T T Mboweni: Origins and causes of recent financial market turbulence
and its implications for the CMA
Speech by Mr T T Mboweni, Governor of the South African Reserve Bank, at a public
lecture, Windhoek, Namibia, 4 April 2008.
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Introduction
Thank you for your kind invitation to speak to you about the recent financial market
turbulence and its implications for the Common Monetary Area of Lesotho, Namibia, South
Africa and Swaziland, or CMA. As you may know, this morning the Governors of the four
CMA central banks had a meeting which was hosted by the Bank of Namibia to discuss
matters of mutual interest and exchange observations on economic developments in the
region. It is always a delight to visit Namibia, renowned for its friendliness, and this lecture
gave me an excuse to extend my visit to your beautiful and super-tidy capital.
Unfortunately, one should add a footnote to the reference in the topic of my lecture to the
"recent financial market turbulence": As we are all aware, the turbulence is still ongoing.
I will first touch upon the build-up to the turbulence in the international financial markets, and
use a number of indicators to illustrate the turmoil. This will be followed by some
observations regarding international policy reactions to the disturbances. Thereafter I will
pinpoint a number of key implications for the CMA, before concluding.
The development of the turbulence in the international financial markets
Significant developments in the global economy seldom start in isolation. Rather, most
episodes are extensions of or reactions to previous episodes. With any analysis, one has to
start somewhere - but be mindful that important dimensions may be lost by doing so.
We can largely trace the origins of the current turmoil to the United States (US) housing
market. I would like to go back to the mid-1990s, when property prices in the US started
rising alongside increasing income levels and positive demographic influences on the
demand for housing. This upward momentum continued, despite the sharp fall in prices in
major share markets early in 2000.
Partly in order to stem the negative impact of the share price decline on economic activity,
monetary policy became accommodative in the US. This attempt at moderating the
slowdown in economic activity seemed to be successful. At the same time, the low interest
rates and rising levels of income bolstered the real-estate market, with house prices in the
United States going from strength to strength.
A long period of rising prices creates an expectation that the trend will persist. Economic
agents - and not only unsophisticated ones - may be drawn into this belief, and may adjust
their behaviour accordingly. By doing so, they may well reinforce and extend the duration of
the trend. Translated to the US housing market, there was a fairly widespread belief that
acquiring fixed property was a sure way to make a profit, because rising house prices would
cover any cost of borrowing or the opportunity cost of owners' equity, and still leave a
handsome return. This drew numerous borrowers into that market, and caused lenders to
happily extend mortgage loans to such borrowers. Many of these borrowers were borrowers
in good standing, and their business continues to be good to this day as they continue to
repay their mortgage instalments and as the market values of their fixed property continue to
exceed their mortgage debt.
But there were also home loans extended to very risky borrowers, with little or no income and
few, if any, assets. A significant number of these were extended to so-called subprime
borrowers - meaning the borrowers were of below-prime quality. (It does not mean that they
got an interest rate below the prime rate! Given their riskiness they were usually charged
higher-than-average interest rates.) The "security" in this instance was primarily a belief in
the continuation of the uptrend in property prices and the ability of homeowners to rent out
these dwellings. One of the catchwords of the time says it all: NINJA loans, or loans to
borrowers with "No Income, No Job or Assets". According to the Chairman of the Board of
Governors of the US Federal Reserve - the US central bank - advances in technology, the
development of credit scoring techniques and the emergence of a large secondary market
significantly increased the access to mortgage finance in the US (Bernanke, 2008:1).
Consequently, from 1994 to 2006, subprime lending increased from an estimated US$35
billion or 4,5 per cent of originations to US$600 billion or 20 per cent of originations. Although
responsible subprime lending was helpful in fostering sustainable homeownership, far too
much of the lending was based on abusive, unfair or deceptive lending practices.
As mortgage loans were extended, the lender initially extending the loans in many instances
securitised the loan. For example, a group or pool of, say, five thousand mortgage advances
with an average value of US$100 000 each would be created and sold to a cash-flush
investor such as a pension fund for US$500 million. This is nothing new - mortgage
advances have been securitised on a substantial scale for many decades. Incidentally, the
borrower would usually not even know that his or her mortgage loan had been securitised -
the borrowers continue to send their instalments to the institution or "mortgage originator"
which initially extended the loan. But the mortgage originator now simply passes on the
instalments received to a company created to handle the pool of securitised mortgages, a
"special purpose vehicle", from where it is redistributed to the ultimate owner of the
securitised mortgages - the pension fund in this example.
Numerous "structured financial products" were developed around the securitised mortgages.
For instance, a batch of risky or sub-prime mortgage advances could be lumped together
and sold off as a separate "tranche" which would pay a higher rate of interest than a batch of
standard mortgages. Furthermore, some institutions provided guarantees or partial
guarantees to enhance the risk-return characteristics of some of these products. And all
remained well as long as the property boom continued. Loans could be extended quickly and
repackaged and securitised speedily. The US housing market eventually ran out of steam
around 2006 as supply started to outstrip demand, reinforced by tighter interest rates. This
set in motion a chain of events in which subprime borrowers increasingly fell behind on their
commitments and certain types of securitised assets and structured products started to show
their true colour. As these assets stopped performing (or, at best, paid significantly less than
previously projected) investor appetite for structured products and securitised assets
diminished rapidly. This interrupted the process in which original lenders (mortgage
originators) could so comfortably extend a loan and sell it off to somebody else to carry the
credit risk. Liquidity in that market evaporated rather quickly, its previously smooth-running
machinery grinding to a halt.
More fundamentally, investors and borrowers as well as all those institutions in between
discovered that the risk premia which they had priced into a range of financial assets were
grossly inadequate. This inadequacy extended beyond sub-prime mortgages, and beyond
the USA only: numerous types of securities and derivatives were involved. During the credit
boom, investors had struggled to understand complex new securities, so they relied on the
credit-rating agencies. The credit-rating agencies labelled the new securities with the same
ratings already applied to corporate bonds and this gave investors a handy frame of
reference. The ratings methodology for corporate credit risk is, however, fundamentally
different from that used for structured credit and yet the ratings that resulted were placed on
the same scale, implying similar potential losses. Ratings agencies in their methodologies
also assumed adequate liquidity in the trading of structured credit securities - an assumption
that did not hold when this market unravelled.
Unfortunately, investors placed excessive trust in rating agencies' approach to structured
credit as the new securities had little in common with corporate bonds. When the agencies
pointed out that they relied on facts presented by issuers, and that due diligence was not
conducted on any of the individual mortgages within a pool, investors' perceptions of ratings
on most innovative financial instruments changed. Accordingly, prices of such assets fell
considerably as investors became less willing to assume risk. Furthermore, because financial
assets are traded in global financial markets, the repricing of assets and drying up of liquidity
in trading such assets spread across borders. Consequently, the financial market strains that
originated in the U.S. subprime sector began intensifying in the second half of 2007 and led
to a sell-off in global equity markets.
In a recent speech, the Governor of the Bank of Canada emphasised three underlying
causes of the ongoing dislocations in financial markets (Carney, 2008:2). Firstly,
overconfidence among market participants that ample liquidity would continue to prevail,
providing an outlet for new products and facilitating the rapid growth of the
"originate-todistribute" credit model - loans are extended but then repackaged, tiered, securitised and
distributed to end investors. Secondly, a lack of transparency and inadequate disclosure in
respect of many highly structured financial products, complicating their valuation and
reducing secondary market liquidity under conditions of stress. Thirdly, a series of misaligned
incentives, which led to the watering down of credit quality standards and encouraged
excessive risk-taking.
Following the sharp increase in delinquencies, the subprime-related securities were
downgraded by rating agencies, causing this market to be impaired significantly. Funding
pressures subsequently forced mortgage lenders to scale back or close down, and banks
became reluctant to provide liquidity to each other. Uncertainty about who owed how much to
whom resulted in overnight interbank lending rates increasing significantly and central banks
had to provide additional liquidity to facilitate the orderly functioning of financial markets.
Current estimates regarding the scale of losses suffered by mortgage owners in the US
range between US$400 billion and US$500 billion, although in a recent article Krugman
(2008) states that " I think there'll be $1 trillion of losses on mortgage-backed securities..."
The turbulence came to the fore in many ways. Probably the most pervasive immediate
consequence was the repricing of risk. Global markets generally experienced considerable
volatility and illiquidity and borrowers were confronting tighter terms and conditions,
spawning fears of a "credit crunch" which could harm economic growth. Credit spreads which
had declined to extraordinarily low levels picked up considerably, as illustrated in the
accompanying graph.
Policy reactions to the turbulence
One should point out immediately that some part of the turmoil - an upward adjustment to
the risk premia imbedded in the prices of a range of financial assets - should be welcomed
as a normalisation of affairs, such premia previously having been unsustainably low.
However, authorities had to be mindful of the need to prevent total overshooting behaviour,
and had to ensure the continued smooth functioning of the financial system as a whole. At
the same time the hard-won gains in the fight against inflation had to be consolidated and
protected, keeping inflation low and stable. Fortunately, the deterioration in the global
inflation environment due to the rising prices of energy and food was partly offset by the
continued impact of globalisation, the pursuit of sound macroeconomic policies and the effect
of a long period of low inflation on inflation expectations.
When the turmoil struck the financial markets in the United States quite visibly in August
2007, the Federal Reserve responded decisively by loosening monetary policy and adding
some liquidity to the money market. This provided some relief to cash-strapped borrowers.
Over the subsequent six months the authorities in the US loosened monetary policy further,
with the objective among other things to restore the affordability of housing and halt the rising
delinquency rate. The Fed also became engaged in match-making and rescuing troubled
institutions.
A number of prominent financial institutions had to write off huge amounts on account of bad
loans, dragging down their share prices and raising concerns regarding their status as
creditworthy counterparties. In the past few weeks the Federal Reserve put its balance sheet
in harm's way to give assurance to the creditors of Bear Stearns (a mid-size investment
bank) and extended that protection to the other primary dealers. In the UK in the meantime,
an institution named Northern Rock, which to a significant extent relied on the loan
origination-securitisation model, became the first UK banking institution in a long time to
experience a bank run as its depositors queued to withdraw their deposits. As the authorities
increasingly became mindful of the risks of a widespread crisis developing, Northern Rock
was granted emergency liquidity assistance by the Bank of England and eventually
nationalised by the British government.
Internationally, regulators were given much food for thought by the turbulence in the financial
markets. The ability of a problem in one area of the financial system to spread and
contaminate other areas was again illustrated rather vividly. The problems attached to
innovative financial products were again underlined, including the need for adequate
transparency and disclosure of the exact nature of and risks attached to each type of asset.
Although regulators certainly had a role to play, the need for investors to ultimately be wary,
do their own homework and not assume that others - regulators, credit ratings agencies,
sellers of financial products - have already done it for them, was emphasised. To avoid
future confusion regarding the risk attached to particular securities, ratings for the different
types of obligation should be clearly distinguished and investors should never rely purely on
ratings to determine investment policy. Credit-rating agencies will also have to work harder to
ensure that users understand the nature of their ratings.
Implications for the CMA
It is only fair to point out that the countries of the CMA are "in this together", in dealing with
the impact of these disturbances. South Africa and Lesotho, Namibia and Swaziland, through
our currency union, have a shared financial market and similar if not identical interest rate
policies. In many instances the same banks and financial institutions are active throughout
the CMA.
The direct CMA exposure to the sub-prime market and to structured products seems to be
quite limited. One or two institutions with a strong international presence may have, through
companies in their groups, some exposure to the now discredited instruments. However,
relative to their overall business and to their capital base, such exposure seems to be small.
Fortunately, institutions in the CMA seem to have preferred to focus on more straightforward
business and refrained from building up large positions in structured products. Not that banks
and other financial institutions in the CMA are not familiar with securitisation; many mortgage
and instalment sale contracts have already been securitised, but these have tended to be
very straightforward "plain vanilla" securitisations.
The international financial market turbulence has resulted in slower global economic growth,
and is projected to continue doing so. Recent forecasts suggest a significant slowdown in
growth in the US, which is bound to spill over to the rest of the world. Talk of decoupling from
the United States is dodgy, at best. Accordingly, CMA exports - and especially those exports
destined for the countries most affected by the financial turmoil - are likely to be held back to
some extent.
As far as the money market in the CMA is concerned, liquidity has remained adequate
throughout this episode of international financial market turmoil. The lack of enthusiasm to do
business with other private-sector participants in the money market has not emerged in the
CMA. Interbank lending, for instance, has continued without any disruption, and the interest
rates at which interbank funds are placed have not risen significantly (as would have
happened if perceptions of risk had deteriorated). For instance, the margin between the
South African Reserve Bank's repurchase rate and the Sabor, or South African benchmark
overnight rate, has not changed much over time.
The turbulence prompted investors to demand higher risk premia on a wide variety of
securities. Securities issued by emerging-market countries were affected, and the CMA was
no exception. Accordingly, the spread of debt instruments issued by CMA governments over
"risk-free" US Treasuries have widened. However, as can be seen in the graph, this widening
was mostly attributable to declining US Treasury yields, which attracted investors owing to
their safe-haven status.
While it seems fairly safe to say that the pricing of financial instruments has been influenced
by this turmoil, it is more difficult to establish what the impact has been on non-resident
capital movements - in other words, the magnitude of capital flows rather than the price
thereof. South Africa currently runs a sizable deficit on the current account of the balance of
payments, and has since the emergence of the deficit been able throughout to finance the
shortfall through capital inflows. Since late 2007 the composition of the flows has changed:
portfolio inflows have faltered but at the same time inflows of foreign direct investment and
other investment funds have picked up considerably.
The turmoil has so far been accompanied by high and often rising international commodity
prices. Greater uncertainty for instance tends to be good for the prices of precious metals.
Southern Africa has generally benefited from the ongoing boom in commodity prices.
However, these gains also imply a number of challenges: These include dealing with the
windfall responsibly by not allowing the bulk of it to be translated into consumption;
transforming the economy in such a way that the quantities of commodities produced and
exported increase in response to favourable prices; and promoting beneficiation.
Levels of bad debt in the financial system of the CMA have remained fairly moderate. As
indicated previously, there is not much direct exposure to structured financial products
among financial institutions in the CMA. The increase in overdue loans which is currently
observed is from extremely low initial levels, and is not unexpected, given the increases in
interest rates since mid-2006.
Bank supervisors and financial supervisors, more generally, in the CMA have again been
alerted by the recent events to the forces of globalisation, the significant cross-border
activities undertaken by financial institutions in the region, and the accompanying risks. This
has underlined the need for continued and effective cooperation and dialogue between
supervisory authorities, which are essential for effective cross-border supervision.
This legitimate need should, however, not be confused with a need for more comprehensive
and intensive financial regulation. The dislocation in certain financial markets has certainly
been painful and some of the consequences far-reaching. While a worthy debate can also be
entertained regarding possible regulatory changes in the light of the experience gained from
the sub-prime fallout, an overambitious extension of regulation could easily be the wrong
option. Such extensions often have noble intentions but unintended consequences. A
modest and nuanced regulatory response is more likely to succeed than an overambitious
attempt to eliminate risk-taking (thereby possibly destroying much of the dynamism and most
of the positive gains which have arisen from financial innovation).
Conclusion
Against a background of volatility in the global financial markets, the CMA seems in some
respects to enjoy safe haven status. Very little exposure to the structured asset markets has
contributed to maintaining a fairly good level of credit quality and adequate levels of liquidity
in the integrated CMA financial system. Our financial institutions are now, it would seem,
being rewarded for not being too adventurous and aggressive in conducting their business.
But to ascribe the relatively healthy state of affairs in the CMA only to lack of exposure to the
structured asset markets would be unfair; the crucial role of CMA financial institutions' sound
internal risk management processes, robust levels of capital and solid supervision should be
acknowledged.
A general lesson from the recent events is that it is better to assume that trends rarely
continue forever. This rings true, whether it involves the prices of houses, shares, gold,
platinum or any other asset. Within reason, institutions, regulatory authorities and
policymakers should develop feasible contingency plans and take active steps to make
systems more robust in the event of significant reversals.
In an article presented on behalf of Edward Gramlich at the Federal Reserve Bank of Kansas
City's Economic Symposium, legislators were urged to better protect consumers against
predatory lenders and to improve regulation of mortgage lenders and banks (Gramlich,2007).
Sound institutions, first-class disclosure, sustainable policies, the building up of adequate
reserves - being robust in the face of a storm requires that the relevant authorities focus on
basics such as these. Prudential oversight and surveillance by regulators and risk
assessment by market participants can also be enhanced by filling the gaps in information on
global financial flows. International financial institutions such as the International Monetary
Fund (IMF) have taken initiatives in this area. Some authorities have already put in place
mechanisms to collect information to monitor capital flows by source countries and types of
investors. However, the IMF has suggested that, given the severity of the current credit crisis
in the US and notwithstanding the comprehensive monetary and fiscal policy steps already
announced by their authorities, additional public funds might be needed to rescue the U.S.
financial system in this instance.
Despite the severe U.S. credit crisis and its palpable spill-over effects on international
financial markets, the CMA region's economies have thus far remained buoyant given the
greater resilience and flexibility that have resulted from sound macroeconomic policies and
structural reforms adopted over the past few years. While one should not underestimate the
difficulty in the detail of doing so, the financial system in the CMA has weathered many
storms successfully and there is no reason to doubt that it will continue to do so. Central
bankers will also have to continue to be vigilant as the United States credit turmoil unfolds,
and if confronted by deterioration in local financial-market conditions, stand ready to do what
is required to facilitate the continuation of orderly trade. However, inflationary pressures
currently pose a greater challenge to the CMA region's economies than the international
financial turmoil and equally important therefore, is the assurance that we will continue to
protect the purchasing power of the money in your pocket through appropriate monetary
policies i.e. the pursuit of price stability.
References
Bernanke, B.S. 2007. Housing, Housing Finance, and Monetary Policy. Speech at the
Federal Reserve Bank of Kansas City's Economic Symposium, Jackson Hole, Wyoming.
31 August.
Bernanke, B.S. 2008. Fostering sustainable homeownership. Speech at the National
Community reinvestment Coalition Annual Meeting. 14 March.
Carney, M. 2008. Addressing financial market turbulence. Remarks presented to the Toronto
Board of Trade. 13 March. Toronto: Bank of Canada.
Gramlich, E.M. 2007. Booms and Busts, The Case of Subprime Mortgages. Article presented
on behalf of Edward Gramlich at the Federal Reserve Bank of Kansas City's Economic
Symposium, Jackson Hole, Wyoming. 30 August.
Krugman, P. 2008. How bad is the mortgage crisis going to get? Fortune, 31 March.
Board of Governors of the Federal Reserve System. 2008. Flow of Funds Accounts of the
United States. Flows and outstandings, fourth quarter 2007. Federal Reserve statistical
release. 6 March.
South African Reserve Bank. 2007. Financial Stability Review. September.