Finance and Investment By CPA/FA William Irari, williamirari@gmail.com GLOBAL ECONOMIC MELTDOWN 28 SEPTEMBER - OCTOBER <strong>2016</strong>
Finance and Investment Lessons Learnt About 8 years ago, on or around 2008, the western world experienced an economic meltdown (financial crisis) which economists described as the worst financial crisis since the Great Depression when the stock market crashed in <strong>Oct</strong>ober 29, 1929 throwing the Wall Street in unprecedented panic. <strong>The</strong> spillovers of that crash were to be felt for the next decade until 1939. Despite the fact that the credit crunch of 2008 was experienced principally in United States of America and parts of Europe, no doubt all economies that trade with US got the shocks thanks to systemic risk. This article is going to highlight some of the causes that led to the global debt crisis and experiences arising there from. • Bursting of the housing bubble – Soon after US 2001 terrorist attack, the government started a recovery programme to assist nationals rebuild their lives and at the same time counter the effects of dot-com generation that demanded robust economy. Home ownership was encouraged and mortgages became cheap and affordable. Buyers were lured with very low rates (the Congress had lowered the interest rates from 6.5% to 1%) though on the flipside, these were floating rates that kept rising steadily due to runaway inflation as the US Federal Reserve Bank had printed a lot of currency which was directly injected into the economy. This created a smokescreen that the economy was so robust, which in fact was a mere illusion. • Sub-prime lending – An expansive threshold to qualify for a mortgage was relaxed allowing many nationals to access these facilities who ordinarily would not have afforded them. As these were Mortgaged Backed Securities (MBS) and Collateralized Mortgage Obligations (CMOs), there was imminent mismatch between the assets (houses) with the securities that backed them. In other words, mortgages were given without adequate collaterals and it wasn’t long before mass evictions and foreclosures took centre-stage. <strong>The</strong> wage levels in the US had come down and widespread unemployment led to mortgage defaults. • Weak and fraudulent underwriting practices – Due to greed for money and insatiable appetite for quick profits, due diligence seemed an unimportant factor in credit accreditation and caution for risk was thrown out of the window. Wide range of personalized financial products, issuing of junk bonds, unsecured credit notes, etc were traded against a backdrop of very weak regulations and this led to overleveraging to already debt-burdened firms. • Easy credit conditions and predatory lending –Most commercial banks lured their customers with easy credit terms by extending highly discounted interest rates. Contrary to the customers’ beliefs that these rates were fixed, it turned out that they were floating rates which kept rising long after the loan was advanced. This led to massive defaults by borrowers with lenders experiencing huge losses as well. <strong>The</strong>re was a lot of undercutting to secure deals and a big portfolio of loans was secured on very weak collaterals. • Deregulation of financial institutionsis also considered a key source of the crisis. Though banks perform well in a liberalized economy, the need for regulation cannot be overemphasized. As demand for loan products increased, some banks lend more than their balance sheet could allow, margin-ratio requirement with the Federal Bank was not adhered to and disclosures were very scanty with most banks opting to hide dubious transactions under “offbalance sheet financing”. • Financial innovation and incorrect pricing of risk –It was during this time as a result of robust economic growth and excess liquidity, that most investment banks came up with variety of financial innovations such as, futures, swaps, options or generally what we refer to as derivatives. Few people knew about these new forms of financial assets and so the merchants took advantage to rip off investors and lack of regulations on these products only worsened the situation. Due to the institution’s avariciousness to make quick gains, risk profiling wasn’t done and there was a lot of apparent mismatch between the loans issued and the assets/securities that backed them. This led to high exposure of risk, a factor that was ignored in pricing of these securities due to undercutting. What were the impacts of this global financial crisis? <strong>The</strong>re is a saying that goes “When America sneezes, the other side of the globe catches the flu”. This could not be further from the truth, going by the impacts that rocked parts of Asia, Europe and Africa. A good example is where one of the biggest insurance underwriters in US, American Insurance Group or AIG sought a bailout from Federal government. <strong>The</strong> local Kenyan subsidiary had to change its name to Chartis to ‘unmask’ itself from the parent company which was crawling on its knees. Years later after the AIG was bailed out, the local Chartis reverted its name to AIG. Besides AIG, other firms like JP Morgan, General Motors, etc were also in the list of bailout by the US government. Others like Lehman Brothers, a financial services firm, were not as fortunate as they filed for bankruptcy in what is considered the largest filing in US history as by then the firm was holding $600 billion in assets, where another ailing financial firm known as Wachovia ended up being acquired by Wells Fargo. <strong>The</strong> ripple effect of the financial crisis was not felt in the US alone, but as indicated earlier due to systemic risk, most SEPTEMBER - OCTOBER <strong>2016</strong> 29
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