The current crisis started with a burst housing bubble, which led to widespread mort- gage defaults, and hence to large losses at many financial institutions. That initial shock was compounded by secondary effects, as lack of capital forced banks to pull back, leading to further declines in the prices of assets, leading to more losses, and so ona vicious circle of “de-leveraging.” Pervasive loss of trust in banks, including on the part of other banks, reinforced the vicious circle […] We have a globalized financial system in which a crisis that began with a bubble in Florida condos and California McMansions has caused monetary catastrophe in Iceland. (Krugman, 2008)
In our opinion (Karyotis, Fimbel, Guidici, & Lle´o, 2012), we can use Poincare´’s notion of chaos:“a tiny cause, that we are unaware of results in a considerable effect that we cannot fail to see, and so we say that this effect is a result of chance […] It can happen that small differences in the initial con- ditions engender huge differences in the end results; a small error in the for- mer would produce an enormous error in the latter” (Poincare´, 1908). The subprime crisis became a global crisis: it is perhaps an example of the but- terfly effect made famous byLorenz (1963): a butterfly flapping its wings in Brazil that caused a hurricane in Texas. This effect can be explained by the complex, nonlinear financial system (coupled with considerable financial leverage). Along with this phenomenon were well-established discontinu- ities when interbank markets dried up in 2008 as a result of the bankruptcy of Lehman Brothers and in 2011 during the Eurozone crisis. For this rea- son the characteristics of complex systems (nonlinearity, discontinuity, 187 Ten Challenges to Have a Sustainable Financial System
dependence of trajectory, and dependence on initial conditions) can be applied to the international financial system. All has become unpredictable and uncertain; the crisis is also a crisis of the models.
The instrument that spread the crisis was securitization; and securitiza- tion was associated with greed: avarice has triumphed over prudence and is pushing the world into freefall (Stiglitz, 2010).
Whilst, we cannot change the paradigm immediately, we need to change the financial system to secure it, because it is the life blood of every econ- omy, all over the world.
Therefore, three points must be taken into account: universally applied regulations (because better regulation is necessary rather than more regula- tion), the elimination of shadow banking, and the elimination of synthetic securitization (the prohibition of irresponsible securitization in order to avoid toxic assets).
In our opinion, the best example of shadow banking is securitization.
Securitization consists of transforming a non-negotiable debt into a cash security which can then be bought and sold in financial markets. This tech- nique, known equally as primary securitization, removes a debt liability from a bank’s balance sheet replacing it with a financial asset. For this pur- pose, the bank uses a special purpose vehicle to buy the debt prior to finan- cing the purchase through a round of public offering as shown inFig. 3.
The primary goal of securitization consisted of improving banks’ bal- ance sheets while at the same time securitization was designed as an instru- ment to address the growing need for funds. The banking institutions embarked upon a secondary level securitization, referred to as “Collateralised Debt Obligation” (CDO), soon to be followed by a tertiary-level securitiza- tion known as CDS. Scheicher (2008) defines a CDS as “claims of varying exposure to the cash flows from a portfolio of credit instruments […] ranging from ‘equity tranches’ with high risk exposure to ‘senior tranches’, where expected losses are much smaller.” As commonly traded credit derivatives a CDS operation is similar to an insurance contract used against potential default losses to creditors. At the beginning only mortgages referred to Mortgage Backed Securities (MBS) were bundled together.
Synthetic securitization is without doubt the archetype of financial engi- neering. Primary securitization was initially used to improve bank balance sheets and to fulfill the need for finance in economies facing limited bank capital, not to get round international regulation. But it became more and more complex and was diverted from its original purpose. Everything that could be converted into financial terms was securitized: property loans, car purchase loans, credit card debt. “The first significant bank credit card sale
came to market in 1986 with a private placement of $50 million of bank card outstandings. This transaction demonstrated to investors that, if the yields were high enough, loan pools could support asset sales with higher expected losses and administrative costs than was true within the mortgage market.
Sales of this type with no contractual obligation by the seller to provide recourse allowed banks to receive sales treatment for accounting and regulatory purposes (easing balance sheet and capital constraints), while at the same time allowing them to retain origination and servicing fees. After the success of this initial transaction, investors grew to accept credit card receiva- bles as collateral, and banks developed structures to normalize the cash flows”.
But the arrangement was gold-plated (Roubini & Mihm, 2010) and the financial system was increasingly weakened. “Securitization, for all the vir- tues in diversification, has introduced new asymmetries of information; for- cing originators of mortgages to bear some of the risk would mitigate some of the resulting moral hazard” (Stiglitz, 2009).
Fig. 3. Securitization Process.
189 Ten Challenges to Have a Sustainable Financial System
The complexity of financial engineering is only matched by the complex- ity of the products it has engendered. After primary securitization came secondary and tertiary securitization. We now have CDO (Collateralised Debt Obligation), CDO2, and CDS.
Lucas (2008)presents the structure of the various products as below and calls it “Russian Dolls” (Fig. 4).
Fig. 4 highlights the division and subdivision of credit and shows how difficult it is in the case of default to retrace the origin of the problem.
Securitization is the instrument through which finance has totally mutated.
The Financial Stability Board (2012) defines shadow banking as “the system of credit intermediation that involves entities and activities outside the regular banking system.” According to the Green Paper of the European Commission (2012), the shadow banking system is based on two pillars:
“First, entities operating outside the regular banking system engaged in one of the following activities: accepting funding with deposit-like characteristics;
performing maturity and/or liquidity transformation; undergoing credit risk transfer; using direct or indirect financial leverage. Second, activities that could act as important sources of funding of non-bank entities. These
Russian Dolls
Russian Dolls
Risk profile of Subprime Mortgage Loans
Subprime
LowHigh
BorrowerDown Payment
Good Bad Borrower Credit
Mezz ABS CDO AAA
AA A BBB BB, NR
81%
11%
4%
3%
1%, not in all deals Other Credit Support Excess Spread, Over- collateralization
Senior AAA Junior AAA
AA A BBB
NR
Senior AAA Junior AAA
AA A BBB
NR
Senior AAA Junior AAA
AA A BBB
NR High Grade ABS
CDO
Subprime Mortgage Bonds
CDO2
62%
14%
8%
6%
6%
4%
88%
5%
3%
2%
1%
1%
60%
27%
4%
3%
3%
2%
Other Credit Support Excess
Other Credit Support Excess
Fig. 4. Financial Packaging (Lucas, 2008).
activities include securitization, securities lending and repurchase transac- tions (Repo).”
Poszar, Adrian, Ashcraft, and Boesky (2013) identify three groups con- cerned by shadow-banking activities: the government-sponsored subsystem, and the internal and the external subsystems. In the first group, we find the FHLB Federal Home Loan Bank, Fannie Mae Federal National Mortgage, Freddie MacFederal Home Loan Mortgage Corporation and Ginnie Mae Government National Mortgage Association in 1968, and the Federal Bank that securitize their mortgage and loan portfolios in struc- tured products (MBS); the second group is made up of the largest banks that originate, distribute, and securitize their loans in order to increase their ability to lend to households and raise their RoE; the external subsystem is based on the same intermediaries, it is a “global network of balance sheets”;
it is defined as “the credit intermediation process of diversified broker-dealers, the credit intermediation process of independent, nonbank specialist interme- diaries, and the credit puts provided by private credit-risk repositories.”
The process is shown inFig. 5(Poszar et al., 2013).
Some figures can illustrate this hyperfinancialization:
According to the Bank for International Settlements (BIS), notional amounts outstanding on OTC derivatives markets totaled $693,000 billion in 2013, higher than 10 years ago. It was seven times the outstanding notional on regulated markets and ten times the global GNP.
The global figure of shadow banking at the end of 2012 wash53 trillion and the biggest share is concentrated in the United States (US) (h19 tril- lion) and in the European Union (EU) (h16 trillion).
Finally, on the foreign exchange, $5,300 billion are negotiated in a day;
according to the BIS, only 7% or 8% would be used by nonfinancial actors who want to cover their risks.