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Neolib video : http://www.youtube.com/watch?v=XIUWZnnHz2g&feature=related neolib as a water balloon 12 min
Lec 5 global capitalism Fin crisis DW post Oct 29
Global Capitalism, Financial Crisis & Developing Countries
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Origins of the Crisis: USA
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Impact of the Crisis: Global
What caused the US/EU financial system to fail in 2007-9 that led to a shock to global production and trade?
What has been the impact of this crisis on the DW?
Why has the impact on the Developing World been less than on the AICs?
Why has the recovery been quicker in the Developing countries?
What caused the crisis?
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Market failure?
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Policy failure?
Market failures
• Information: markets do not know how to price systemic risk (hidden by derivatives) and investors “herd” (risk aversion)
• Principle-agent: incentives to traders to take risks; securitization of loans by banks removes monitoring
• Moral hazard/market distortion: banks “too big to fail” and government underwriting assumed
Security
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An instrument representing ownership (stocks), a debt agreement (bonds) or the rights to ownership (derivatives).
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A security is a negotiable instrument representing financial value. The company or other entity issuing the security is called the issuer
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A country's regulatory structure determines what qualifies as a security.
For example, private investment pools may have some features of securities, but they may not be registered or regulated as such if they meet various restrictions.
Derivatives
A derivative is an agreement between two parties that is contingent on a future outcome.

In finance, a derivative is a financial contract with a value linked to the expected future price movements of the asset it is linked to - such as a share, currency, commodity or even the weather.
Derivatives allow risk about the price of the underlying asset to be transferred from one party to another. Options, futures and swaps, including credit default swaps, are types of derivatives.
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A common misconception is to refer to derivatives as assets. This is erroneous, since a derivative is incapable of having value of its own as its value is derived from another asset.
SayItVisually--US Financial Crisis http://www.youtube.com/watch?v=h4Ns4ltUvfw
Derek Banas fin instruments - deregulation http://www.youtube.com/watch?v=S3AXHQcXYMk
Subprime
Subprime is a classification of borrowers with a tarnished or limited credit history.
Lenders will use a credit scoring system to determine which loans a borrower may qualify for.
Subprime loans are usually classified as those where the borrower has a credit score below 640.
Subprime loans carry more credit risk, and as such, will carry higher interest rates as well.
Approximately 25% of mortgage originations are classified as subprime.
Subprime lending encompasses a variety of credit types, including mortgages, auto loans, and credit cards.
Collateralized Debt Obligation (CDO)
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CDOs are a type of structured asset-backed security whose value and payments are derived from a portfolio of fixed-income underlying assets.
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CDOs are split into different risk classes, or tranches, whereby "senior" tranches are considered the safest securities. Interest and principal payments are made in order of seniority, so that junior tranches offer higher coupon payments (and interest rates) or lower prices to compensate for additional default risk.
Note:
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Each CDO is made up of hundreds of individual residential mortgages.
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CDOs that contained subprime mortgages or mortgages underwritten because of predatory lending were at greatest risk of default.
• They are blamed for precipitating the global crisis and have been called WMD “weapons of mass destruction.”
Credit Default Swap (CDS)
A CDS is an insurance contract in which the buyer of the CDS makes a series of payments to the protection seller and, in exchange, receives a payoff if a security (typically a bond or loan or a collection of loans such as a CDO) goes into default.
NOTE: CDOs are widely thought to have exacerbated the financial crisis, by allowing investors who did not own a security to purchase insurance in case of its default. AIG almost collapsed

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Policy failure
• US and EU government “populism” over-indebts lower-income groups
• US and EU fiscal low-interest policies fuelled asset bubble (including commodities)
• Global imbalances generated growing and unsustainable G3 debt
Origins of current financial crisis
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Since 1990s deregulation of financial markets: risk pricing replaces prudential supervision. Rise of derivative “assets” with opaque markets and few players. Bank loans replaced by bonds etc.
• Huge US fiscal deficit, monetary expansion (“Greenspan put”), low savings led to a US mortgage boom/bust (non traded sector) and a huge current account deficit (traded sector).
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Mortgage bubbles (e.g. 1992 in UK) are familiar with obvious political costs; join recurrent bubbles in past decade (dotcoms, LTCM, Tequila etc);
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But this is by far the most serious s ystemically because it threatens the global banking system itself as creditor, and whole US electorate as debtor.
Sub-prime lending
By 2005, one in five mortgages were sub-prime, and they were particularly popular among recent immigrants trying to buy a home for the first time, and the poor.
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Repossessions of houses in America as many of these mortgages reset to higher rates.
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By late 2007, one in ten homes in Cleveland had been repossessed
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As many as two million families will be evicted from their homes as their cases make their way through the courts.
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Collapse of the government backed mortgage system in the USA (Fannie and Freddie) followed by meltdown of major investment banks (Lehman, Bear, Merrill) exposed to mortgage market
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Mark-to-market asset pricing effects on balance sheets and cumulative liquidity retraction due to rising risk aversion;
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Affecting Insurance (AIG) ; and pensions funds

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Financial Times , 20 Sept 2008
Financial Times , 20 Sept 2008
• “…bank boards and bank executives have failed to understand complex mortgage-backed banking products, as have central bankers, regulators and credit rating agencies.”

• “…a reward system that has granted huge bonuses to those who peddled toxic mortgagerelated products….”
• “Almost as absurd has been the degree of leverage racked up by investment banks.”
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Developing Countries pursued autonomous policies not dependent on those of IMF strictures:
• Reserve accumulation to insure themselves after learning form 1990s crises
• Countercyclical macro-policies (fiscal, monetary and exch-rate) to stabilize their output
• More extensive safety nets (universal rather than targeted) to sustain demand

World International Reserves (USD million) http://www.nber.org/public_html/confer/2011/GFC11/Dominguez_Hashimoto_Ito.pdf
However, income distribution has worsened and poverty risen in the DW
• Managed exchange rates maintain output/employment rather than wages/incomes in the formal sector.
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The burden falls on the informal sector – lower wages and spending by the poor.
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Remittances from abroad declined.
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World Bank estimates poverty rising due to deceleration in growth
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Decline in job creation while labour force continues to grow
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What Does Sovereign Debt Mean?
Bonds issued by a national government in a foreign currency, in order to finance the issuing country's growth. Sovereign debt is generally a riskier investment when it comes from a developing country, and a safer investment when it comes from a developed country. The

stability of the issuing government is an important factor to consider, when assessing the risk of
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Rapid (and massive) US & EU government response
•Monetary expansion
• Fiscal expansion
• Bank bailouts

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Advanced economies’ debt/GDP ratio risen by 35% 2007-14
Income distribution and poverty
Stabilization and income distribution:

• Output shocks reduce employment; real devaluations reduce real wages
• Decrease of modern sector wage bill cuts informal incomes through lack of demand for the informal sector
• Poor urban households (casual labour and petty services) particularly hard hit
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TheWorld Bank Global Monitoring Report 2010: The Millennium Development Goals (MDGs) after the Crisis (April 2010)
• WB projects the poverty impact of the crisis through the effect on growth; also for MDG targets
• “The crisis left an estimated 50 million more people in extreme poverty in 2009, and some
64 million more will fall into that category by the end of 2010 relative to a pre-crisis trend”
(p. 102)
• That is 2% of the world population

Is there an equitable stabilization possible?
• the heterodox stabilization policies of EMs have not protected wages and jobs or contained the impact on countries’ poverty
Consequences for longer-term inequality and poverty:
• Mainly depends on (a) growth/employment effects; and (b) fiscal redistribution
• Accelerated industrial shift for some countries
(esp. Asia) creating employment and skills; commodity export model for others (esp LAC and SSA), requiring fiscal redistribution
• But greater reliance on domestic investment and saving would possibly favour Small & medium Enterprises and thus asset redistribution worldwide?
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