Price increases create expectations of further price increases that feed on themselves producing what former Federal Reserve Board Chairman Alan Greenspan called irrational exuberance. The dot-com bubble, in which the NASDAQ composite index soared 500 per cent from 1996 to March 2000 before collapsing back to its original value in 2002 (1,000 to 5,048 and back in six years!). And now the real estate bubble are the latest of many. The famous South Sea bubble collapsed in 1720.
Global financial markets and most developed country economies are staggering from the effects of the bursting of housing price bubbles (more serious in Europe than the US). In the US this bubble resulted primarily from very large inflows of foreign capital to finance US imports in excess of its exports, an accommodative monetary policy of very low interest rates and a government policy that encouraged mortgages to low income households (now called subprime) that promoted increasingly lax mortgage lending standards. The securitisation of mortgages (issuing bonds collateralised by pools of mortgages called Mortgage Backed Securities) attracted huge amounts of financing to the mortgage market at relatively low interest rates to the benefit of home buyers. Government Sponsored Enterprises, Fannie Mae and Freddie Mac, own or guaranteed about half of them. With such attractive financing the demand for houses rose more rapidly than the supply. Home prices more than doubled in California and Florida, for example, from 2001 through 2006. They have fallen 31 per cent (through August) in the Los Angeles area from their September 2006 peak and would need to fall another 24 per cent to return to their level at the beginning of 2003.
The current bubble differs from earlier ones because of its scale. Residential mortgages in the US amount to almost $11 trillion. With declining home prices, foreclosure rates have increased significantly with losses to mortgage lenders of around $500 billion by mid 2008. These losses are expected to rise to over $1 trillion by the end of 2009. At the end of 2007 the capital of US banks, their financial cushion for absorbing losses, was around $700 billion. However, because Mortgage Backed Securities were sold all over the world, these losses are also spread over the whole world, which has additional capital to absorb them. Because of these increased expected losses individual MBSs are difficult to value. The dramatic growth of MBSs and other complex financial instruments has made it difficult for the market to determine who will actually bear these loses. All of these uncertainties have made MBSs difficult trade reducing both their liquidity and market value (and the capital of banks holding them).
The world economy is in the process of adjusting to several shocks at the same time (oil, food, and other commodity prices, housing market glut in the US and Europe, external and fiscal deficits in the US, and over valued stocks in the US). This has put the otherwise healthy and productive US economy and most European economies into recession, which will add additional losses to banks from credit card loans, car loans, and other credits. Banks have become concerned about the soundness of their borrowers (often other banks) and increased the risk premium charged for loans while attempting to build up their own liquidity. The Federal Reserve Banks in the US responded to this liquidity crunch by providing banks with hundreds of billions of dollars in cash through their traditional and newly enlarged lending facilities and through open market operations (outright purchases and sales of securities). The ECB, Bank of England and many other central banks have done the same. These are traditional and appropriate central bank functions.
But financial market problems were more serious than temporary liquidity problems. Mortgage losses and market turmoil have brought down a number of banks, starting with Northern Rock in the UK, followed later by Fortis in Benelux, Landsbanki, Kaupthing and Glitnir Banks in Iceland, and Countrywide, IndyMac, Washington Mutual, and Wachovia in the US, to name the bigger ones. The US has efficient legal tools for failing bank resolution and these failures were handled with barely a ripple in the market. As a few big non bank financial firms headed toward failure, their resolution without the efficient tools available for commercial banks became more difficult (Bear Stearns, Fannie Mae, Freddie Mac, and AIG).
With the bankruptcy of Lehman Brothers (an investment bank) on 15 September, large banks around the world panicked and largely stopped lending to each other for longer than overnight indicating a capital shortage on top of the liquidity squeeze. More importantly, the broader credit markets (the so called shadow banking system of investment banks, hedge funds, pension funds, insurance companies, etc) froze up as well as hedge funds and other financial market players accelerated their de-leveraging (investment of borrowed funds) by selling assets to repay creditors. Non financial companies suddenly had difficulty obtaining normal working capital loans. It was this financial panic and the nose dive of the stock market wiping out trillions of dollars in equity value that led US Treasury Secretary Paulson and Federal Reserve Board Chairman Bernanke to plead with the US Congress for board authority to buy up to $700 billion of financial assets, including bank shares, and to raise the coverage of Federal Deposit Insurance. These emergency measures (and some other unrelated things) were adopted a week later as the Emergency Economic Stabilization Act of 2008. Secretary Paulson later decided to use these funds primarily to inject capital into solvent and viable banks in order to free them up to lend more.
On October 8, UK Prime Minister Gordon Brown announced that the British Treasury would inject capital (buy shares) in eight major British banks and guarantee interbank loans, the Bank of England would double the size of its special liquidity scheme and the government would increase the size of guaranteed deposits.1 On 13 October most European governments promised to follow suit. These measures taken together were meant to stop bank runs, increase bank capital and remove the counterparty risk of interbank lending in order to restore normal lending and credit flows.
Stopping the financial panic required steps to reassure depositors and investors that it was safe to leave or put their funds in banks and to increase bank capital to levels that would allow them to continue lending to credit worthy customers. Uncertainty about the soundness of banks needed to be removed. It was too late for carefully considered and finely tuned measures, thus broad brushed guarantees and capital injections were used. None the less, the cost to tax payers should be considered and damage to market discipline should be minimised where possible.
Bank capital deficiencies would also be reduced by measures to help homeowners unable to service their mortgages and thus to reduce the number of mortgage defaults and foreclosures. The financial panic could have been ended overnight by a blanket government guarantee of all mortgage loans, however, the moral hazard would have been severe and public outrage over the gross unfairness of rewarding reckless speculators with the tax dollars of more prudent borrowers would surely have been pronounced. However, there is scope for mortgage lenders to renegotiate more favourable terms as long as the cost to them is smaller than from foreclosure and the government will probably share some of that cost.
More time will be needed to fully understand the causes of the current crisis and thus what best to do to avoid repeats in the future. There is always the danger that over reacting to quickly enact new regulations will do more harm than good. Areas where reforms are being discussed range from extending the legal tools found in American bank insolvency laws to a broader range of financial institutions, improving the pluming (back office processing and accounting) for Credit Default Swaps and other derivatives); limiting CDS’s to those with the actual credit exposure being insured (i.e. banning naked CDS’s), strengthening capital charges for CDSs, reducing or eliminating tax incentives for leverage (including the mortgage interest deduction from personal income tax), refining the treatment of on and off balance sheet items for bank capital adequacy, making rating agencies liable for their work to the same standard as auditors, to strengthening rules on broker/dealer/bank use of collateral.2 More broadly, solutions must be found for the break down of lending standards arising because private sector actors (brokers and agents) make decisions for fees with regard to other peoples money (should mortgage originators be required to keep some of the risk—to have some skin in the game—and should bonuses have to be structured to avoid rewording undue risk taking?). In addition, in the US existing gaps in and poor coordination of financial sector supervision should be fixed by the reorganisation of supervisory agencies and responsibilities.3 Morris Goldstein of the Peterson Institute of International Economics has outlined 10 points for reform “Making the G-20 Summit Work: The ‘Ten-Plus-Ten’ Plan” that provide a good basis for discussion of what might be needed.
The implications for the Cayman Islands of these developments divide into those for the economy and those for the future of its financial services industry. A recession in the US and Europe will almost certainly reduce tourism to Cayman. It is also likely to reduce foreign demand for vacation homes and real estate development in Cayman. Thus Cayman will share the recession with the rest of the world.
The likely restructuring of global financial markets away from complex derivative instruments, reduced reliance on leverage, and a dramatic curtailment of Credit Default Swaps and the number of hedge funds, will reduce the demand for the financial services provided in Cayman to construct the special purpose vehicles through which MBS’s and other Collateralized Debt Obligations are created and other associated back office financial services. The expected fall in the number of hedge fund licenses will hurt government revenue.
Even before the current financial crisis pressure has been building, especially from France and Germany, to strengthen countries’ access to potential tax liability relevant information of their resident’s foreign investments. Though offshore financial centres like Cayman have played no role whatsoever in the current global crisis, it will dramatically increase those pressures. As in the past, the emphasis is on information exchange.
Over the past decade Cayman has worked hard to develop a solid reputation for cross border cooperation as part of the wider effort to protect the international system from the activities of illicit actors. The excellent progress recorded is particularly evident in the very positive report of the CFATF in late 2007 on the compliance of Cayman with international anti-money laundering and terrorist finance standards. While unfortunately that outcome has not yet resulted in Cayman being placed on the EU white list of equivalent countries and territories for AML purposes, the report will be of significant value in any future discussions with standard setters in these and related spheres.
The work plan adopted by the Group of 20 heads of state meeting in Washington DC 14-15 November contained the following (bolding added for emphasis):4
Promoting Integrity in Financial Markets
Immediate Actions by 31 March, 2009
* Our national and regional authorities should work together to enhance regulatory cooperation between jurisdictions on a regional and international level.
* National and regional authorities should work to promote information sharing about domestic and cross-border threats to market stability and ensure that national (or regional, where applicable) legal provisions are adequate to address these threats.
* National and regional authorities should also review business conduct rules to protect markets and investors, especially against market manipulation and fraud and strengthen their cross-border cooperation to protect the international financial system from illicit actors. In case of misconduct, there should be an appropriate sanctions regime.
Medium -term actions
* National and regional authorities should implement national and international measures that protect the global financial system from uncooperative and non-transparent jurisdictions that pose risks of illicit financial activity.
* The Financial Action Task Force should continue its important work against money laundering and terrorist financing, and we support the efforts of the World Bank – UN Stolen Asset Recovery Initiative.
* Tax authorities, drawing upon the work of relevant bodies such as the Organization for Economic Cooperation and Development, should continue efforts to promote tax information exchange. Lack of transparency and a failure to exchange tax information should be vigorously addressed.
The OECD and others will be looking for scapegoats for the current financial crisis and the off shore financial centres are likely, if undeserving, targets. Cayman will have to work hard to stay ahead of the game. Commitments made by the Cayman Islands Government 10 years ago to pursue tax information exchange agreements as part of the measures taken to get off potentially deadly black lists, have so far only produced one such agreement (with the US). The recent signals from the OECD that countries’ progress will be judged by such things as how many TIEA’s are in place underscores the urgency for Cayman to make much more rapid progress in this area. The fact that the offshore centres have contributed nothing to the current crisis will not spare Cayman from the greatly increased risks of isolation from the community of information sharing cooperative jurisdictions. Such isolation could seriously cripple Cayman’s most important industry and source of jobs and income as customers turn elsewhere. Cayman has its work cut out for it if its financial services industry is to survive and thrive.