadels of US capitalism as the spectre of a severe credit crunch began to reverberate in Wall Street itself. The emergence of a pervasive credit crunch signifies an evaporation of bank lending to the private sector, which is also accompanied by a deterioration of the balance sheet of banks as the rate of non-performing loans skyrockets.

As the corporate sector experiences a falling rate of profit, the ability to service previous debts creates widespread and pervasive financial distress and a rising tide of bankruptcies. The tightening of credit conditions leads to a scramble for liquidity and a rebalancing of portfolios away from equities and toward more liquid assets in bonds and securities. Long-term interest rates also rise but at a slower rate than short-term rates, which leads to an inverted yield curve as higher long-term rates cause a further portfolio adjustment into long-term bonds.

It can be surmised that the harbinger of a global financial crisis is emerging as the fall-out from the sub-prime crisis begins to engulf global markets. The logic of capitalist crises is precisely what Marx describes as "the slaughtering of capital values".