The 2007 to 2010 financial crisis led to the failure of a number of investment banks and financial institutions failure in U.S. This means that their capital is too low to meet their obligations to their depositor or creditors because they are too illiquid to meet their liabilities. They (e.g. Merrill Lynch and Bear Stearns) are either acquired or merged by another financial institution, declared insolvent or liquidated or filed for bankruptcy (e.g. Lehman Brothers). The Federal Deposit Insurance Corporation (FDIC) who is appointed by the U.S. government to guarantee the safety of deposits in member banks would normally take order these failed banks. Therefore, the financial crisis has transformed the status of investment banks as well the role of state in banking.
New financial instruments innovations are the key drivers to the change in the financial business environment which lead to bank failure and subsequently the recent financial crisis. In this section we will look at these financial instruments in details especially those that caused bank failures, what we can do about them and how the business environment had been changed.
Introduction to Financial Instruments
Financial instruments are designed to facilitate trade on financial market or are created through financial intermediation. Financial transactions that take place in the money market incurred costs to the borrowers and lenders. The modern financial system has opened the following platforms to economize on these costs.
Financial market is where financial instruments are traded. Depending on whether the instruments are first issued or retraded, these markets are named as primary market or secondary market respectively. When a financial instrument is issued, transaction costs are incurred such as the costs for issuer to draw up the instrument, costs for borrower to evaluate the terms and creditworthiness of the issuer, dealers/brokers fees, fees for clearing payments, government taxes and administration fees for changing the ownership. In an organized financial market, quality price information, market news, interest rate news are reported and published in a timely manner and easy accessible. Trades are being regulated by government or regulatory bodies. All these features mean that a lot of money can be made quickly by trades which anticipate price movements.
Financial intermediary is a media for indirect financing with an act of borrowing from ultimate leaders and re-lending the funds to ultimate borrowers. All financial intermediation creates new financial instruments with an incentive to reduce the costs of financial transactions. Technical advances which lower transaction costs will make viable new forms of intermediation and new instruments. Financial intermediaries can be depository institutions or authorized institutions that issue receipts and deposits, insurance company that issue insurance contracts, institutions that issue mutual funds, unit trusts or pension funds.
Financial instruments can be debt instruments, equity instruments, money market instrument or capital market instruments. A debt instrument is a promise to repay the principal plus the interest. The instrument is issued by the borrower and held by the lender in exchange for giving up or deferring the use of his funds. The instrument is a liability for the borrower and an asset for the lender. Some examples of debt instruments are fixed-term loans (must be held to maturity by the lender); bonds and equities (negotiable in that they can be re-sold before maturity); mortgages (principal to repay over the term to maturity); Government bills (interest can be paid at maturity, along with principal); Government bonds (interest to be paid over the term to maturity). A debt instrument with a stated term to maturity can be revoked before maturity by one of the parties. For example a bank can demand repayment of the principal and interest of a loan before maturity or an issuer of a callable corporate bond can have the right to repay the loan in whole or part before maturity.
An equity instrument is an ownership claim on assets, entitling the holder to a specified share of the income from those assets issued by the legal entity managing those assets and held by the shareholders in exchange for the funds that they contributed to purchase the assets. It is a liability of the corporation and an asset of the shareholders. Some examples of equity instruments are stock; stock options; equity futures; exotic instruments.
Money market instruments are debt instruments issued with maturities of one year or less. They provide efficient, low-cost source of funds (liquidity management) to firms, intermediaries and the government in need of a short-term cash injection. Securities that are being traded in this market are short-term and highly liquid and therefore they are easily converted into the medium of exchange. Because of this features, trades can easily be arranged electronically over the phone. Because of this flexibility, there always exists an active secondary market for money market securities as it is easy to resell it to a third party after the initial sales. This is a very flexible instrument for secondary markets to manage short-term cash flows and a media for firms, financial institutions or government to "warehouse" surplus funds for short time frame. Some examples of money market instruments are federal funds market that banks borrowed; Governments bills; commercial papers issued by finance companies; money market mutual fund.
Capital market instruments are issued with maturities of more than one year. Some examples are bonds and equities. The issuers of these instruments are aim to raise funds for financing investment projects that will generate profits for the future. The bonds markets and money markets are interrelated as the interest rate, price to liquidity, availability of funds for money markets (short-term) investments drive the bonds markets (long-term). In the presence of active money markets in a country to establish short-term interest rate, borrowers and lenders will have more confidence that longer-term rate are reasonable and that their securities can be sold on the secondary markets.
Types of Financial Instruments
Below will describe in further details the financial instruments that are dominated in the U.S. or global financial markets and that lead to bank failure and the current financial crisis.
Bills are short-term government debt securities issued to cover government budget deficits and refinance maturing government debts. U.S. Treasury bills or T-Bills are the most common forms of bills in the world's financial markets. The transactions of bills are only recorded in a book-entry system by the Treasury and the Federal Reserve whereas physical securities are never delivered. This enhanced the secondary market trading which constitute the world's largest and most liquid market attracting investors who are seeking a safe haven for temporarily surplus funds.
Interbank Loans are immediately available funds which are loaded or borrowed amongst financial institutions for a very short period of time or just overnight in order to meet depositor withdrawals and regulatory requirements. This allows a bank to minimize its holdings of highly liquid but low income-earning instruments like government bills. The borrowing bank paid an interbank rate. This interest rate charged is a key rate as it represents bank's cost of funds and served as a benchmark for other interest rate in the economy. The most common interbank rates are federal funds rate (U.S.), LIBOR (UK) and HIBOR (HK). Of which federal funds rate is the most important interest rate in the world as U.S. central bank and the Federal Reserve will manipulates this rate when they execute monetary policy to influence economic growth especially during financial crisis. One reason that lead to the fall of Lehman is that there high costs of borrowing that banks are charging each others.
Bankers' Acceptance is a money market instrument created to facilitate international trade transactions where the creditworthiness of trading partners is unknown to each other. Acceptances are sold at a discount face value of the payment order and trade at a discount from par value at a spread over T-bills. The rates at bankers' acceptance are traded are called bankers' acceptance rates. These rates became the standard index of various derivatives and interest rate swaps. Bankers' acceptance can also be traded on the secondary market prior to maturity as they are payable to the bearer.
Commercial paper is short-term unsecured promissory notes issued by corporations, banks and financial companies to obtain short-term debt obligations such as to finance the corporations' daily operations. They are only backed by the promise of the issuing parties to pay the face value on the maturity date spelled out on the notes. They are less liquid and therefore a much cheaper mean to raise funds should they have strong credit rating. They have less resale flexibility and are more exposed to default risk. The market for commercial paper diminished after the collapse of Lehman Brothers in September 2008.
Figure 1 - U.S. Commercial Paper outstanding at end of each year 2001 to 2007
Negotiable certificates of deposit (NCDs) is a type of contract for payment of money issued by a bank indicating that a depositor has placed a specified sum of money with it for a particular period of time at a specified rate of interest. This type of instrument is very common for U.S. corporations after T-bills as they are negotiable in that they can be re-sold on the secondary market in the course of managing their liquidity positions. They enjoy higher interest rates than on Government bills, however, they are subjected to higher default risk and credit risk especially when financial crisis in banking system.
Eurodallars are dollar-denominated deposits held outside the U.S. They are not subjected to high regulations and therefore they are entitled to higher margin rates. Eurodallar markets has expended rapidly as borrowers can raise funds at a more favourable rate than in the domestic market. LIBOR fund rate are offered for sales in this market.
Repurchase Agreement (Repo) is a collateralized loan which the collateral is a security. In a repurchase agreement, a securities dealer will first sell securities it owns to an investor agreeing to repurchase the securities at a specified higher price on an agreed future date. Then some days or months later, the repo position is unwound when the dealer buys back the securities from the investor. Corporate Treasury/ Government bills/bonds may all be used as collaterals in repurchase agreement transactions. Repo played a critical role in the U.S. money markets as they enhanced the liquidity and ensured constant supply of buyers for new money market instruments. However, Repo is subjected to credit risk and many factors as terms of repo, creditworthiness of the parties and liquidity of the securities. Both parties may default on their obligations to repurchase or sell the securities as agreed.
Money Market Mutual Fund is a short-term open-end mutual fund invested in debt obligations such as T-bills, NCDs and commercial paper. The shift of short-term funds into money market mutual funds rather than banks is most advanced and common in U.S., which began deregulating its financial sector. Thus, money market funds are a comparatively recent innovation and has been growing rapidly especially in the U.S. market that owned more than one-quarter of the world's money market instruments.
After the collapsed of Lehman Brothers, the Reserve Primary Fund (one type of U.S. money market fund) broke the buck when its share fallen below the $1 to 97 cents after writing off Lehman's debts. This almost caused the money market fund to collapse and bankruptcy on the shadow banking system. During the crisis, investors tended to redeem their holdings and therefore forced funds to liquidate. This caused a huge liquidity crisis as more institutions are going to default on their obligations to repay their debts.
Figure 2 - Assets of money market mutual funds
Bonds are one form of capital market instrument that provide an efficient means for channeling saving into productive investments by firms. Public authorities, credit institutions and companies can raise funds for expansion by issuing either debt or equity instruments. Long-term debt securities (Bonds) are also issued by governments to finance their infrastructure projects. Bonds offered a way for governments to borrow from public individuals rather than just limited banking organizations. Bonds are being most widely used amongst all financial instruments. They entitled the owner to receive interest payments during the life of the bond and repayment of principal on maturity without ownership and control of the issuer.
The main reason for issuing bonds is to diversify funding sources as the issuer can raise more funds from a larger base of bond-market investors. Bonds also enable issuers to minimize financing costs because the cost of bonds issuing are relatively lower as compared to other forms of leverage and the funds can be repaid over a long period.
U.S. Treasury bonds, also known as Treasuries, are the most widely held securities in the world. The Treasury market is the most liquid bond market in the world as they are backed by "full faith and credit" of the U.S. government. Treasury securities are viewed as free from default risk and their interest rates benchmark the risk-free rates on international capital markets.
Figure 3 - Top Foreign holders of U.S. Treasuries [1]
Corporate bonds are issued by business enterprises. They are mostly term bonds that matured on a single date and some of them are serial bonds which they are going to be paid off on different maturity dates. Other bonds issued by corporations included mortgage bonds that are secured by collateral in the case of payment default and guaranteed bonds that are secured obligations guaranteed by an entity. Corporate bonds can also be in the form of debentures which they are unsecured and riskiest but generating higher return on profit.
In the past, bonds are being underwritten by underwriters and dealers and with the current market situation, mergers and acquisition of investment banks, the huge investment banks that dominate bond underwriting are mostly based in the U.S. Also with the changes of business environment and innovation of new technology, bond issuers now sell their bonds directly to investors over the internet, without the intermediation of underwriters or dealers. This had greatly reduced the profits of investment banks.
Traditionally, bonds are being considered as fixed-income securities with low-risk for investors as their capital are normally being preserved in the volatile market. Since 1970s, bond markets have transformed greatly. Many new forms of bonds now bear a high risk and no longer guarantee a fixed income. Until 1970s, the bond market was based on primary market trading and that investors would hold the bonds until maturity. The obligations could be predicted far in advance as their investment strategy was just to match assets and liabilities. Since late 1970s, the development of computers and technologies and the change in accounting rules that bond price are valued "market-to-market", many bonds trading are now performing on the secondary market. This is to take advantage of price differences, rather than holding them until maturity. The majority of bond trades now are happening over-the-counter market. The problem arises are prices reported on the exchanges are generally considered to be inexact estimates and it involved higher degree of liquidity risk.
Junk bonds are important bond-market developments in recent years and are growing in the U.S. bond market. They are known as high-yield debt insured by entities with weak credit ratings. In return for offering higher interest, high-yield bonds carry a much larger risk of default, especially in times of economic stress. Emerging market bonds also start to growth in 1990s, firms and governments in emerging economies have issued bonds internationally and about 65 to 75% of emerging market bonds is denominated in U.S. dollars. These bonds carry foreign exchange risk, when the currency of these emerging countries deteriorated or when government policies changed on exchange controls, many bonds issuers are unable to afford the foreign exchange required to service their bonds, defaulted.
With the increase in subprime mortgages and home loan during 2004, asset-backed securities were developed. An asset-backed security is a type of bond offering no promises of cash flows and guarantee of bond repayment upon maturity. There is often no backing by the full faith and credit of government or private company. There is no assurance that the income will be received as anticipated as these securities are supported by a stream of future income expected from specific assets such as mortgage loans, credit card loans or future sales. To compensate for this greater uncertainty, asset-backed securities yield higher returns than regular government or corporate bonds. With higher profit margin, this market has grown rapidly in recent years and most of these are mortgage-backed securities and three-quarters of all asset-backed securities are issued in U.S. and therefore when the housing bubble busted, asset-backed securities went into default which caused the financial crisis. Mortgages dominate the securitization market. It originated from Fannie Mae in 1983 to boost the economy during the Great Depression by purchasing mortgages from thrift institutions thus allowing them to generate more loans. Furthermore, the U.S. government established the Ginnie Mae and Freddie Mac associations to provide direct or indirect guarantees to mortgage-backed securities.
UBS reported a loss related to subprime mortgages for the year ended December 2007. They engaged capital to invest in high-yielding mortgage-backed securities. UBS charged a very low cost of capital and did not vary that charge based on the riskiness of the assets being purchased. Their fee structures provide incentives for buyers to invest in this risky security. Traders received 3-4 times higher of this fee income when they brought CDOs. However, when the asset values declined, the liquidity of the assets also flawed.
At Bear Steans, the company had massive exposure to mortgage-backed securities. Even with rising default rate and lower house prices, it had not changed its business strategies or financing. Same as for CitiGroup and Merrill Lynch who are also involved in huge off-balance sheet activities that are difficult to value on their financial book such as Structured Investment Vehicles. These financing instruments provide them with extra income but they are ended up being toxic assets when the short-term capital markets froze.
Besides mortgage-backed securities, private sectors, commercial and investment banks also developed new ways of securitizing subprime mortgages, i.e. to re-pack them as "Collateralized Debt Obligations" (CDOs), where cash flows were divided into "tranches" catering to different classes of investors with varied risk tolerances. By doing so, the developers of CDOs were convincing enough to get the highest ratings for the securities. In some cases, so-called "mono-line" bond insurers were selling protection insurance to CDO investor's that would pay off in event that loans went into default. In other cases, investment banks and other parties were also selling "credit default swaps" (CDS), similar to mono-line insurance in principle but the difference was in their risk categories, as CDS sellers put up comparatively less capital to back up their transactions. [2]
They maximized their income by maximizing the number of transactions and the layers of derivative securities. They were free to do so because the shadow banking system eluded regulatory oversight and capital requirements. The shadow system froze when its players realized that the multiple layers of the derivatives had made it so complex and interconnected that credit ratings were unreliable, while the CDS market simply exchanged guesses and rumours. This raised the negative capital of the shadow system so high that it froze.
Goldman was sued by U.S. regulators on 14 April 2010 for fraud tied to collateralized debt obligations that contributed to the worst financial crisis since the Great Depression. The firm's shares tumbled 13 percent and financial stocks slumped. Goldman Sachs created and sold CDOs linked to subprime mortgages in early 2007, as the U.S. housing market faltered, without disclosing that hedge fund Paulson & Co. helped pick the underlying securities and bet against the vehicles. [3]
Diminish of Money market diminished and collapse of investment banks
The development of financial instruments suggested that they are providing a platform for investment banks and financial institutions that are involved in the money market transaction a stronger incentive to engage in risky business behavior; to measure wrong things with the wrong time horizon and less incentive to protect their company. This also reflected that the top level management had focused too much on growth in profits, product innovations, pricing, market shares revenues and neglecting the risk incurred that drive their company to fall. And the majority of financial instruments they created had given investors the inevitably incorrect concept that their returns are high and risks are low. One obvious fact about the cause of current financial crisis is that that had been an explosion in global liquidity. If we looked at Lehman Brothers, Bear Stearns and other similar financial institutions who have high incentives for greater short-term profits, they had borrowed short to invest long. They had high debt level relative to equity which caused them to have very limited cash liquidity. Once there was a general shock to confidence from a major default, short-term loans dried up for all institutions. This deteriorated their power to response to the financial crisis and ended up being declared bankrupted or merged with another financial institutions.
