Latest News Editor's Choice


Opinion / Columnist

The whys and wherefores of the Eurozone financial crisis

17 Nov 2011 at 07:58hrs | Views
I have often been asked the fundamental question: what are the causes of the ongoing Eurozone financial crisis and why is it so difficult to solve it? The Eurozone financial crisis has its roots in the US subprime credit crisis. In essence, it is a crisis of capitalism (the free markets system). Notwithstanding the incontrovertible truism that the free markets system has unequivocally triumphed over communist economies, it has nevertheless been exposed as inherently flawed, underpinned by unstable foundations which have been violently destabilised and shaken by the two aforementioned crises.

The US subprime crisis was typically caused by recklessness and greed within the banking and quasi-banking industry. Typically, mortgage loans being extended to individuals who could not afford to repay them. That was the nexus of the US subprime crisis. Banks and quasi-banking institutions extended loans to these individuals. The result? Massive and dramatic defaults on the part of borrowers causing severe dislocations within the fianncial system triggering huge mark-to-market losses on ubiquitous bank products like collateralised debt obligations and other derivative products whose values were invariably dependent on the defaulted loans. Collateralised debt obligations like asset backed securities (ABS) generally consist of pooled receivable loans that that have been packaged and rebranded into a derivative financial instrument which can be sold to investors like any debt instrument (e.g. a bond). Consequently, the value of an ABS is intrinsically linked to the rate at which borrowers of loans are repaying them. Any slow-down on the rate of repayment simply diminishes the value of the ABS, and, at worst can trigger illiquidity of the financial asset resulting in spectacular losses as the security gets marked-to-market (i.e. valuing at market price).

Back to the issue of capitalism as a system, Capitalism is a people driven system which is therefore susceptible to the whims and caprices of mankind's irrational behaviour. Former US Federal Reserve Chairman, Alan Greenspan called such behaviour "irrational exuberance" in his 1996 address to the American Enterprise Institute. The late acclaimed British economist, Lord John Maynard Keynes famously referred to this kind of euphoric behaviour among investors as "animal spirits" in his ground-breaking book, General Theory of Unemployment, Interest and Money. The idea that unregulated capitalist markets would always produce the best outcomes was fundamentally wrong and has since been discredited.

The infatuation with free markets and hence minimal regulation was central to the current financial markets crisis as obtaining in Europe and, and hitherto, in the US. Sworn advocates and adherents of the free markets system religiously opposed all manner of financial regulation, arguing that the markets will self-regulate itself through Adam smith's so-called "invisible hand" which would allegedly correct any defective behaviour within the markets and punish any errant behaviour. Moreover, a conviction took root, and was accepted as an orthodox by establishment economists of all ideological stripes that the self-interest of owners and managers of companies would always lead them to act in the best interest of their companies and safe-guard shareholder value, and thus mitigate the probability of default and bankruptcy. Elegant and exaggerated risk management models embellished with befuddlingly complex mathematical equations were developed on the basis of the premise of self-regulation by companies.

The opacity and complexity of financial instruments that were being churned out through financial engineering, was compounded by the perplexity of the flummoxing risk-management models that were meant to assist investors to better-understand risk associated with these ubiquitous financial derivatives. In August 2007 (onset of the US subprime crisis) all the sophisticated rocket-science inspired mathematical quadratic equations underlying the risk management models cracked. The assumptions that the markets would self-regulate optimally to the benefit of company shareholders was found to be hollow and scandalous. The economics profession was thrown into disarray. No answers could be found in establishment economics text books and journals of finance. The Queen of England posed a question: Why did the economics profession fail to foresee the crisis? To date her question has not been answered.

All the financial products that had been hatched under these premises turned out to be toxic, leaving Nobel prize-winning economists disoriented and in the proverbial sixes and sevens. Illiquidity, opacity and complexity became the immediate enemies of the financial system. Regulators began to ask tough questions. Derivative products had to be explained. Some of these financial instruments were proved to be worse than useless. Warren Buffet, the celebrated US investor, referred to the destructive financial products as weapons of mass destruction. Even rating agencies had relied on such models and assumptions in assigning credit ratings on numerous US and European banks.

Given the foregoing, when banks that had been dishing out loans recklessly to borrowers who had derogatory entries or blemishes on their credit records started tottering and teetering on the brink of collapse. Heretofore, these banks had been misperceived by investors to be too-big-to-fail. This assumption by investors fueled what Benjamin Bernanke (current US Fed chairman) termed "negative feedback loop", typically a process that gives rise to unintended repercussions. Respective governments intervened in defence of their banks (particularly after the collapse of Lehman Brothers). The US bailed out its banking groups like Citibank, and agencies like Fannie Mae and Freddie Mac (agencies of the US government that facilitate the housing loans for Americans). The European government bailed out and guaranteed their banking groups and in some instances recapitalised them. Ireland guaranteed all bonds issued by the Irish banking groups.

The UK recapitalised its banks like Royal Bank of Scotland, Lloyds, inter alia. The stage was set for a situation where problems of banks were transferred directly to their governments. An issue which is at the heart of the criticism leveled against the socialisation of losses and privatisation of profits by Wall Street banks. The situation started cracking in Iceland which failed to honour its undertaking to guarantee its banks against default. When Icelandic banks defaulted, Iceland refused to compensate depositors who had invested their money on the back of perceived government guarantee. The situation then spread to the Eurozone countries particularly the peripheral sovereigns like Italy, Ireland, Spain, Portugal and Greece. The markets soon realised that when it comes to a crunch, these countries would not be able to bail out their banks without outside assistance. The Eurozone crisis had set in. The situation was compounded by the falsification of GDP numbers by the likes of Greece who had deceptively submitted fudged numbers in order to gain entry into the Eurozone single currency group. Investors began to look closely at the debt levels of these countries and discovered that given the status quo, these countries would not be able to repay their debts.

Hitherto, the assumption was that sovereigns particularly those of the US and Western Europe were risk-free. Consequently their credit default swap (CDS) spreads had been hovering near zero basis points (reflective of their perceived risk-free status). However, the situation has turned around. The crisis has exposed these countries as worse than some developing countries. Their risk spreads (CDS and credit spreads) have widened dramatically since August 2007. The situation took a dramatic turn for the worse pursuant to Lehman Brothers bankruptcy filing and became a full blown Eurozone sovereign crisis with Greece at the centre of the strife. The bottom line is that all these weaker Eurozone countries are heavily indebted, and their debt levels are unsustainable. The crisis claimed political cuasualties in its wake, Italy's Silvio Berlusconi has been swept aside, Greece's Papandreau is gone, Portugal's Jose Socrates was thrown out early this year, Ireland's Brian Cowen was also a casualty of the raging financial crisis. The question which arises is: Why has the crisis affected mostly the members of the single currency, i.e. Eurozone members? I will address this question in my next instalment.

------------
Colls Ndlovu can be contacted on, wabayi@hotmail.com


Source - Colls Ndlovu
All articles and letters published on Bulawayo24 have been independently written by members of Bulawayo24's community. The views of users published on Bulawayo24 are therefore their own and do not necessarily represent the views of Bulawayo24. Bulawayo24 editors also reserve the right to edit or delete any and all comments received.