Credit crunch: islamic perspective

Chapter III: the financial crisis

The financial crisis started with a credit contraction in 2007 spread to banking crisis and stock markets failure in 2008.

We will try to briefly describe the crisis in order to derive later the lessons to be learnt from Islamic finance practices to avoid future crises.

1) From a subprime mortgage contraction...^83(*)

Since 1970, we witnessed a market change and evolution, following the collapse of the Bretton Woods agreements, the new environment was based on interest rate instability.

Since that time growth was sustainable by the overseas expansion, high prices of oil, and the telecommunications boom.

Steps have been taken to the creation of a major financial market.

In 1999, the adoption of the Gramm-Leach Billy Act and the creation of a holding company which allowed the union between investment banks and commercial banks in the USA was a significant achievement.

Banks have been subject to a lot of competition during recent years, this has led to the deconstruction of financial risk in order to improve their profits.

A large part of the credit has moved from the banks towards the market through the process of securitisation. Securitisation allows a lot of profits for lower costs of funds.

The banks have lost the function of intermediation (disintermediation) with a lot of debtors issuing their own debt through bonds or commercial papers or via the process of securitisation by creating their own special purpose vehicles (SPV).

The process of securitisation is process by which the non tradable debts for example bank mortgages are transformed into securities that are sellable to a wide audience of investors according to their diverse risk profiles.

The repackaging of the securities and their sale has participated into the deconstruction of risks.

The widespread use of this process has led to less transparent and more complex products and procedures which were more difficult to assess by the rating agencies.

The weaknesses of this process were revealed with the deepening of the subprime mortgage crisis in the US which was the immediate cause of the financial meltdown.

The crisis began with a credit contraction starting the 9^th of August 2007.

On the 20^th of July 2007, Ben Bernanke warned of USD 100 bn of losses in the subprime market.

On the 9^th of August 2007 the credit crisis began. BNP Paribas decided to suspend the payment on three investment funds exposed to the subprime market.

Share prices started to fall; banks became concerned about each other's exposure to losses and restricted lending to each other.

On the 28^th of August 2007, The German Sachsen Landesbank was sold to the Landesbank Baden Wutterbeng. IKB lost USD 1 bn due to US subprime debt exposure.

On the 13^th of September 2007, Northern Rock faced a public run followed by a request for liquidity assistance from the Bank of England.

The bank was eventually nationalised on the 17^th of February 2008 after the refusal of private bidders by the treasury.

Société Générale suffered a EUR 4.9 bn loss through its trader Jerome Kerviel.

The instability spread to the US monoline insurance market worth USD 2.3 bn with the Federal Reserve having to announce a special USD 30 bn facility to allow JP Morgan to buy Bear Sterns initially for USD 2 per share on the 17^th of March 2008. This was the first occasion in recent times that the Federal Reserve has assisted in the bail out of a non banking financial institution.

The crisis seemed to be over and the dramatic success took everybody by surprise.

2) ....To Financial collapse^84(*)

However, it was still far from being the end. The credit crisis spread to other financial sectors. Financial insolvency and bail outs were the theme of the period starting the fall of Lehman brothers on the 12th of September 2008.

A) Freddie Mae and Freddie Mac.

On the 7^th of August 2008, Freddie Mae and Freddie Mac were nationalised at cost of USD 200 bn.

B) Lehman brothers

On the 14^th of September 2008, Lehman Brothers collapsed after 158 years .The bank had to file for chapter 11 bankruptcies.

After a record USD 3.9 bn loss, the shares of Lehman Brothers dropped and a saviour needed to be found.

Any rescue plan couldn't be possible without the intervention of the state.

However, the treasury took the decision that the US authorities could not bail out another investment bank and that a private solution had to be found. Lehman was forced into bankruptcy on the 15^th of Sept 2008 after Barclays walked away from the negotiation. Barclays would later acquire Lehman's North American investment platform for less than USD 2 bn.

The fall of Lehman Brothers was the trigger to the spread of the systemic financial crisis.

C) Merrill Lynch

With the crisis at Lehman Merrill Lynch was forced to accept a USD 50 bn offer by bank of America after a week of negotiation with the deal being announced on the first day of the announcement of Lehman Brothers' bankruptcy.

D) Goldman Sachs and Morgan Stanley

Goldman Sachs and Morgan Stanley registered as bank holding companies to save themselves from bankruptcy.

E) American International Group

The treasury then had to provide a separate support package for AIG which was the world's largest insurer with a market value of USD 239 bn with the allowance of USD 89 billion credit facility in return for an 89% stake in the group.

Following its practice of providing insurance for the financial institutions in «credit default swap» format, the bank announced in May 2008 a loss of over USD 10 bn.

F) Washington Mutual

Considerable market pressure was also placed on Washington Mutual (WAMU)

With deposits of USD 188 bn in June 2008, it was decided by the federal deposit Insurance Corporation to allow WAMU to close on the 25^th of September 2008. By acquiring the deposits of all the retail branches of the company but without the unsecured debts, JP Morgan became the biggest bank in the US.

Thirteen other lenders were allowed to fall down in 2008; WAMU was the biggest failure in the US.

The crisis also affected the United Kingdom.

The shares of the financial institutions and banks dropped during September and October 2008.

Panic spread. However, it was limited by the intervention of the government via a package which included injection of liquidity into the interbank market, bank recapitalisation and credit guarantee schemes.

Bradford and Bingley and Halifax Bank of Scotland suffered a lot of pressure due to the drop in their asset prices joint by the contraction in the inter-bank market.

G) Bradford and Bingley

The discussion about which solution is better to approach the financial institutions in difficulty led to the lack of confidence and interest in the financial market, the treasury had to consider whether to take B&B over in the form of public ownership either in whole or in part.

The decision was taken to nationalise part of the business and to sell the 200 branches to Spanish Banco Santander.

H) HBOS(Halifax Bank of Scotland)

Following the collapse of HBOS shares of 40%, a rescue package was agreed with Lloyds TSB on the 17^th of September 2008. A merger was discussed for GBP 12.5 bn.

In September 2008, The Financial Services Authority (FSA) announced that it would ban financial short selling.

We are currently suffering a major recession even more severe than originally predicted.

After analysing the financial crisis a study of the causes which led to such an unprecedented crisis becomes imminent.

3) The causes of the crisis^85(*)

The causes of the crisis can be resumed to four main reasons:

A) Credit accumulation^86(*)

Following 9/11 and the boom in the technologies, the interest rates were kept low in US to encourage spending and give a boost to the economy.

Following the Community reinvestment Us Act, banks had to lend to diverse panoply of borrowers in order to give access to housing for everyone.

Interest rates were kept low encouraging spending. The flow of money resulting from securitisation and from the Asian countries led to a raise in the prices, which created a bubble in the housing, oil, commodities and food markets.

The cheap credit provided by the «originate to distribute» model followed by the financial institutions, linked to a greed or appetite for consumption and for easy money resulted in the creation of a housing bubble resulting in the increase of the prices which attained its limits in August 2007 when prices started to drop down inciting people to sell their houses, with more houses on the market, the cycle started triggering backwards and basically a lot of mortgage borrowers were not able to meet their mortgage payment and found their mortgages moving into negative equity territory which triggered the crisis.

B) Product complexity^87(*)

The securitisation process which started developing since the 1970s with the creation of Fannie Mae and Freddie Mac in the US was the basis of the creation of more complicated financial products.

The re-securitization of securitised products linked with other products creating Collateralised Debt Obligations (CDOs) in what is called repackaging of debts in a structure which was widely spread made the matters worse.

New derivative products were launched including CDS (credit defaults swaps) and TRS (Total return Swaps).

Also, the expansion of what is called «shadow banking» system contributed into the transformation of the subprime mortgage crisis into credit crunch.

Shadow bank by definition means an intermediary between banks and investors. Not allowed to granting deposits, they weren't regulated. A familiar example would be special purpose vehicles, hedge funds, mutual funds and monolines.

These entities were created by banks as off balance sheets funds in order to follow the more profitable investment strategies. Not regulated shadow institutions didn't have to follow the safety and soundness instructions in the sense that they could borrow and invest with high leverage. The function of these institutions and the fact that they borrow short and invest in long term illiquid assets make them vulnerable to the market disruption. They were made to sell their illiquid assets precisely when the prices of such assets were falling therefore deepening the crisis.

C) Asset valuation^88(*)

The complexity of the products led to a mispricing of debts. After Basel II, the system relied on the grading of the rating agencies. Amid the growing competition and the increasing complexity of products, the rating agencies failed to assess the risks and used wrong methods of assessment.

Relying on the professional opinion of the rating agency a lot of banks who retained highly rated assets had to reassess them and record their losses on the balance sheet according to the mark to market practice.

D) Market risk^89(*)

The «originate to distribute» model meant that the debt was originated and immediately sold off the balance sheet. So the banks didn't exercise any credit assessment on the mortgages any further.

These bad debts were mingled with good debts. When they went into default, they triggered the loss of value to the entire pyramid.

4) Response to the crisis.^90(*)

The responses to the crisis were immediate national and international responses.

The immediate regulatory responses:

A number of immediate reactions were scheduled in response to the turmoil of the financial crisis. These immediate responses were characterised by their protectionist nature in an attempt to contain the immediate effects of the crisis.

The US has taken a macro reaction trying to pull liquidity into the market and purchase the bad assets.

An injection of USD 180 bn was initiated by the US government. The funds were provided by national central banks including Switzerland and Canada. This extended lender of last resort funding intended to maintain dollar liquidity within the market.

The TARP or Troubled Asset Relief Programme was initiated. It was based on the principle of buying the distressed debts from the US financial market.

Under the initiative of treasury secretary Henry Halson, the TARP consisted of a new corporation established to buy distressed residential and commercial mortgage backed security from any major institution.

It was later announced that 250 billion of the funds used would be used to recapitalise the banking system following the UK model.

In the UK, the immediate response following the Lehman Brothers collapse consisted of the deposit protection scheme, a new special resolution regime, the ban of short selling by the FSA and the Bank of England extended a special liquidity scheme.

The special resolution regime or SRR helped the banks in difficulty by providing a set of tools to permit the authorities to take control of a bank that is judged to be failing.

The special liquidity scheme is a swap system of highly rated assets into government treasury bills.

The recapitalization of the major banks with investing around GBP 37 bn in RBS (20bn), HBOS (12bn) and Lloyds TSB (5bn).

The international Response includes a G20 meeting which decided to inject money into the system and some reports including Turner report^91(*), De larosiere Group Report^92(*). After assessing the causes of the crisis, de larosiere report invited for more supervision via and better crisis management whereas Lord Turner report blamed the shadow banking, rating agencies for their responsibility for the crisis and strengthen a solution based on liquidity, capital control and fundamental accounting changes.

Some proposed solutions for the crisis can be resumed as the following^93(*):

Joseph Stiglitz invite for a new glass Stegall act and the minimizing of the leverage of lending.

Simon Johnson consider that the too big to fail doctrine is an essential feature for the systemic risk. For that reason, institution too big to fail should be restricted.

Paul Krugman invite for a wider regulation to include deregulated sectors like hedge funds.

Ben Bernanke invited for the closure of the non regulated activities.

These entire propositions to change the system prove that mistakes were made and lessons are to be learnt.

* 83 ^_ G .A Walker, `Credit Contraction, Financial Collapse and Global Recession' Butterworths Journal of International Banking and Financial Law JIBFL (Feb 2009)

* 84 ^_ Ibid

* 85 _ G A Walker, `G A Walker, `Financial Crisis Cause and Correction' (Financial Regulation International (Informa 2008) Dec, 1-2

* 86 ^_ Ibid

* 87 ^_ Ibid

* 88 ^_ Ibid

* 89 ^_ Ibid.

* 90 ^_ G .A Walker, `Credit Contraction, Financial Collapse and Global Recession' Butterworths Journal of International Banking and Financial Law JIBFL (Feb 2009)

* 91 ^_ http://www.fsa.gov.uk/pubs/other/turner_review.pdf

* 92 ^_ http://ec.europa.eu/internal_market/finances/docs/de_larosiere_report_en.pdf.

* 93 ^_ Encyclopedia Wikepedia ,accessible in 31 August 2009, http://en.wikipedia.org/wiki/Regulatory_responses_to_the_subprime_crisis#cite_note-stigcnn-10