Financialization Promotes Dangerous Speculation

By Jomo Kwame Sundaram and Michael Lim Mah Hui
KUALA LUMPUR and PENANG, Jun 18 2019 – Financialization has involved considerable ‘innovation’, often of opaque, complex and poorly understood financial instruments. These instruments typically have large debt components involving leveraging, deepening connections across markets and borders.

Jomo Kwame Sundaram

Three important financial innovations that have changed the financial landscape — by promoting speculation, amplifying risks, and increasing economies’ vulnerability to financial vicissitudes — are securitization of debt, derivatives and the repo market.

Debt securitization
Long-term bank loans were illiquid. Loans were booked and sat on bank balance sheets until maturity. With securitization, illiquid loans could be packaged as securities to be sold and traded in secondary markets. Examples include collateralized debt obligations (CDOs) containing packages of house mortgage loans, divided into tranches with different credit ratings.

Tranches define priority of payment of both principal and interest from underlying loans, involving different interest rates. The AAA rated tranche has priority of payment over mezzanine and junior tranches, offering a lower interest rate reflecting its safer profile.

The originating bank sells these CDOs to a ‘special purpose vehicle’ (SPV) that is not treated as a bank subsidiary. It is thus treated as an off-balance sheet transaction. The SPV sells the securitized debt to investors who receive cash flows from the interest due to the underlying loans.

This was originally hailed as a brilliant financial innovation as US Fed chair Alan Greenspan believed that CDOs transferred risk from banks to investors able and willing to take it on. But securitization not only increased systemic risks, but also did not reduce risk to the originating banks who had sold off the loans.

Derivatives
Derivatives are financial products meant for hedging risks, but often used for speculation. Investors can also secure additional leverage via derivative markets. Examples of derivatives include options, futures, swaps and structured products such as credit default swaps (CDSs).

Michael Lim Mah Hui

Before the 2008 global financial crisis, CDSs were used to provide ‘insurance’ on CDOs. CDS issuers guaranteed the financial viability of CDOs, for a premium. Issuing CDSs was seen as a risk-free way to capture premia, by assuming that the asset prices underlying the CDO would always rise; CDOs could thus continue generating cash flows even when subprime borrowers defaulted.

Such expectations of risk-free financial gain inspired the issue of various CDSs, e.g., AIG issued half a trillion dollars worth. Regulators sanctioned such instruments by allowing issuers to use regulatory loopholes exempting them from the ‘normal’ capital requirements.

The US subprime mortgage crisis, which started in 2007, quickly spread, via related CDOs and CDSs, to much of the rest of the financial system and across national borders, with repercussions for the real economy worldwide, not least through trade and other policy responses, including protectionism.

Securities financing transactions (‘repos’)
‘Repo’ is short for ‘repurchase agreement’, also known as a securities financing transaction. Repos and reverse repos are simply collateralized borrowing and lending respectively. The borrower sells a security to a lender, agreeing to repurchase it at an agreed future date and price, i.e., upon maturity of the repo loan.

Repos play two critical functions. First, as an asset-liability management tool for banks. To match their assets and liabilities, banks resort to lending or borrowing, collateralized with securities (normally government securities) bought and sold.

Second, repo markets have been used to cheaply fund financial institutions’ securities portfolios, with repos now accounting for large shares of banks’ balance sheets. Collateralized loans are safer, and hence cheaper to finance than uncollateralized ones.

The lenders receive returns on repo loans from borrowers with the securities marked to market daily. With prices fluctuating, borrowers have to provide additional security when prices fall, while lenders have to return excess security if prices rise.

With financial innovation such as ‘shorting’ — i.e., borrowing securities to sell for profit when their prices fall — repo markets have increased opportunities for profitable speculation on changes in the market prices of securities.

Risks and rewards have increased as collateral is rehypothecated, i.e., used by lenders for their own purposes. Such leveraging allows lenders to become borrowers. Mark-to-market practices, shorting and rehypothecation thus increase risks for the financial system.

More of the same
While securitization creates new asset classes for sale to varied investors with different risk preferences, derivatives allow investors to hedge, thus increasing their exposure to securities. Repos allow borrowers to maximize leverage at low cost for shorting.

These transformations generate more fragility in transnational finance, vulnerable to large asset price swings, and thus to financial instability. The 2008 global financial crisis started in securities markets, with CDOs involving subprime mortgages, and was transmitted via repo markets to other interconnected financial institutions.

CDO losses accounted for nearly half the total losses sustained by financial institutions between 2007 and early 2009, when the collapse of Lehman Brothers triggered a run on global repo markets that triggered banking and European sovereign debt crises.

Financial regulators recognize the systemic significance of these financial developments. Although the Financial Stability Board, created in the wake of the 2008 crisis, identified securitization and repo markets as critical priorities for shadow banking reform, securitization is back on financial development agendas, especially for developing countries.

Filed in: Latest World News

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