CURRENT FINANCIAL CRISIS : A Review of Background, Impact & Outlook

BACKGROUND
- In history, financial crashes shared one trait – “excessive expansion of credit” (Prof Charles P Kindleberger - Panics, Manias & Crashes : A History of Financial Crisis)
- Present problems caused by 3 excesses : excess credit, excess leveraging, excess greed (Tan Sri Andrew Shen, Advisor, Central Bank of Malaysia)
- Current crisis originated from housing bust and subprime mortgage lending

CREDIT EXPANSION
- Dotcom boom in the USA ended up with a bust in 2000. US Government needed to boost the economy
- US Federal Reserve pushed on monetary acceleration programme by rapidly cutting interest rate
- Credit facility became very easily available. The interest rate was kept too low too long (Tan Sri Lin See Yan, former Deputy Governor, Central Bank of Malaysia)
- This helped spur consumer and housing spending through credit cards & mortgage financing

SUBPRIME LENDING
- US banking institutions abandon normal risk standards in financing for demands on consumption & housing mania
- Lending can be for housing mortgages, auto loan, lifestyle financing or credit cards
- Subprime or near-prime or non-prime or second chance lending involved financial institutions (FIs) providing credit to borrowers who are of lower credit worthiness ratings
- FIs involved in excessive fraudulent lending to people with doubtful credit records
- Borrowers are charged at higher interest rates due to higher risk of default in repayment

HOUSING BOOM & BUST
- Low interest rate result in housing boom
- People could borrow 100% (even higher) of inflated house price without down payment
- Lower grade borrowers started defaulting and house pricing started dwindling
- The housing boom from cheap & easily available credits but risky borrowers ultimately lead to housing bust in 2008 following default payment & house price collapse (Prof Taylor, Stanford University)

RELEVANT DEVELOPMENT
(USA Banking System)
- 40 years ago, 90% of all loans were backed by bank deposits, today it’s 60%
- Regulators remove leverage (debt : equity ratio) cap for financial institutions (FIs) of 15:1 in 2004 without having to raise share capital
- End of 2007, average leverage was 30:1, Lehman Bro’s leverage exceeded 40:1 when it collapsed
- Uncontrolled development & packaging of complex financial instruments such as derivatives, options, swaps etc

TRADING OF DEBTS
- Mortgage loans are packaged in the form of debt papers such as derivatives, bonds etc and sold in the financial markets
- Banking institutions in New York & London which are always liquid readily trade in debt securities created from mortgage financing, securitisation of debts & derivative papers
- FIs sold loan to investment banks (Lehman Bros, Meryll Lynch, JP Morgan etc) as high quality bond
- Debt papers (bonds etc) given good ratings by rating agencies such as S&P, Moody’s etc

DEFAULT GUARANTEE
- Debt papers from subprime mortgage lending are sold as prime quality papers (derivatives, bonds etc) on the strength of default guarantee insurance
- Credit default swap (CDS) – an insurance policy where 3rd party (insurance co) assumes risk of a debt and pay the lending bank when the debt is defaulted
- When default occurs, insurance companies failed to pay on the guarantee as asset value backing the guarantee has deteriorated : AIG Insurance, USA
Derivatives & CDS schemes were created in MIT & Cambridge in 1994 for JP Morgan (investment bank)

DERIVATIVES EXPLAINED
- Financial contracts or financial instruments whose values are derived from something else known as underlying
- “Underlying” can be asset (commodities, equities), residential mortgages, commercial real estate, loans, bonds), an index (interest rate, exchange rate, stock market indices) or other items (weather conditions, credits etc)
- Main types are forwards/futures, options, swaps
- Used to mitigate risk of economic loss arising from changing value of “underlying”
- Hedging is to mitigate losses due to reduction in value
- Speculation is to increase profit if value moves in the direction as expected

DERIVATIVES MARKET
- In the USA, estimated at USD62 trillion and came down to USD55 trillion in September 2008
- CDO (credit default obligation) i.e. CDS for corporate debt, in USA is estimated at USD6 trillion
- Entire derivatives market is estimated at USD668 trillion i.e. about 15 times of world economy
- Underlying assets worth is about USD15 trillion i.e. slightly larger than the US economy

FINANCIAL COLLAPSE
- Credit boom collapse in September 2007 following subprime crisis
- Downgrading of ratings for financial papers and write off of loans due to doubtful collection or un-recoverability
- USA derivative papers lost value about USD7 trillion (12%) 3Q 2008 following downgrading

IMPACT FINANCE INDUSTRY
- Executives greed and market indiscipline was the order of the day prior to the collapse
- Banking institutions is trapped in toxic assets & inadequate capital (Tan Sri Lin See Yan, Malaysia)
- Lehman Bros, Fannie Mae, Freddie Mac, Meryll Lynch, Northern Rock, 14 US banks, Royal Bank of Scotland collapsed, bailed out or nationalised
- Banking institutions in steep liquidity and solvency problems

IMPACT IN USA
- Subprime losses estimated at USD100 billion, banking institutions run out of capital
- First half of 2008, financial system suffers USD476 billion in credit losses
- USA stock market lost USD75 billion during the crash in September 2008
- AIG Insurance defaulted USD14 billion of USD440 billion it is holding in 2008
- AIG, General Motors nationalised/under bankruptcy protection

IMPACT IN ASIA
- GDP contraction, growth estimated less than 1% in 2009
- Job loss estimated currently at 24 million 2008/2009 (Malaysian population 25 million)
- 140 million could be under poverty level
- Losses in market capitalisation, erosion in property values, huge provisions for bad debts in FIs

IMPACT IN AFRICA
- African economy USD469 billion 2007
- Lower government revenues, budget deficit, GDP contraction
- Pressure on business expansion & credit availability
- Less availability of funds for aids & sponsorship programmes (2007 – 15% of GDP)
- Reduced remittances from overseas Africans (substantial source of financial support)

IMPACT ON MALAYSIA
- Malaysia is a trading nation & now top 30 exporters
- Demands worldwide shrink and natural resources prices (oil, palm oil,ubber) decrease reduction in trading income & revenue
- Reduced economic activities result in retrenchment, increase unemployment & squeeze on cost of living
- Prices of goods & consumer items increased due to earlier increase of oil & other prices – pressure in corporate & individual spending capabilities
- FIs uncertain of outlook, may be in liquidity problems, lost capital, therefore conserve cash, stop/hold on lending

IMPACT ON ECONOMY
- Economic depression – meltdown, recession, retrenchment, personal spending
- Country cannot produce, do not achieve GDP required, individuals squeezed due to lesser money, money value deteriorates, credit facilities unavailable
- Entire economic expansion halted & pressure on liquidity affect spending & growth
- The world needs to address the depression, recession with combination of fiscal & monetary policies
- Next problem areas – credit cards? derivatives?

SOME TERMINOLOGIES
FINANCIAL CRISIS
- FI’s or assets suddenly lose large part of their value
- Can be due to banking panics, recessions, stock market crashes, currency crisis, sovereign default, financial bust, speculative bubbles
BRETTON WOODS
- System of monetary management for commercial & financial relations among world’s major industrial states post World War II agreed at Bretton Woods, USA
- Formation of IMF and later World Bank
- Obligation for each country to adopt monetary policy that maintain exchange rate within fixed value by reference to gold
- System collapse in 1971 when USA suspended convertibility from USD to gold
GREAT DEPRESSION
- Worldwide economic downturn starting in most places in 1929 and ending at different times in the 1930s or early 1940s
- Originated in the USA with the stock market crash on 20 Oct 1929 known as “Black Tuesday”
- Devastated country and population around the globe with international trade plunged by ½ to 2/3rd affecting personal income, industries, farming, mining, employment etc
RECESSION
- When there is significant reduction of a country’s GDP for at least two consecutive quarters
- Reduces economic activity reflected in reduction/erosion in personal income, employment, industrial production, whole-retail sale
GREAT DEPRESSION
- Worldwide economic downturn starting in most places in 1929 and ending at different times in the 1930s or early 1940s
- Originated in the USA with the stock market crash on 20 Oct 1929 known as “Black Tuesday”
- Devastated country and population around the globe with international trade plunged by ½ to 2/3rd affecting personal income, industries, farming, mining, employment etc
RECESSION
- When there is significant reduction of a country’s GDP for at least two consecutive quarters
- Reduces economic activity reflected in reduction/erosion in personal income, employment, industrial production, whole-retail sale

GLOBAL OUTLOOK
- Global financial system suffered heavily and leads to economic depression
- IMF estimates world GDP growth for 2009 only 0.5% (2008:4.8%)
- Banking institutions need USD1.7 trillion to re-capitalise
- World economy needs USD4 trillion to get back on track of growth target
- Malaysian GDP growth for 2009 is estimated below 3% (2008:5.9% USD397b)
- Malaysia need RM40b to achieve GDP growth target, has RM23b o/s on credit cards (population 25m)

MICRO ECONOMIC OUTLOOK
- Generally immediate term outlook is still bleak & uncertain
- Next 6 to 9 months does not seem exciting & perhaps some improvement towards end of 2009 or early 2010
- Much depends on market confidence, stimulus packages, monetary & fiscal policy
- Stock market may slide further in the absence of new leads - may offer opportunity to accumulate some valuable selected counters
- Property market softening but offers investment opportunity with right asset that has upside potential
- Business environment play wait & see – effect of stimulus packages & availability of financing facilities
- Need adjustment in lifestyle, conserve liquid asset, selective new commitment that can bring value

GOING FOWARD
- Global stimulus package announced by various governments to date almost USD2 trillion (USA USD825b, China USD586b, Japan USD250b, Malaysia USD67b)
- SMI & micro-financing to generate economic activities & job creation
- Strategic M&A exercise
- Selective assets & stocks accumulations with upside potential
- There seems to be improvement in the 1Q 2009 compared to 2008
- Next downturn cycle - 10years?

by abdul khudus naaim
ks & associates
chartered accountants
16-1-1a, jalan medan pb2a, seksyen 9, pusat bandar bangi
43650 bandar baru bangi, selangor, malaysia
t : +6 03 8925 8454 * f : +6 03 8926 8454
email : aknaaim@streamyx.com