The Impact of Subprime Mortgage Crisis in Central America
The Subprime Mortgage Crisis
The financial crisis triggered by the subprime mortgage crisis in the US was initially referred to as the worst economic crisis since the great depression. It was estimated that millions of citizens across the globe will be driven into poverty and the worst hit would be the third world country. Rightly so, the magnitude of this financial crisis was as predicted the US economy went into recession, the British, German, French, Japanese, and other world leading economies slipped also followed suite.
Some countries that had liberalized their financial sector for the sake of rapid economic growth were hardest hit. Top of the list are Iceland and Ireland, whose domestic and international debt will be paid by future generations, long after the recession has passed. Greece has also found itself in a similar situation in terms of accruing an unimaginable debt. Together with Greece, the likes of Ireland and Iceland have one thing in common they all liberalized their financial sectors to the point that banks could conduct individual transactions valued at billions of dollars without any form of oversight.
Interestingly, some countries were barely scathed by the financial crisis triggered by the subprime mortgage crisis in the US. China and India continued with their impressive growths but their economies did slow down a bit when the recession hit. The Central American economies were somehow expected to collapse spectacularly like the Icelandic and Irish economies but this wasnt the case. This was highly unusual, considering their dependence on the US economy.
The same can be said about Latin America. Emerging nations like Brazil have been recording strong growths over the last couple years but their major hindrance is the high poverty level within its borders. A similar situation is witnessed in Argentina, Bolivia and Venezuela these countries have a strong export market but the huge divide between the haves and have-nots translates to poor distribution of the countrys resources. Since the financial crisis was supposed to hit the poor much harder, it was hypothesized that the Latin and Central American economies will eventually come tumbling down like a house of cards. However, this wasnt the case. Why is that
Lessons Learnt by Latin American Countries
The answer lies in how their financial markets are regulated or deregulated. In the 1980s, the US embarked on a financial deregulation campaign which saw the reduction of caps put on loans and deposits. These caps were hurting banks in that investors were opting for mutual funds which offered less restrictive investment vehicles. Congress played an important role in holding hearings and ultimately in passing legislation in the early 1980s that guided deregulation (Hornbeck, 2009, p 2). The FDIC (Federal Deposit Insurance Corporation) was given the mandate of being the financial watchdog during these prosperous times. On the other hand, the Latin American economies followed a totally different route to that of the US. The Latin American countries were prone to financial crises triggered by deep fiscal deficits, poor prospects for servicing debt, questionable macroeconomic and exchange rate policies, and weak institutions (Hornbeck, 2009, p 4). Most investors shied away form these countries during the 1980s and 90s. Those that did always had an exit plan which was initiated the moment they sensed trouble.
With time, oppressive regimes in Latin America were replaced with more sensible governments which embarked on realistic financial reforms. The debt crisis which hit the Latin American countries in the 1980s trained them to be more prudent when it came to regulating their banks and credit institutions. Even though these countries managed to establish, long-term equity and bond markets, they did not engage in the same level of risks as their US and European counterparts. Even though the bond markets have played an important role in Latin America (in terms of attracting foreign exchange), we will look at the banking sector because this was the catalyst in the current financial crisis.
Regulation of Financial Markets
Prudential regulation and bank supervision are the hallmarks of the Latin American banking sector. The past financial crises have taught them to converge with the current international standards in banking, but not at the expense of exposing them to unnecessary risk. In fact, the ability of Latin American countries to avoid major financial instabilities is rather striking. The main reason is their macroeconomic policies. The movement towards flexible exchange rates, in particular, is a major change from previous periods of crisis (Hornbeck, 2009, p 6). Depreciation of their respective currencies is relied upon to do most of the adjustment works and this has freed up their monetary policies, a feat that wasnt achieved in their previous financial crises. Furthermore, the Latin American Central Banks have made efforts to support their banking systems by maintaining high levels international reserves and this has led to a direct increase in liquidity in the private sector. Banks no longer have to comply with stringent reserve requirements and this has provided alternative financing to the corporate sector.
Its clear that the current financial systems in Latin America are more robust than in the past. As reported by the International Monetary Fund (IMF), the starting conditions of Latin American banks, on average, were healthy as the current financial crisis unfolded (Hornbeck, 2009, p 8). The Capital-Asset ratios were nearly double the required standards and the returns on equity and liquidity ratios were adequate for non-crisis situations. In short, the banks balance sheets were healthy. They had adequate levels of domestic deposits, few toxic assets, and only light exposure to derivatives, mostly in the large banks (Hornbeck, 2009, p 8).
Lack of Oversight in the US
In general, the Latin American financial systems were effectively regulated and this was unlike their US counterparts. To understand, the unregulated manner of the US financial systems, this paper will look at how the subprime mortgage crisis was triggered. Economists believe the current financial crisis was triggered by a shadow banking system operating within the Western economies. This parallel banking system essentially caused the credit market to freeze due to lack of liquidity in the banking system. The entities which make up the shadow banking system include hedge funds, which borrowed short-term loans in the liquid market and then purchased long-term, illiquid risky assets (Dropkin, 2009). They disrupted the credit markets (banking sector) and made it vulnerable to rapid changes in the market. These entities became critical to the credit markets, underpinning the financial system, but were not subject to the same regulatory controls (Dropkin, 2009).
To illustrate the influence of these entities within the shadow banking system, the total assets they held in 2007 was roughly 2.2 trillion but after unregulated short-term borrowing, this grew to 2.5 trillion, with hedge funds accounting for 1.8 trillion. The shadow banking system owned a big chunk of the entire credit market if one compares them to the assets held by major commercial banks. The combined balance sheet of the then five major investment banks was 4 trillion, while the total assets of the top five bank holding companies in the United States at that point were just over 6 trillion (Gandel, 2009). The entire banking industry in the United States was valued at 10 trillion. As the shadow banking system continued expanding by borrowing from the credit markets, the conventional banking system was continuously exposed to financial vulnerabilities.
The financial crisis was eventually triggered when corporations that had invested in commercial paper withdrew from the money market mutual funds worth 144.5 billion in one week and this was after they had withdrawn 7.1 billion in the previous week. (Chicago Tribune, 2008)These massive withdrawals in two weeks affected the credit markets ability to meet its short-term obligations. The actions of the shadow banking system and the role of the FDIC in insuring some of these transactions were the focus of sharp debate.
It appears like the FDIC was reduced to the mere role of a toothless watchdog due to some weaknesses in its legislations. The first problem was no uniform law that governs the dealings of the entire financial institutions has ever been drafted. Banks, thrifts and insurance companies are answerable to the Bankruptcy Code, with banks and thrifts being subject to a specialized insolvency regime under sections 11 and 13 of the Federal Insurance Act if their deposits are insured by the FDIC (FDIC, 2009). Broker dealers on the other hand are subject to the Securities Investor Protection Act in addition o the Bankruptcy Code (FDIC, 2009). These differing legal regimes made it had for any federal body to regulate all the financial dealings in a fast-moving economy. If any forced regulations were instituted, then time would have been wasted in-between transactions. The common assumption was there are enough professionals in the industry and common sense would prevail. Adding to this, another hypothesis was the system was too big to collapse a mentality which fuelled the demutualization of stock exchanges in Europe, Asia and America.
As much as FDIC might blame the weaknesses on the current legislations and the sheer number of players on the banking industry for their inability to predict and avert the current financial crisis, the fact remains they were caught off-guard and the only word that defines such a weakness is incompetence. This assumption might seem overtly rude but there is credible evidence which shows FDIC did not do enough to avert the crisis. In an interview with Reuters in February 2008, the chairman of FDIC, Sheila Bair, predicted that the probability of a big bank failure was highly unlikely and the institutions that are most likely in trouble are the smaller ones. When asked what keeps her up at night she replied Probably a large bank failure but I dont think thats going to happen the chances of that happening are very, very remote (Poirier, 2008).
Comparing the situation in the United States to the one a stable Latin American economy like Chile, one gets a totally different picture. By all accounts, Chiles economy is the most stable in Latin America and this has been sustained for the last 25 years, thanks to a banking law which that was passed in 1986. In the aftermath of two financial crises, the first that resulted from macroeconomic policy failures that were exacerbated under a system of over regulation, the second directly related to catastrophic under regulation, Chile redesigned its financial regulatory system (Hornbeck, 2009, p 12). After the changes, Chile was able to avoid the major financial crises and the current one is no different. The current capital adequacy standards in Chile demand that every bank must maintain a capital-asset ratio exceeding 8. Chilean banks have to meet capital requirements relative to reserves, deposits, and other liabilities capital must equal at least 3 of total assets. If the banks fail to comply, the government may place caps on their loans or investment abilities.
Unfortunately, this isnt the case in the US financial sector. Hedge funds are allowed to trade without proving that they have the necessary reserves to back up their activities. If the FDIC attempts to regulate them further, then they will be blamed for slowing down a fast-moving economy. The lessons applied from past mistakes have enabled the Latin American countries to steer away from the global financial crisis. The existing prudential regulatory and oversight system has so far limited these types of mistakes from being repeated and is credited with helping maintain the health of the banking sector during the global financial crisis (Hornbeck, 2009, p 12). The focus is now on the US and other debt-riddled countries. It remains to be seen what changes theyll institute to avert future crises.
Categories:
0 comments:
Post a Comment