Senior Chinese bank official analyzes US subprime crisis, impact on China
Sep 16, 2008 (BBC Monitoring via COMTEX) -- [Article by Luo Xi, Vice-President of Agricultural Bank of China: "The Evolution of the US Subprime Crisis and its Warning for China"]
The US subprime mortgage crisis broke out in April 2007, hallmarked by the bankruptcy of the New Century Financial Corporation, the second biggest US subprime mortgage company; it spread from the real estate market to the credit market, and proceeded to evolve into a global financial crisis. Since the crisis emerged, its impact on the financial markets and real economy of countries around the world has continually deepened, many financial institutions have made huge losses or even gone bankrupt, and there have been dramatic fluctuations in stock and bond markets. Along with the big surge in oil prices, intensified inflation, and tight credit, the danger of a global economic recession is increasing by the day. This crisis originated in the United States, the country with the greatest economic power and most developed financial system; it started with the securitization of house mortgages, and rapidly involved the whole world; why did the crisis break out so suddenly in this place and in this form, and rapidly spread to the whole world? What were the starter, development, and conductive mechanisms? Getting a clear idea on these issues is of extremely important significance as reference for us in preventing and controlling economic and financial risks at the macro and micro levels.
Recalling and reflecting on the entire course of the outbreak of the crisis, we can clearly see: Against the historic background of the cyclical relaxation of monetary policy and financial controls, a break occurred between the two capital cycle chains - the capital cycle around the US real estate market and the global capital circle centred on the United States, and this was the fundamental cause of the subprime crisis.
I. Breaks in the Multi-link Interest Chain is the Deep-seated Cause of the Crisis
The establishment of the US real estate financial system can be traced back to the last century, hallmarked by the founding of the Federal National Mortgage Association (Fannie Mae for short) in 1938. The securitization of real estate mortgage loans was viewed as a new creation in financial history; it made a massive contribution to improving liquidity of real estate capital and resolving Americans' housing problems, but at the same time it gradually derived an excessively long capital chain, foreshadowing a crisis.
In the early stages the same bank functioned as both issuer of house mortgages and bearer of the risks, hence the bank would strictly check on the borrower's repayment capability; so long as the business was managed well, the bad debt rate was relatively low, but this method restricted the bank's liquidity. People's surging demands for housing and the banks' need to pass on the risks resulted in the United States setting up institutions such as Fannie Mae, specifically to purchase the banks' mortgage loans. These institutions streamed the cash generated from loans into basic issue of bonds and sold them to investors, thus greatly expanding the source of capital for the housing market, reducing the banks' risks and the interest rate on loans, and proceeding to spur the development of the real estate market; this formed a capital cycle centred on real estate, and this financial innovation provided endless massive capital for the US housing market.
Beginning in the 1990s, very many Wall Street corporations also joined in this sector; they repackaged over and over the house mortgage loans and their securitized capital, pushed a great variety of new financial derivatives such as guarantees for debt securities, and provided investment instruments with varying degrees of risk for investors who favoured a variety of risk. Subprime mortgage loans have fixed-period cash repayments, and this is a new source of all returns around these mortgages. Hence, so long as house prices continue to rise, houses purchased are bound to increase value; with increased value, there will certainly be a source of repayment; and with a source of repayment, the risk can be spread through securitization. Here lies the secret to the returns on subprime mortgages and their derivatives. A complex interest chain composed of a variety of institutions and individuals formed around this product innovation process, and as the chain continually lengthened, the original borrower-lender relationship became more and more obscure, and responsibility constraints became more and more diffused, with the result that behavioural dissimilation emerged between the main parties in the chain in pursuit of maximizing their own interests.
When the distance between the final fund provider and the end user became too great, another level of ethical risk in the securitized derivatives of house mortgages arose for each level that trustee agent relationships developed. The drastic changes in the credit and controls cycles were an important cause of promoting the realization of these ethical risks. When credit and control are relaxed, this chain will cause rampant liquidity. The financial loan institutions have an extremely great impulse to release loans, even to persons with a bad credit record, because by turning them over they can be sold; and when monetary policy is tightened and real estate prices fall, the repayment failure rate of the low-credit stratum will increase, and since it is impossible to have 100 per cent securitization, the loan institutions bear the brunt, and then all the participants in the chain are involved. This US subprime financial crisis is precisely confirming the process of this collapse of the interest chain.
II. US Federal Reserve's Loose Monetary Policy is an Important Cause of the Crisis
The formation of the US real estate bubble should first be ascribed to the loose monetary policy practiced since 2000. When the US dotcom bubble burst around 2000, the US economy fell into recession. From January 2001 to June 2003, the Fed lowered the federal fund interest rate 13 times, from 6.5 per cent to a historically low 1 per cent; this round of interest cuts spurred the prosperous housing market from 2001 to 2005. By practicing a low-interest policy, and keeping the interest rate on federal funds as low as 1 per cent for a whole year, the Fed provided a great amount of cheap funds for American society, driving the continued swelling of the housing bubble.
As the US economic rebound and inflation pressure increased, beginning in 2004, the Fed launched a cycle of rising interest rates, with 17 increases in one and a half years; the return rate on one-year T-bonds rose from 1.25 per cent to 5 per cent. Since previous market expectations regarding interest rate were low and borrowers favoured a floating interest rate on loans, after the rate increase the interest burden became much heavier, and in particular, borrowers of subprime mortgage loans were mainly low-income groups with poor risk-resistant capability, and very many people were unable to repay in these circumstances, and the rate of repayment failure rose. It was precisely the sudden loosening and tightening of credit that pricked the US real estate market bubble.
III. Slack Supervision and Control of Financial Institutions is an Important Factor Causing the Crisis
Taking an all-round view of this crisis, among the countries where a burst real estate bubble and credit crisis has occurred, the United States, Britain, and Ireland are typical Anglo-Saxon models. This model believes in the idea of free trade, minimum government interference, and maximum degree of competition; it has established a highly flexible economic system, but gradually slackening supervision and control over financial institutions causes the financial system to frequently get into a crisis.
Looking at the Fed's functions, it has three main tasks: to curb inflation, increase employment, and maintain financial stability. Unlike the European Central Bank, the Fed is not solely focused on inflation. In maintaining financial stability, the market rescue activity adopted by the Fed when turmoil occurred in the financial market in the past was prone to promote the speculative mindset. In particular, Greenspan's methods of liquidity fund injections and big interest rate cuts have been copied by central banks in many countries; this has promoted a mentality of depending on central banks, with the result that financial institutions have relaxed wariness against risks and even produced irresponsible ethical risks.
Looking at the slack supervision and control of the financial institutions, first of all, it was Wall Street lobbying that caused the supervision and control organs to repeal the "Glass Stiegel Act" which was aimed at separating investment banking business from commercial bank business, and that enabled the commercial banks to engage in the whole gamut of banking business. In the United States, financial enterprise profits account for 40 per cent of all listed companies, compared with 5 per cent 20 years ago. The degree of financial expansion is markedly greater than the real economy which it serves, and in addition, as the stumbling block of supervision and control is removed, more and more commercial banks have joined in the derivatives banquet, thus further increasing the hidden perils. The explosive growth of this relaxation of controls is unsustainable, and once the housing bubble bursts, the chain of all kinds of trustee agent relationships is fundamentally broken, and crisis will inevitably occur.
IV. Financial Globalization is the Background Condition Spreading the Crisis
Here we need to mention another major capital cycle, that is, the global capital cycle centred on the US financial market; this is also an important expression of financial globalization. Individual American consumer spending is the main force driving US economic growth, and this consumer spending stems to a very extent from other countries' savings. When a great amount of dollars flow into these countries, in order to avoid the appreciation of their own currencies, these countries' central banks have no choice but to buy dollars and at the same time issue a great amount of their own currency. The result of doing this on the one hand affects the independence of their monetary policy, causing inflationary pressure, and on the other they accumulate massive foreign exchange reserves; considering these reserves from the perspectives of security and value maintenance, they have no choice but to buy US T-bonds. In this way, the funds flow back into the United States, on the one hand lowering the US interest rate and the cost of Americans' consumer credit, and on the other boosting the prices of US assets such as stocks and real estate, further boosting US consumption, and thus forming a big global capital cycle.
In this cycle, the majority of developing countries which depend on exporting primary commodities and raw materials have become America's creditors; Americans export not only dollars but also the Fed's monetary policy and Wall Street's novel products. And the Wall Street investment bankers fly in their spacious Boeings to all corners of the world to peddle their derivatives. As an analyst has explained in imagery: "They put bad pork into the mincing machine and then sell sausages to the world."
The reason why this crisis involves the whole world is because US financial institutions packaged the subprime mortgages into bonds and sold a great amount to international investors, including to some financial institutions in China. Even more serious, the subprime crisis is affecting the real US economy and forcing the United States to readjust its macroeconomic policy; and today when globalization is continually deepening, a US economic policy readjustment is bound to cross America's borders and spread to the whole world, and this is bound to have a still more profound impact on the world economy and evolve into a situation whereby "the whole world foots the bill for US subprime."
V. The Warning of the US Subprime Crisis for China's Financial Business
The impact of the subprime crisis on China is already apparent. Along with the new payment crisis of Fannie Mae and Freddie Mac, oil prices have frequently hit new highs, and the subprime crisis is raging more and more intensely without any sign of a halt, and the US economy may fall into stagflation. The international economic environment has become more complex and changeable by the day since the crisis emerged, and is already putting massive pressure on China's macroeconomic operations. First of all, China's economic dependence on foreign trade is relatively high, and as the US and European economies slide, this will seriously affect China's export fields and enterprises, and this requires corresponding readjustment and change of China's economic structure. Second is the challenge of inflation. Since the United States itself has massive debts, its moves in easing the pressure through cutting interest rates and issuing money are bound to intensify rampant liquidity in the international market, causing price hikes for products in high demand; and since China's natural resources are limited, the resulting inflationary pressure is increasing by the day. In order to deal with inflation, China has recently intensified its tight monetary policy.
The subprime crisis warns us to be cautious in dealing with financial innovations and to do a good job in risk management. The core of finance is risk management; through risk management, funds are operated in a rational way, and more people are able to raise funds in convenient fashion. Very many financial innovations enable people who were previously unable to obtain loans to get funds, and this is the good aspect. The securitization of real estate mortgage loans is a good financial innovation, and we cannot negate it just because of the emergence of this subprime crisis. However, certain problems that have appeared in this crisis, such as many loan institutions luring inexperienced low-income strata into taking loans without clearly demonstrating the risks, is one of the shortcomings of this financial innovation. Profit-chasing Wall Street with its ossified supervision and control, irresponsible grading institutions, and swelling hedge funds bear an unshirkable responsibility in this series of chains.
Looking at the impact on the financial business, the total amount of China's commercial banks' investment-grade bonds is not great, and the direct impact of the subprime crisis is limited. A number of listed banks this year have revealed the state of their investment in subprime products and set aside reserves for losses on the balance sheet. However, timely summing up of the experiences and lessons of the subprime crisis will help us a great deal in our work, and at least we have enlightenment in the following respects regarding bank risk management. First, it is necessary to persist in independent risk judgement in investment and loan activity, ensure our capability to distinguish and control risks, and refrain from investing in products and fields that "we do not understand." Second, the inherent relationship nature between risks of all sorts in modern finance is increasing all the time, and the manifestations of risk are becoming ever more complex. The subprime crisis is the result of the joint role of credit risk, market risk, and operational risk. Since financial risks today can hardly be distinguished and managed in isolation, this demands that our domestic banks must speed up the improvement of their overall risk management standard. Third, it is essential to have a clear-cut risk strategy and policy system and healthy risk culture, put the internal handling structures on a sound basis, strictly enforce risk policy and system, and achieve sustainable development amid the long-term balance of risks and returns. Fourth, we must pay closer attention to the trends in China's real estate market, examine afresh the existing housing development loan and mortgage loan management system, and estimate to the maximum the possibility of large-scale nonperforming loans triggered by the bursting of the real estate bubble. A very important reason why the subprime crisis occurred is that the United States had never experienced a big slide in the overall real estate market; from borrowers and lenders to financial institutions of all types and investors, it was precisely based on this historical experience that they adopted apparently similar tactics, but in the end they could not go beyond the iron rules of market economy; this point is of particularly warning role for China's present macroeconomic policy and micro investment decisionmaking.
Source: Qiushi website, Beijing, in Chinese 16 Sep 08
The US subprime mortgage crisis broke out in April 2007, hallmarked by the bankruptcy of the New Century Financial Corporation, the second biggest US subprime mortgage company; it spread from the real estate market to the credit market, and proceeded to evolve into a global financial crisis. Since the crisis emerged, its impact on the financial markets and real economy of countries around the world has continually deepened, many financial institutions have made huge losses or even gone bankrupt, and there have been dramatic fluctuations in stock and bond markets. Along with the big surge in oil prices, intensified inflation, and tight credit, the danger of a global economic recession is increasing by the day. This crisis originated in the United States, the country with the greatest economic power and most developed financial system; it started with the securitization of house mortgages, and rapidly involved the whole world; why did the crisis break out so suddenly in this place and in this form, and rapidly spread to the whole world? What were the starter, development, and conductive mechanisms? Getting a clear idea on these issues is of extremely important significance as reference for us in preventing and controlling economic and financial risks at the macro and micro levels.
Recalling and reflecting on the entire course of the outbreak of the crisis, we can clearly see: Against the historic background of the cyclical relaxation of monetary policy and financial controls, a break occurred between the two capital cycle chains - the capital cycle around the US real estate market and the global capital circle centred on the United States, and this was the fundamental cause of the subprime crisis.
I. Breaks in the Multi-link Interest Chain is the Deep-seated Cause of the Crisis
The establishment of the US real estate financial system can be traced back to the last century, hallmarked by the founding of the Federal National Mortgage Association (Fannie Mae for short) in 1938. The securitization of real estate mortgage loans was viewed as a new creation in financial history; it made a massive contribution to improving liquidity of real estate capital and resolving Americans' housing problems, but at the same time it gradually derived an excessively long capital chain, foreshadowing a crisis.
In the early stages the same bank functioned as both issuer of house mortgages and bearer of the risks, hence the bank would strictly check on the borrower's repayment capability; so long as the business was managed well, the bad debt rate was relatively low, but this method restricted the bank's liquidity. People's surging demands for housing and the banks' need to pass on the risks resulted in the United States setting up institutions such as Fannie Mae, specifically to purchase the banks' mortgage loans. These institutions streamed the cash generated from loans into basic issue of bonds and sold them to investors, thus greatly expanding the source of capital for the housing market, reducing the banks' risks and the interest rate on loans, and proceeding to spur the development of the real estate market; this formed a capital cycle centred on real estate, and this financial innovation provided endless massive capital for the US housing market.
Beginning in the 1990s, very many Wall Street corporations also joined in this sector; they repackaged over and over the house mortgage loans and their securitized capital, pushed a great variety of new financial derivatives such as guarantees for debt securities, and provided investment instruments with varying degrees of risk for investors who favoured a variety of risk. Subprime mortgage loans have fixed-period cash repayments, and this is a new source of all returns around these mortgages. Hence, so long as house prices continue to rise, houses purchased are bound to increase value; with increased value, there will certainly be a source of repayment; and with a source of repayment, the risk can be spread through securitization. Here lies the secret to the returns on subprime mortgages and their derivatives. A complex interest chain composed of a variety of institutions and individuals formed around this product innovation process, and as the chain continually lengthened, the original borrower-lender relationship became more and more obscure, and responsibility constraints became more and more diffused, with the result that behavioural dissimilation emerged between the main parties in the chain in pursuit of maximizing their own interests.
When the distance between the final fund provider and the end user became too great, another level of ethical risk in the securitized derivatives of house mortgages arose for each level that trustee agent relationships developed. The drastic changes in the credit and controls cycles were an important cause of promoting the realization of these ethical risks. When credit and control are relaxed, this chain will cause rampant liquidity. The financial loan institutions have an extremely great impulse to release loans, even to persons with a bad credit record, because by turning them over they can be sold; and when monetary policy is tightened and real estate prices fall, the repayment failure rate of the low-credit stratum will increase, and since it is impossible to have 100 per cent securitization, the loan institutions bear the brunt, and then all the participants in the chain are involved. This US subprime financial crisis is precisely confirming the process of this collapse of the interest chain.
II. US Federal Reserve's Loose Monetary Policy is an Important Cause of the Crisis
The formation of the US real estate bubble should first be ascribed to the loose monetary policy practiced since 2000. When the US dotcom bubble burst around 2000, the US economy fell into recession. From January 2001 to June 2003, the Fed lowered the federal fund interest rate 13 times, from 6.5 per cent to a historically low 1 per cent; this round of interest cuts spurred the prosperous housing market from 2001 to 2005. By practicing a low-interest policy, and keeping the interest rate on federal funds as low as 1 per cent for a whole year, the Fed provided a great amount of cheap funds for American society, driving the continued swelling of the housing bubble.
As the US economic rebound and inflation pressure increased, beginning in 2004, the Fed launched a cycle of rising interest rates, with 17 increases in one and a half years; the return rate on one-year T-bonds rose from 1.25 per cent to 5 per cent. Since previous market expectations regarding interest rate were low and borrowers favoured a floating interest rate on loans, after the rate increase the interest burden became much heavier, and in particular, borrowers of subprime mortgage loans were mainly low-income groups with poor risk-resistant capability, and very many people were unable to repay in these circumstances, and the rate of repayment failure rose. It was precisely the sudden loosening and tightening of credit that pricked the US real estate market bubble.
III. Slack Supervision and Control of Financial Institutions is an Important Factor Causing the Crisis
Taking an all-round view of this crisis, among the countries where a burst real estate bubble and credit crisis has occurred, the United States, Britain, and Ireland are typical Anglo-Saxon models. This model believes in the idea of free trade, minimum government interference, and maximum degree of competition; it has established a highly flexible economic system, but gradually slackening supervision and control over financial institutions causes the financial system to frequently get into a crisis.
Looking at the Fed's functions, it has three main tasks: to curb inflation, increase employment, and maintain financial stability. Unlike the European Central Bank, the Fed is not solely focused on inflation. In maintaining financial stability, the market rescue activity adopted by the Fed when turmoil occurred in the financial market in the past was prone to promote the speculative mindset. In particular, Greenspan's methods of liquidity fund injections and big interest rate cuts have been copied by central banks in many countries; this has promoted a mentality of depending on central banks, with the result that financial institutions have relaxed wariness against risks and even produced irresponsible ethical risks.
Looking at the slack supervision and control of the financial institutions, first of all, it was Wall Street lobbying that caused the supervision and control organs to repeal the "Glass Stiegel Act" which was aimed at separating investment banking business from commercial bank business, and that enabled the commercial banks to engage in the whole gamut of banking business. In the United States, financial enterprise profits account for 40 per cent of all listed companies, compared with 5 per cent 20 years ago. The degree of financial expansion is markedly greater than the real economy which it serves, and in addition, as the stumbling block of supervision and control is removed, more and more commercial banks have joined in the derivatives banquet, thus further increasing the hidden perils. The explosive growth of this relaxation of controls is unsustainable, and once the housing bubble bursts, the chain of all kinds of trustee agent relationships is fundamentally broken, and crisis will inevitably occur.
IV. Financial Globalization is the Background Condition Spreading the Crisis
Here we need to mention another major capital cycle, that is, the global capital cycle centred on the US financial market; this is also an important expression of financial globalization. Individual American consumer spending is the main force driving US economic growth, and this consumer spending stems to a very extent from other countries' savings. When a great amount of dollars flow into these countries, in order to avoid the appreciation of their own currencies, these countries' central banks have no choice but to buy dollars and at the same time issue a great amount of their own currency. The result of doing this on the one hand affects the independence of their monetary policy, causing inflationary pressure, and on the other they accumulate massive foreign exchange reserves; considering these reserves from the perspectives of security and value maintenance, they have no choice but to buy US T-bonds. In this way, the funds flow back into the United States, on the one hand lowering the US interest rate and the cost of Americans' consumer credit, and on the other boosting the prices of US assets such as stocks and real estate, further boosting US consumption, and thus forming a big global capital cycle.
In this cycle, the majority of developing countries which depend on exporting primary commodities and raw materials have become America's creditors; Americans export not only dollars but also the Fed's monetary policy and Wall Street's novel products. And the Wall Street investment bankers fly in their spacious Boeings to all corners of the world to peddle their derivatives. As an analyst has explained in imagery: "They put bad pork into the mincing machine and then sell sausages to the world."
The reason why this crisis involves the whole world is because US financial institutions packaged the subprime mortgages into bonds and sold a great amount to international investors, including to some financial institutions in China. Even more serious, the subprime crisis is affecting the real US economy and forcing the United States to readjust its macroeconomic policy; and today when globalization is continually deepening, a US economic policy readjustment is bound to cross America's borders and spread to the whole world, and this is bound to have a still more profound impact on the world economy and evolve into a situation whereby "the whole world foots the bill for US subprime."
V. The Warning of the US Subprime Crisis for China's Financial Business
The impact of the subprime crisis on China is already apparent. Along with the new payment crisis of Fannie Mae and Freddie Mac, oil prices have frequently hit new highs, and the subprime crisis is raging more and more intensely without any sign of a halt, and the US economy may fall into stagflation. The international economic environment has become more complex and changeable by the day since the crisis emerged, and is already putting massive pressure on China's macroeconomic operations. First of all, China's economic dependence on foreign trade is relatively high, and as the US and European economies slide, this will seriously affect China's export fields and enterprises, and this requires corresponding readjustment and change of China's economic structure. Second is the challenge of inflation. Since the United States itself has massive debts, its moves in easing the pressure through cutting interest rates and issuing money are bound to intensify rampant liquidity in the international market, causing price hikes for products in high demand; and since China's natural resources are limited, the resulting inflationary pressure is increasing by the day. In order to deal with inflation, China has recently intensified its tight monetary policy.
The subprime crisis warns us to be cautious in dealing with financial innovations and to do a good job in risk management. The core of finance is risk management; through risk management, funds are operated in a rational way, and more people are able to raise funds in convenient fashion. Very many financial innovations enable people who were previously unable to obtain loans to get funds, and this is the good aspect. The securitization of real estate mortgage loans is a good financial innovation, and we cannot negate it just because of the emergence of this subprime crisis. However, certain problems that have appeared in this crisis, such as many loan institutions luring inexperienced low-income strata into taking loans without clearly demonstrating the risks, is one of the shortcomings of this financial innovation. Profit-chasing Wall Street with its ossified supervision and control, irresponsible grading institutions, and swelling hedge funds bear an unshirkable responsibility in this series of chains.
Looking at the impact on the financial business, the total amount of China's commercial banks' investment-grade bonds is not great, and the direct impact of the subprime crisis is limited. A number of listed banks this year have revealed the state of their investment in subprime products and set aside reserves for losses on the balance sheet. However, timely summing up of the experiences and lessons of the subprime crisis will help us a great deal in our work, and at least we have enlightenment in the following respects regarding bank risk management. First, it is necessary to persist in independent risk judgement in investment and loan activity, ensure our capability to distinguish and control risks, and refrain from investing in products and fields that "we do not understand." Second, the inherent relationship nature between risks of all sorts in modern finance is increasing all the time, and the manifestations of risk are becoming ever more complex. The subprime crisis is the result of the joint role of credit risk, market risk, and operational risk. Since financial risks today can hardly be distinguished and managed in isolation, this demands that our domestic banks must speed up the improvement of their overall risk management standard. Third, it is essential to have a clear-cut risk strategy and policy system and healthy risk culture, put the internal handling structures on a sound basis, strictly enforce risk policy and system, and achieve sustainable development amid the long-term balance of risks and returns. Fourth, we must pay closer attention to the trends in China's real estate market, examine afresh the existing housing development loan and mortgage loan management system, and estimate to the maximum the possibility of large-scale nonperforming loans triggered by the bursting of the real estate bubble. A very important reason why the subprime crisis occurred is that the United States had never experienced a big slide in the overall real estate market; from borrowers and lenders to financial institutions of all types and investors, it was precisely based on this historical experience that they adopted apparently similar tactics, but in the end they could not go beyond the iron rules of market economy; this point is of particularly warning role for China's present macroeconomic policy and micro investment decisionmaking.
Source: Qiushi website, Beijing, in Chinese 16 Sep 08
