Introduction
The credit crisis that began in 2007 has been explained as the greatest threat to the global financial system since a similar crisis in the 1930s. The credit crisis that caused significant chaos in the global financial markets and triggered a recession to other parts of the economy has been attributed to lack of credit or liquidity available to banks both domestically and on the international markets. The 2008-9 credit crisis was mainly a crisis in debt markets (Madura, 2012). In October 2007, the stock market peaked with the Dow Jones Industrial Average reaching about 14,000 and was still an impressive 12,000 by August 2008. Though the Dow Jones ultimately crushed to 6,600 in March 2009, most of that crushed occurred in late 2008. Nonetheless, it must be noted that problems in debt markets, just as the case of mortgage-backed securities market, were pronounced since Augusts 2007.
Trades in debt markets are mainly involve financial institutions such as banks, insurance companies, hedge funds as opposed to households. A main characteristic of markets in debt instruments is that a trader desiring to make an investment needs that it first raises money through sale of current financial assets or borrowing funds from another party. Debt markets would only function smoothly if the funds can be raised in a fair and easy manner. However, during a credit crisis, it is often difficult to raise funds easily or quickly (Madura, 2012). As a result, the fundamental elements for certain assets usually become disjointed for a time from market prices, resulting in consequences that can have negative far reaching effects to the real economy. Banks repackaged bad debts and sold on to investors in overly complicated “derivatives” not clearly understood by the investors themselves. When it became evident that the sub-prime debts were not repayable, international banks and investors were left hugely exposed to bad debts and forced into free-fall.
Credit Crisis of 2007-08
Following a few years of easy credit, much liquidity, as well as cheap debt, the global financial markets begun unravelling in the period between the summer of 2007 and late 2008. It resulted in widespread defaulting by subprime borrowers pressured by the rising interest rates together with falling home prices which rendered selling or refinancing a home very difficult. The first to be substantially affected were investors in the mortgage-backed securities (MBS) along with collateralized debt obligations (CDO) as they begun reporting massive losses due to the plummeting value of mortgages underlying the securities (Stowell, 2010). On July 31, 2007, two Bear Stearns hedge funds with heavy investments in subprime securities were forced to declare bankruptcy after failing to meet their margin calls. On August 6, 2007, American Home Mortgage, which was at one time the tenth largest mortgage lender in the U.S., filed for bankruptcy after losing the funding it required to make new loans. As a result, corporate credits spreads reacted to these high-profile collapses by widening dramatically irrespective of generous cash holdings by most nonfinancial companies at the time. There was drying up of short-term financing (i.e. commercial paper backed by assets), threatening the future of several financial institutions (Madura, 2012). These events culminated in a full-blown credit crisis with far-reaching consequences for the global economy.
While governmental reaction to the subprime mortgage crisis was largely swift, it did not result in improve market conditions. On August 9, 2007, taking into consideration the lack liquidity particularly in the debt markets, the European Central Bank (ECB) responded by injected €95 billion in overnight credit to the interbank market. This was immediately followed by the action of the U.S. Federal Reserve to inject $38 billion into its markets, which was the largest such cash infusion since the terrorist attacks of September 11, 2001 (Madura, 2012). The Fed further lowered the discount rate by a massive 50 basis points and a subsequent 50 basis points by September 18. In an effort to stimulate short-term liquidity, the U.S. Fed further established the Term Auction Facility, mandated to give 28-day loans to banks in December 2007. On January 2008, he Fed funds rates was further slashed by another 75 basis points, which was the first emergency cut since the last one in 1982.
Nonetheless, the efforts by the Fed only served as short-term relief to the debt markets as it did not resolve the losses incurred by mortgage lender and CDO investors. At the same time, two of the largest mortgage lenders in the U.S., Countrywide Financial and Washington Mutual, requested for cash infusions so as to bolster their capital positions as well as cover losses (Madura, 2012). Following months of liquidity challenges, Countrywide receive an offer from Bank of America to exchange 0.1822 of its shares for each Countrywide’s share. The deal made Countrywide to be valued at $7.03 per share as of April 18, 2008, which was in excess of 70 percent discount to the stock trading a year earlier. The escalation of the credit crisis led to the ballooning of IndyMac Bank’s loan charge-offs and the plummeting of its assets. The bank’s efforts to seek capital following experience with a bank run were unsuccessful as it was taken over by federal regulators on July 11, 2008 (Stowell, 2010). The shares of Freddie Mac and Frannie Mae, two U.S. federal-sponsored firms owing about $5.2 trillion in home mortgages (almost half the mortgage loans outstanding in the U.S.) tumbled more than 80 percent from a year earlier.
The credit crisis also severely affected investment banks. Such large banks as UBS, Citigroup, and Merreill Lynch announced substantial write-downs associated with investments in subprime securities. Similarly, Lehman Brothers also experienced large downs and reported its first quarterly loss in June 2008 since its IPO in 1994 (Madura, 2012). The weakening economy and fast fading confidence made investment banks to continue incurring huge profit losses in their investment banking, principal investing businesses, and propriety regardless of massive staff reductions. Most of investments were sold off, others filed for bankruptcy while some such as Citigroup would experience significant huge stock declines to warrant massive private and public capital infusions in order to stay afloat.
Role of liquidity in credit crises
Liquidity, in this context, refers to the ability to purchase financial assets as well as real goods and services instantly. As such, cash is the most liquid asset is cash. Deposit and current accounts together with such assets as treasury bills are also by nature very liquid. Berger and Bouwman (2008b) have employed their liquidity measure to explore the link between liquidity and credit crises (Madura, 2012). The study’s sample period stretched from 1984-2007 to cover two main banking crises, the credit crisis of early 1990s as well the recent financial crisis that started in 2007. The researchers focused on “abnormal” liquidity creation i.e. the deviation from the time period of liquidity creation modified for seasonal reasons. Their findings indicated that both credit crises were preceded by an abnormal positive liquidity creation, which also applies to the 2008-9 financial crisis (Stowell, 2010). In this regard, there is always a build-up of capital as well as a loosening of lending standards by banks and financial institutions in the lead-up to a crushing in the debt market. Liquidity fell during the credit crisis of the 1990s. As concerns the recent credit crunch, data set indicates a fall in liquidity following the start of the crisis.
As been seen above, the credit crisis of 2008-9, debt markets suffered due to lack of liquidity which resulted in cash flow problems especially for large financial institutions, real estate developers, and insurance companies as well almost all of U.S. automobile industry. As such, the trigger for the liquidity crisis was a direct increase in the number of subprime mortgage defaults which begun in February 2007 (Madura, 2012). Figure 1 below shows the ABX price index based on the price of credit default swaps. With the decline in the price index, there was a corresponding increase in the cost of insuring a given basket of mortgages at a certain rating against default.
(Stowell, 2010)
Two main trends in the banking industry were significantly responsible for the lending boom along with the housing frenzy that formed the foundations of the 2008-09 credit crisis. First, banks did not hold loans on their balance sheets instead adopted an “originate and distribute” model (Madura, 2012). This was the banks repackage loans and pass them on to a number of other financial investors, in so doing off-loading risk. Second, most banks greatly financed their asset holdings using shorter maturity instruments which rendered them highly exposed to a dry-up in funding liquidity.
It is evident that liquidity has significantly contributed to the recent credit crisis and others that came before. It is worth exploration how liquidity provision on the part of the banking system contributed to the occurrence of a credit crisis. According to the asset pricing theory, financial economics providing tools for both asset valuation and risk management are based on the assumptions of rational agents together with perfect and complete markets. The agents are fully aware of all risk relating to investments they undertake as well as how to price them accordingly. Similarly, the recent theory that informs central bank inflation-target policy is founded on similar assumptions. Ideally, financial institutions should have no role to play in this frictionless world, and credit crises are not possible. However, credit crises still occur in badly functioning money markets where the role of financial institutions as liquidity creators is great (Stowell, 2010).
Bryant (1980) and Diamond & Dybvig (1983) developed the standard model of banking which enables consideration of the function of banks as providers of liquidity. A short asset provides liquidity for the next period while a long asset provides a relatively higher return though at a future date. Consumers are at start uncertain of the time they need liquidity and thus cannot directly insure against this risk. In this regard, banks play a role of providing liquidity insurance to the depositors. Allen and Gale (2004a, 2007) develop a banking model that includes both markets and financial intermediaries. Consumers make investment in such financial intermediaries as banks and mutual funds, which in turn reinvest in financial markets. Direct trading is costly for individual investors because of high information and transaction costs. The financial intermediaries thus provide liquidity insurance against consumer’s individual liquidity shocks (Madura, 2012). At the same time, markets afford financial intermediaries together with their customers a chance to share aggregate risks. Such a general equilibrium frameworks lends itself to a normative assessment of liquidity provision by the banking system. Banks often allow their customers to make deposits that they withdraw whenever they need liquidity (Stowell, 2010). The role of liquidity provision enable banks to accumulate funds which they lend to other organizations to fund their long term investments. However, banks need to effectively manage their liquidity in order to fulfill liquidity needs of their customers.
The actions of financial institutions are influenced by such factors as falling risk capital, increased counterparty risk, and rising repo haircuits. These factors significantly reduce the liquidity in debt markets. As such, a decline in liquidity occurs either because of the action of financial institution providing secondary market with debt instruments to reduce their purchasing on grounds of the above factors (Madura, 2012). Further, during a credit crisis, most investors often become more averse as relates to owning illiquid investments due to their preference to have their investment as liquid assets. The drying up of liquidity in the interbank markets resulting in credit crises can be attributed to the action of banks to hoard liquidity in the effort to counter the increasing uncertainty relating to aggregate liquidity demand along with the fear to lend out to other banks (Madura, 2012). During the 2008-09 credit crisis, banks seemed to greatly hoard liquidity as opposed to declining to lend to counterparts because the credit defaults swaps on the part of the banks were elevated somehow.
When a large credit facility is requested but the borrower’s credit lacks rating at the top of the credit pile from Standard & Poor’s or Moody’s Investors Service, there is often a proportional increase in interest rate pricing as compared to the amount of leverage the loan request generates for the borrower. The larger credit facilities could be requested for the purpose of supporting product or market expansions, for financing existing credit lines lacking necessary flexibility due to market conditions, or to enable company or business line acquisitions. During a credit crises, such loans are often in the company of overly complex commercial loan documentation which usually have nothing to do with the quality of the relationship between the management of the borrower and the lender.
Effect on Interest Rates
Interest rates are essentially the price of money i.e. the value that a borrower has to pay in the future in order to be lend money in the present. During the credit crisis of 2007-09, the central banks strived to suppress interest rates (Madura, 2012). Chairman of the Federal Reserve, Ben Bernanke, adopted unconventional programs in the effort to control interest. First, the Federal Reserve stepped in to bail out several large banks in addition to devising a series of innovative lending operations meant to spread credit to banks, SMEs, and consumers. The Fed also lowered its short-term interest rates to almost zero besides making private banks to undergo a gantlet of stress tests so as to guarantee some minimal degree of solvency going forth (Stowell, 2010). Since 2009, the U.S. Federal Funds rate (the rate that depository institutions lend to each other overnight) has steadily decreased from 0.16% to 0.14%. The rate has not risen above 10 percent since 1984.
Public Initial Offering (IPO) during Credit Crises
The global credit crisis and the shockwaves it caused across equity markets resulted in a sharp decline in initial public offering (IPO) activity especially in 2008. Generally, since the onset of the 2007-09 credit crisis, fewer but bigger IPOs have been offered. In 2007, the global IPO activity hit an all-time high with a record of $287 billion in returns but considerably slowed in 2008 due to the tumultuous markets and economic uncertainty (Madura, 2012). While big emerging markets such as BRIC maintained their market share during the first half of 2008, developed markets in general experienced a sharp decline in not only the volume but also proceeds. Four of the five biggest IPO in the first half of 2008 came from emerging markets. According to the 2007-08 Deloitte Corporate Finance’s Annual IPO Report, a mere 199 IPO were undertaken in the financial year ending June 30, 2008. This represented a significant drop from a record 221 IPOs listed in the previous year. This a particular decline in the number of small IPOs due to the unwillingness of investors to on the risk linked with less-mature companies. Investors shied away from small, speculative IPOs in favour of larger companies renowned for exceptionally strong fundamental performance (Stowell, 2010). In addition, the total value of funds that IPO investors managed to raise during the period almost halved from as high as $10.5 billion during the period 2006-07 to a modest $5.9 billion in 2007-08. The Deloitte figures showed that the greatest change during the period was in the form of a major drop in average returns from IPOs. This is because IPO investors recorded an average loss of about 3 percent in 2007-08 as compared to an average gain of 91 percent in 2006-07. However, the June quarter figures revealed that there were a mere 16 IPO floats compare to 75 floats in the previous year.
(Stowell, 2010)
The financial year results showed an average loss of 29 percent for investors in the year’s top ten IPOs . These floats accounted for about 60 percent of all revenues raised during the 2007-08 period. Eight of the biggest ten IPOs of the year traded below their issue prices by the end of the year. In fact, RAMS Home Loans (the biggest IPO of the year) was also the top loser with its $2.50 shares managing to trade at a mere six cents, reflecting a 98% drop. Other large IPOs that incurred heavy losses included real estate giants Babcock & Brown Communities (65% drop), Orchard Industrial Property (62% drop), as well as Multiplex European Property (45% drop). The poor performance of IPOs during the credit crisis is attributable to the reluctance of IPO investors to participate in IPOs without the hope of an upturn in market conditions.
(Stowell, 2010)
The Middle East markets showed exceptional resilience during the credit crisis due to liquidity created from higher oil prices at the time. In July 2008, Maaden or Saudi Arabian Mining, the country’s largest gold producer managed to raise $2.5 billion in its IPO.
Shleifer & Wolfenzon (2002), Doidge et al. (2007), and Stulz (2009) have addressed the influence of financial globalization on initial public offering activity and conclude that home country laws and regulations may have significant opposite effects on the domestic activities as compared to global activities (Stowell, 2010). This is as a result of the mixed burden of plunging capital market and economic recession leading to a drying up of many sources of financing for firms, a slowdown in corporate investment along with growth. The main reasons for the low volume and poor performance of IPOs during the 2007-08 period were the shaky economic fundamentals, loss of investor confidences as well as the widespread volatility in global equity markets. However, 2009 became a transition year from crisis and recovery to economic normalcy (Madura, 2012). The number of IPOs increased considerably throughout the year due to reinforced market fundamentals.
References:
Stowell, D. (2010). An introduction to investment banks, hedge funds, and private equity: The new paradigm. Burlington, MA: Academic Press/Elsevier.
Madura, J. (2012). Financial markets and institutions. Mason, OH: South-Western, Cengage Learning.
