The most severe financial crisis since the 1930s
The current credit crunch is the most severe financial crisis since the 1930s and that marks the end of an era of credit expansion based on the dollar. A new paradigm is urgently needed to better understand what is going on. The paradigm used until now by most economists was based on false premises.
The existing paradigm, often referred to as free-market fundamentalism, holds that markets are self-correcting, that they naturally tend toward equilibrium. Economists as far back as Adam Smith have argued against regulation or government intervention of any kind since it would interfere with the natural forces of the market.
Since 1980, we have had about five or six crises. Most serious of these crises are: the international banking crisis in 1982, the bankruptcy of Continental Illinois in 1984, and the failure of Long-Term Capital Management in 1998.
(Read Soros prognosis about financial crisis).
The international banking crisis in 1982
• The banks thought default risk was low in lending to LDCs, (“sovereign nations do not default”, some bankers said). Banks focused more on the interest-rate risk to themselves and required the loans to have floating rates (adjustable rates).
• In 1980-1, new Fed chief Paul Volker raised U.S. rates to fight inflation. Since all loans were
in USDs, the interest costs of LDCs rose dramatically. Default risk rose also.
• Also, as oil prices fell after OPEC II, banks faced a shortage of deposits, many more “rich” OPEC countries now began to withdraw their savings. Banks no longer had excess deposits to recycle.
• Mexico, an oil exporter, but one with heavy debt, was the first to announce that it was unable to
meet it's loan payments to the international banks. Other LDCs soon followed.
• Problem: LDCs need outside capital to grow. If banks stop lending, a recession could follow.
• "Baker" plan: In return for bank rescheduling loan payments (essentially a partial write off) and
continuing to lend to LDCs, LDC borrowers would to adopt economic reforms to spur growth so as to pay off the loans. LDCs were slow in embracing reforms and Citicorp began moving toward writing off loans by adding to loss reserves. Neither side appeared willing to make concessions - and the plan failed.
• Brady Plan: Next plan. Banks could convert the loans into marketable bonds - at 65% of loan face value. The bonds were partially guaranteed (just the principal) by U.S. Treasury securities. Or banks could maintain the loans at 100%, if they would lend 25% more to the LDCs.
• These “Brady Bonds” (named after the Treasury Secretary, Nicholas Brady) actually became a general term for a new asset class – bonds issued by LDCs. (emerging market debt)
Bankruptcy of Continental Illinois Bank in 1984
The Continental Illinois National Bank and Trust Company was at one time the seventh-largest bank in the United States as measured by deposits. In May 1984, the bank became insolvent due, in part, to bad loans purchased from the failed Penn Square Bank N.A. of Oklahoma—loans for oil producers and service companies and investors in the the Oklahoma and Texas oil boom of the late 1970s and early 1980s. Due diligence was not properly conducted by John Lytle, an executive in charge of oil lending, and other leading officers of the bank. Lytle later pleaded guilty to a count of defrauding Continental of $2.25 million and receiving $585,000 in kickbacks for approving risky loan applications. Lytle was sentenced to three and a half years in a federal prison. The Penn Square failure eventually caused a substantial run on the bank's deposits once it became clear Continental Illinois was headed for failure. Large depositors withdrew over $10 billion of deposits in early May 1984.
Failure of Long-Term Capital Management in 1998
The 1998 failure of Long-Term Capital Management (LTCM) is said to have nearly blown up the world's financial system. For such a near-catastrophic event, the finance profession has precious little information to draw from. By piecing together publicly available information, this paper draws risk management lessons from LTCM. LTCM's strategies are analysed in terms of the fund's Value at Risk (VAR) and the amount of capital necessary to support its risk profile. The paper shows that LTCM had severely underestimated its risk due to its reliance on short-term history and risk concentration. LTCM also provides a good example of risk management taken to the extreme. Using the same covariance matrix to measure risk and to optimize positions inevitably leads to biases in the measurement of risk. This approach also induces the strategy to take positions that appear to generate 'arbitrage' profits based on recent history but also represent bets on extreme events, like selling options. Overall, LTCM's strategy exploited the intrinsic weaknesses of its risk management system.
In July 1997 Thailand devalued its currency. This one event sparked financial crises that spread with astonishing speed from Southeast Asia around the world to Russia. Even in the United States and South America the impact was felt. Southeast Asia had been considered a model--in fact a miracle--of economic growth. No one foresaw the crises that soon occurred there, and the severity and contagion of these crises raised questions globally: What happened? Why? And what can we do about it?
At the root of these crises were the government actions. Banks were pawns in the hands of governments, and banks helped fuel the booms that ultimately burst, booms supported by investments from other countries around the world, not incidentally.
Obviously, it is necessary to put following questions:
How effective are bank regulations? And how do we resolve failed and insolvent banks?
