Foreigners Caused America’s Financial Crisis? A Closer Look
Politics / Credit Crisis 2008 Feb 05, 2010 - 01:37 AM GMTBy: Dian_L_Chu
Dian L. Chu writes: In his State of the Union address, President Obama reiterated his ambitious agenda to improve the economy and enact sweeping financial reform aimed specifically at the Big Banks. The European Union is also pursuing similarly ambitious changes aimed at preventing another crisis in the future.
At the World Economic Forum in Davos, Switzerland, where more than forty heads of state met, the proposals for financial regulatory reform were part of the focus of deliberation.
There is undeniably an inexorable drive on both sides of the Atlantic to find new ways to tighten bank and capital market regulations in response to an international financial crisis triggered by the bursting of a U.S. property price bubble and the resulted global domino effects.
Foreigners to Blame?
The financial crisis of 2007–2010 has been called the worst since the Great Depression of the 1930s. Many causes have been proposed and recently, MIT economist Ricardo Caballero made a suggestion that caught the attention of TIME:
"There is no doubt that the pressure on the U.S. financial system [that led to the financial crisis] came from abroad….Foreign investors created a demand for assets that was difficult for the U.S. financial sector to produce. All they wanted were safe assets, and [their ensuing purchases] made the U.S. unsafe."
Did foreign investment demand really “make the U.S. unsafe”? Let’s go back and take a closer look.
Close Point of Origin – Housing
Most economists and pundits seem to agree that the collapse of the U.S. real estate market in 2006 was the close point of origin of the crisis. The housing bubble bursting caused the values of securities tied to real estate pricing to plummet, thus damaging financial institutions globally.
Sophistication Beyond Comprehension
Critics argued that credit rating agencies and investors failed to accurately price the risk involved with mortgage-related financial products, and that governments did not adjust their regulatory practices to address the 21st century financial markets.
However, the entire financial system had become fragile as a result of one factor, among others, that is unique to this crisis - the transfer of risky assets from banks to the markets through creation of complex and opaque financial products.
In fact, these derivative products are so complex that they mystified even Alan Greenspan, the former chairman of the Federal Reserve.
Unknowing & Unwilling Participants
The banks’ strategy of unloading risk off balance sheets backfired when investors, foreign or otherwise, finally became aware of the complexity and risk underlying these asset backed securities.
A vicious cycle of asset liquidation and price declines was set in motion thereafter as these securities were brought back into the balance sheets, banks had to record losses based on the fair value accounting. Global financial integration made possible for the crisis to spread virtually worldwide.
So, how did we get here?
FSMA – Root of Crisis
The root cause of the financial crisis that led to the current recession may be traced back to the Financial Services Modernization Act of 1999 (FSMA), also know as the Gramm-Leach-Bliley Act (GLBA). The FSMA essentially repealed part of the Glass-Seagull Act of 1933 that prohibited the integration of investment bank, a commercial bank, and/or an insurance company into one entity.
The repeal fostered the consolidation of banks, securities firms and insurance companies, which ultimately lead to “too big to fail.” As a result, these institutions have bulked up their profits primarily through areas far beyond the traditional banking. Some have bought or sponsored hedge funds, while others have moved to invest their own money in the markets.
The investment banking units, far more profitable than the banking operations, have grown dramatically since the FSMA, and the related excessive risk taking along with the subsequent offloading to market played a far more significant role than others in the crisis.
Bigger & Back to Risk
After the collapse of Lehman Brothers about 18 months ago, many of these Wall Street companies were in danger of going under only to be rescued by federal bailout programs. The Trouble Asset Relief Program (TARP) practically guaranteed banks easy profit by providing capital at virtually zero interest cost.
Now, big banks are getting even bigger after scooping up smaller competitors weakened by the housing collapse. According to Bloomberg, the six biggest financial institutions now hold assets equivalent to 62% of the economy, up from 58% before the crisis and 20% in 1994.
There are also indications that some big financial institutions are going back to the same risk taking practices that got us into this crisis. The USA Today recently pointed to an independent research by the Demos highlighting that through the third quarter of last year, big banks were increasingly reliant on trading revenue and were taking on more risk in their investment portfolios.
In essence, government guarantees designed to spur lending by letting banks borrow cheaply were instead funding banks' speculative investments and fueling soaring profits.
Their size and complexity raise the risk of a future financial crisis.
Foreigners Do Not Bring Systemic Risk
In the end, foreigners demand did not bring about the systemic risk. It is the lack of check-and-balance in our system allowing a concentration of risk into the hands of a few that almost brought the world to an utter collapse.
The drivers for enacting the Glass-Seagall Act in 1933 are the same as those for financial reform in 2010. However, a meaningful and globally consistent financial reform seems unlikely amid divided politicians and special interests fighting for short-term advantage.
Endgame and checkmate could come when unfettered financial institutions again push the economy to the brink, and there is no resources left for another bailout or rescue.
Dian L. Chu, M.B.A., C.P.M. and Chartered Economist, is a market analyst and financial writer regularly contributing to Seeking Alpha, Zero Hedge, and other major investment websites. Ms. Chu has been syndicated to Reuters, USA Today, NPR, and BusinessWeek. She blogs at Economic Forecasts & Opinions.
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