Financial Markets and the GFC
The world’s financial markets were at centre stage of the GFC. The crisis was very much a financial crisis, as it had its genesis in a global and US housing bubble fuelled by low interest rates in developed economies and a global savings glut in emerging countries. Financial markets acted as transmission channels for the crisis, spreading the housing virus throughout the international economy, infecting financial and credit markets all over the world.
OTC derivatives markets served to highlight the importance of having robust and responsive regulatory frameworks. However, most OTC derivatives markets around the world were largely unregulated and inadequately supervised. As was discussed in Chapter 2, the emergence of a shadow banking system that operated in parallel and in competition with the conventional banking sector served to undermine the overall effectiveness of financial markets regulation. The use of the parallel system by bankers, investment banks, mortgage originators and broker–dealers in sourcing credit and developing sophisticated OTC financial products led to a build-up of risk. When the housing bubble burst, the parallel system was placed under significant stress as securitized sub-prime mortgage loans became almost worthless and subsequently toxic.
The collapse of Lehman Brothers and the bailout of other investment banks undermined consumer trust and investor confidence in the US financial system. Short-term credit markets seized up, leading to a chronic shortage of liquidity in wholesale money markets. The seed was now sown for the perfect financial storm. Over-leveraged banks, investment banks and mortgage originators that used short-term credit to fuel their aggressive growth strategies and business models were now made extremely vulnerable to changes in market sentiment.
Financial Markets, the GFC and the Great Recession
It is now beyond argument that the world’s financial markets were at the centre stage of the current crisis. All financial markets, particularly equity and credit markets, reacted adversely to the global meltdown. In some cases, certain financial markets became dislocated and ceased to function in a rational manner. The financial stress, which restricted the proper functioning of credit markets, was particularly damaging, as credit flows became restricted and short-term liquidity all but dried up.
The ensuing financial crisis and market dislocation, in turn, caused banks, mortgage originators and credit providers to restrict the availability of credit to millions of small and large businesses. The severe shortage of liquidity and available credit led to a dangerous feedback loop, which encouraged deflation in asset prices. As credit dried up, so did the availability of investors, which placed further pressure on an already fragile housing market.
In 2008 the IMF investigated the relationship between financial markets, the GFC and the global recession and came to the following conclusions:1
• Recessions which are accompanied by severe financial turmoil often are more protracted and deeper compared with other economic downturns.
• There is a stronger likelihood that a downturn or recession will accompany an episode of financial turmoil if house prices and aggregate credit rise in the period immediately preceding the downturn.
• Countries which have more open financial systems are generally more vulnerable to sharper contractions in global growth because their financial systems are more procyclical, with their innovations in financial instruments and financial markets. Conversely, countries with less open financial systems are less vulnerable to global economic downturns because their banking sector is less procyclical in respect of financial innovation.
• Countries with strong financial stability frameworks can help alleviate economic downturns through clear policy direction designed to strengthen and restore the capital bases of financial intermediaries, including banks, broker–dealers, hedge funds, investment banks and mortgage originators.
• The relationship of asset prices and aggregate credit in the United States during the current crisis appears to replicate previous episodes that were later followed by recessions.2
The conclusions reached by the IMF suggest that the current crisis, which had its genesis with the US sub-prime mortgage and global housing boom, rapidly escalated to a credit and liquidity crisis in the world’s financial markets. The liquidity crisis continued unabated, which led to severe dislocation in wholesale interbank lending markets. According to the IMF, the associated dislocation in credit and interbank lending markets led the supply of credit to dry up further. Interbank providers who did have funds refused to lend to counterparties because of concerns relating to potential default and creditworthiness.3
Problems with market dislocation, liquidity and credit squeezes are not new. As is discussed in Chapter 1, the October 1987 global stock market crash induced dislocation in equity markets and reduced household wealth considerably. The collapse of hedge fund Long-Term Capital Management in 1998 also introduced considerable stresses to short-term cash, credit and equity markets.4
However, this time around financial markets appeared to exacerbate the crisis, acting like transmission channels and spreading the US sub-prime virus throughout the world. Financial innovation played an important role in making the crisis systemic, as financial markets and financial instruments, including OTC derivatives, were being used to expose investors and market participants to further a downturn in residential house prices.
OTC Derivatives Markets
Bernanke noted that derivatives markets had a mixed record throughout the crisis.5 In most cases derivatives were used by entities to hedge risk and to better manage their risk positions.6 However, in some instances financial intermediaries also used OTC credit derivatives “as a tool for taking excessive risks.”7 According to Bernanke, excessive risk-taking through the use of credit derivatives occurred with the American International Group (AIG).8 AIG took large positions in credit derivatives without appropriate hedges in place. Hence, when the credit positions were unwound, AIG was left with insufficient capital to guard against the “large, correlated risks that it was taking.”9
The lack of transparency and market concentration of OTC derivatives also posed problems for the world’s financial markets. Since OTC derivatives markets were traditionally not centrally cleared or settled, market participants may not have had a proper understanding or enough appreciation to “fully assess their own net derivatives exposures or to communicate to counterparties and regulators the nature and extent of those exposures.”10
The Financial Crisis Inquiry Commission raised concerns relating to the use and abuse of OTC derivatives during the crisis, including within the period immediately prior to the crisis. In his opening remarks, the Chairman of the Financial Crisis Inquiry Commission commented on the exceptional rate of growth of the OTC derivatives markets. OTC derivatives trading grew from $88 trillion in 1999 to $684 trillion in 2008.11 Similar growth was experienced by credit derivatives, which grew notionally from less than $1 trillion in 2000 to be over $58 trillion in 2007.12
The Chairman of the Commodity Futures Trading Commission (CFTC) was less forgiving on the role OTC derivatives played in the current crisis.13 According to Gensler, in 2008 the financial system failed, the financial regulatory system failed, and “derivatives played a central role.”14 The CFTC was also of the view that regulated financial markets such as futures markets and securities markets were more transparent because price was established through supply and demand and listed on an approved exchange.15 By improving transparency through the regulation of clearing houses it was further argued that systemic risk would be reduced.16 This is because a regulated and approved clearing house would not only be more transparent but would also be more liquid and would guard against the risk of counterparty default.
With exchange-traded derivatives, all derivatives instruments use a standardized contract which allows for transferability. The fungible nature of a futures contract allows in turn for the trading of futures contracts on designated exchanges. Since exchange-traded derivatives are open to retail market participants it was thought appropriate that futures contracts should be regulated under a statutory framework and by a market regulator. In the United States, futures exchanges are regulated and supervised by the CFTC, whilst the Financial Services Authority (FSA) is responsible for the regulation of futures markets in the United Kingdom. Similar market regulators and frameworks exist in overseas jurisdictions.
Unlike futures contracts, sophisticated investors almost exclusively use OTC derivatives. Since there is no retail use of OTC derivatives it was thought that formal regulation was not required because there were no “consumers” as such. Sophisticated market participants who were well versed on the underlying risks of OTC derivatives did not require consumer-type protections afforded by regulation. Instead, it was thought that regulation would only increase the underlying costs without necessarily providing any tangible benefits.
However, as is discussed in Chapter 7, all of this has now changed. OTC derivatives and, in particular, swap contracts will now be regulated as provided by the recent amendments enacted by the Dodd-Frank Act 2010. The Act introduces a number of groundbreaking reforms, including the regulation of swaps, along with the requirement that swap contracts be centrally cleared on an organized exchange.17
The reforms were designed to enhance consumer protection for users of derivatives products. The reforms were also a response to one of the key findings of the Financial Crisis Inquiry Commission. The Commission concluded that OTC derivatives “contributed significantly to this crisis.”18 According to the Commission’s Report, the passing by Congress of the Commodity Futures Modernization Act 2000 (CFMA) effectively deregulated OTC derivatives markets because it removed the CFTC and the Securities and Exchange Commission (SEC) from regulatory oversight functions with OTC derivatives markets in the United States.19
The Commission reported that as a result of the reforms introduced by the CFMA, OTC derivatives markets activity not only in the United States but also in the rest of the world, boomed. From the time the CFMA was passed by Congress in 2000, OTC derivatives markets in the United States had a notional value of $US95.2 trillion and a market value of $US3.2 trillion.20 By 2008, the OTC derivatives market had increased by over 700%.21
The CMFA did more than simply deregulate OTC derivatives markets from supervisory oversight. The Act introduced important reforms, which were designed to clarify the legal status of OTC derivatives.22 One of the key reforms introduced by the CMFA concerned clarifying the legal status of hybrid derivatives. With hybrid derivatives such as synthetic securitized swaps, the derivative can have the features of a futures contract, a security or an OTC derivative. The uncertainty in terms of the proper characterization of an OTC derivative was illustrated in the decision of Transnor (Bermuda) Ltd v BP N America Petroleum.23 The case decided that OTC derivatives in the form of bilaterally negotiated energy contracts had the characteristics of futures contracts and hence should be regulated as such, notwithstanding that the contract was not traded on a registered futures exchange.24
The Transnor decision led to a great deal of uncertainty for OTC derivatives traders, as it remained unclear as to whether their instruments would be characterized as a futures contract and regulated by the Commodity Exchange Act 1936. There were similar concerns regarding the proper characterization of OTC derivatives in other jurisdictions, including the United Kingdom, and Australia.25 A number of decisions in the UK had mischaracterized derivatives instruments as illegal and void gaming contracts.26
The Financial Crisis Inquiry Commission was also somewhat critical of Federal Reserve Chairman Alan Greenspan’s support for the deregulation of the OTC derivatives markets in the United States.27 Greenspan had been supportive of deregulated OTC derivatives markets in the United States in the late 1990s and into the new millennium. Greenspan was of the view that regulation in OTC derivatives markets had not provided any discernible benefit.28 OTC markets had functioned well without any of the benefits of regulation under the Commodity Exchange Act.29 Further, regulation would impose considerable costs and burdens on OTC market participants.
Whether OTC derivatives such as swaps markets should or should not be regulated would now be only of academic interest, since the recent legislative reforms in the form of the Dodd-Frank Act 2010 had introduced both regulation and centralized clearing of swap contracts.30 One important issue left for consideration concerned the overall effectiveness of the regulatory reforms. Would regulation and centralized clearing introduced by the recent reforms in the United States reduce the perceived risks associated with OTC derivatives? There is little doubt that centralized clearing will reduce counterparty risk, since the bilateral settlement process with OTC derivatives will now be replaced with centralized clearing and settlement. Transparency will also be improved for the pricing of swaps, since the process of price discovery will now be effectively determined and “advertised” on an organized exchange.31 This is to be contrasted with pricing in OTC derivatives markets, where prices are determined through the process of confidential negotiation and are not generally revealed to other market participants.
The current crisis served to highlight another important issue for consideration, namely whether systemic risk will be reduced through regulation and centralized clearing of swaps. There is little actual evidence to demonstrate that increased regulation and centralized clearing will in fact lead to greater financial stability. Supporters of enhanced regulation have argued that if OTC derivatives markets are subject to regulation and supervisory oversight, overall risk will decline. However, it remains unclear whether regulation and centralized clearing of financial derivatives will in fact deliver more optimal outcomes in times of severe market stress.
It should be remembered that at the height of the financial crisis and following the collapse of Lehman Brothers, all financial markets, whether they were regulated or not, had become dislocated and dysfunctional. In fact, most if not all financial markets had become dislocated at the height of the financial crisis in late 2008 and early 2009. Securities markets and futures markets were highly regulated and were subject to prudential as well as supervisory oversight by a number of regulatory bodies and did not function well at the height of the GFC.
Structured Financial Products: Wrapped, Synthesized, Securitized and Collateralized
In the period preceding the financial crisis, intermediaries created, marketed and sold complex financial instruments which were designed to exploit the growing demand for leveraged financial products. Two types of financial instruments that were typically sold en masse to investors included residential mortgage-backed securities (RMBSs) and collateralized debt obligations (CDOs).32 As part of the marketing strategy to enhance their appeal more broadly in the investment community, both instruments were “wrapped” with a credit default swap and securitized.
Providing credit default swap protection to CDOs and RMBSs allowed these instruments to achieve a higher credit rating than would have otherwise been the case. According to the Financial Crisis Inquiry Commission, between 2000 and 2007 the rating agency Moody’s had issued ratings for $US4.7 trillion in RMBSs and $US736 billion in CDOs.33
A key finding by the Commission of Inquiry into the Financial Crisis was that many of the RMBSs and CDOs attracted AAA credit ratings, which had indirectly contributed to the crisis.34 According to the Commission the “inflated ratings may have enabled the issuance of more subprime mortgages and mortgage-related securities by increasing demand for RMBS and CDOs. If fewer of these securities had been rated AAA, there may have been less demand for risky mortgages in the financial sector and consequently a smaller amount originated.”35