Financial Innovations Instability Factors at the Heart of the Subprime and Euro Zone Crises by Falloul Moulay El Mehdi

8/9/2019 Financial Innovations Instability Factors at the Heart of the Subprime and Euro Zone Crises by Falloul Moulay El Mehdi

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Financial innovations instability factors at theheart of the subprime and euro zone crises

FALLOUL Moulay El MehdiHassan II University of Mohammedia Morocco

“Financial innovation, creative destruction or devastating destruction ?”

In our analysis, we will try to understand the role of financial innovation, in thedevelopment of the financial crisis 2007. The question that arises is:"how financialinnovation which is susceptible to build a sound international financial system was about

to destroy it."

To resolve this problem will begin by doing a historical analysis of financial innovation, inother words we will try to study it since its creation to its current development which no doubtcontributed to financial globalization and therefore the spread of systemic risk which webelieve was at the heart of the financial crisis 2007. Thus, we will try first to do a historical

analysis of the birth of financial innovation, its development, and the role that has played inthe development of financial globalization and financial crises, and then we will try to analyzethe mechanism of securitization which is at the heart of the Subprime crisis.Innovation and its relation to globalization is not a new phenomenon. In fact, there were twoperiods of financial globalization. First, from the second half of the 19th century until the firstWorld War and second since the abandonment of the Bretton Woods system in 1971 onwards.Both of these two periods are characterized by a low correlation between domestic investment

and domestic savings.In fact, severalmethods have been proposed to measure the degree ofcapital mobility . In ourstudy, we will consider the method initiated by Feldstein and Horioka that directly tests therelationship between savings and investments in an open economy.In their seminal paper, Feldstein and Horioka (1980) showed that in a situation of perfectcapital mobility, it should not be a strong link between domestic savings and domesticinvestment rate. The allocation of savings in each country should be based on international

investment opportunities, and


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conversely, domestic investment should be funded from abroad. Also a strong correlationbetween these two variables would be evidence of a low degree of capital mobility andtherefore a low degree of financial integration.The first globalization is the result of a long process of synergy between the geographicalextension of trade and the deepening of market regulation (Norel, 2004, p. 32-34). Before theindustrial revolution, big trade, geographic expansion in exchanges had stimulated thecreation of "national market system," in effect; it is the creation of markets for sophisticatedproducts, allowing a more rational allocation of resources. The first product markets worthyof the name appear in Europe in the Netherlands and England which were leading countries intrade expansion after the Golden Age.At the late nineteenth century, the vast majority of capital flows was used to financeinfrastructures (in particular the railways) and buy government bonds. These capital flowswere thus mainly long-term flows and involved relatively few loans to financial institutions orfor short-term portfolio investments. The situation today is completely reversed: short termcapital flows dominate much long-term capital flows. Accordingly on the foreign exchangemarket, the net positions of most of the stakeholders are on average kept open about 20minutes: it is difficult to consider a shorter horizon. The degree of integration of financialmarkets for short-term capital flows is now without precedent.

Financial globalization has therefore two dimensions, one temporal and one spatial. The timeis shortened, not only for stakeholders on the markets who must continually respond to newinformation but also for policy makers, for whom the period available to respond to a crisis isalso becoming increasingly short. This is due to the strong development of Informationtechnology, an aspect that did not exist during the first phase of globalization.The second aspect of contemporary globalization is that it eliminated the significance ofphysical geography for financial processes: a crisis can start in a region of the world and

spread to the rest of the world without regard to distance and borders. For instance, the Asiancrisis began in July 1997 in Thailand, then it quickly reached South Korea, after that, it set offa wave of panic on the foreign exchange markets and stock markets in the countries of theregion, then in 1998 reached Latin America and the Russia.The near -bankruptcy of the

American hedge fund Long-Term Capital Management ( LTCM ) is an indirect consequence ofthe wave of panic on Russian markets. These events show that


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the financial markets of the rich countries were not spared from a problem that had started in asmall Asian country.

In the contemporary globalization fund managers, insurers and bankers have transformedthe investment practices by creating financial instruments known as derivatives, whose valueis derived from the price of another underlying asset. The original idea of derivatives was tohelp actors in the real economy, such as farmers and manufacturers, insure against risk. Acompany may want, for example, to guard against increases in the prices of steel, wheat orother commodities. Price stabilization and risk mitigation are worthwhile objectives, but manyderivatives trades have crossed the line into speculation rather than risk management.Most derivatives are sold “over the counter” through private trades rather than on public stockor commodity exchanges. This gives investment banks flexibility to propose to theircustomers whatever deal they want, rather than being bound by the trades sanctioned byexchange supervisors. As the deals are secret they do not help other investors price risk, andoften investors, regulators and other analysts do not know what liabilities a company hastaken on.

There are several types of derivative, including financial futures, forwards, swaps andoptions. In the last twenty years traders have invented a series of ever more complicated dealsthat they have sold to manufacturers, but primarily to investors. An example is a paper

company hedging on interest rates through a deal whereby it would receive a fixed rate of 5.5per cent and pay a floating rate, squared and then divided by 6 per cent. One type of derivateinstrument is a credit default swap. In these deals, which were valued at $62 trillion inDecember 2007, the buyer makes periodic payments to the seller in exchange for the right to apayoff if there is a default or credit write-down in respect of a mortgage or other debtsecurities they hold. The uncertainties about this huge market are a major factor in the 2007-2008 credit crunch, resulting in serious difficulties for many families and small businesses.

Financial engineers have also developed collateralized debt obligations (CDOs) throughwhich a financial institution combines assets of various types (for example “prime” mortgageswith “subprime” ones). The packaged debt is then sold to a special purpose vehicle, generallyregistered offshore in a low tax jurisdiction. The new entity then issues its own equity orbonds to resell the debt to other investors, carving it up into different tranches with differentrisk ratings using complex mathematical models. The most actively traded CDOs are thosemade up of credit default swaps. CDOs are also themselves being repackaged into other

CDOs, further obscuring the actual risk and ownership of the


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underlining assets. The interlinked complexity of these deals feeds volatility rather thanreduces it.

Financial innovation in the derivatives market has largely aimed to disguise risk, avoidregulations and generate higher short-term profits. Hedge funds, private equity corporations,investment banks and pension funds have used derivatives to evade regulations. They havedevised elaborate and opaque financial vehicles through which they have dumped risks ontothe state or onto less informed investors including pension holders. Many companies,including Enron and Parmalat, showed that this strategy works only in the short-term, but mayprove disastrous after that. “Parmalat abused the capital markets for years by raising moneyunder false pretences. Money was siphoned off for family purposes and the whole messhidden in a complex structure of 200-plus subsidiaries and special purpose vehicles scatteredacross the globe, including tax havens such as the Cayman Islands, the Dutch Antilles andCyprus.

To understand the relationship between financial innovation and the recent global financialcrisis it is necessary to study the evolution of financial innovations. Hence the first chapterwill be devoted to discuss the link between financial globalization and the development offinancial derivatives particularly, credit derivatives. Is the the second chapter we will firstanalyze securitization as a sophisticated financial engineering product at the heart of the

recent global financial crisis And we will analyze three factors of convergence who acted asamplifiers of the outburst of this crisis which are the rating agencies, Basel II prudentialregulation and international accounting standards IFRS. And Finally In The third chapter willtry to assess the role that has got the CDS on the recent Euro zone financial crisis.

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Financial Innovations Instability Factors at the Heart of the Subprime and Euro Zone Crises by Falloul Moulay El Mehdi