Indonesia has lesson for US
Tuesday, September 30, 2008
THE US financial system entered a new stage last week when the Treasury and the Federal Reserve proposed a US$700 billion ($980 billion) bailout of their financial system. This amount, about 5 per cent of their GDP, seems large. However, looking at the size of the problem and the potential fallout, this amount seems to be reasonable.
The breadth of the bailout is not entirely clear, but as of now a number of issues have surfaced. However, coming to the rescue of the financial system at this stage can be considered a preemptive move before things get out of hand.
This is also the reason why the amount, US$700 billion, is considered adequate to prop up confidence in the financial system. The amount itself is a show of how serious the US government is in tackling the situation. If the authorities are late in making the move, the financial system may experience bankruns (similar to what happened at the Northern Rock Bank in UK) which would change the current situation into an entirely different game. If that happens, the total bill will be much greater than currently proposed.
However, the prompt actions by the US government were also driven by the concerns regarding the integrity of the banking system. Through various interbank and capital market transactions, letting these institutions go will trigger a domino effect in the banking system.
The financial crisis was initially driven by a subprime mortgage crisis. The housing boom (or bubble) created an atmosphere for the financial system to expand very rapidly, including loans to non-creditworthy customers. In the US system, these mortgages were then bundled, repackaged and sold to the capital market in the form of mortgage-backed securities (MBS) and its variant collateralised debt obligations (CDO).
Therefore, while the initiators of the mortgages were commercial banks, savings and loans companies and mortgage companies, the investment banks became involved because of their MBS and CDO portfolios which they purchased from the capital market. Fannie Mae and Freddie Mac also played an active role as the bridge in securitising these loans.
Because of this role, the two institutions often ended up with some securities in their portfolio. Since these assets were rated triple A by agencies such as Standard and Poor and Moodys, this could easily happen.
If the problem was limited to that issue, things would still be manageable. Both MBS and CDO are portfolios with underlying assets. Therefore, any problems with the underlying assets, which were mortgages, could still be deciphered by the authorities. However, things became blurred once other factors surfaced under the name of credit default swap (CDS). This is a new animal in this complex game.
CDS is a new instrument created in the 1990s to provide insurance to the financial system when their bonds, loans or other assets are in default. The seller of this instrument provides a guarantee if the bond or other asset is in default.
For this purpose, the buyer of the instrument has to pay annually for the life of the contract period, say for five years. For this purpose, in return, the sellers have to set aside a certain amount in assets as collateral.
If the transaction follows this mechanism, things can still proceed smoothly because the risk is measurable. In fact, the transaction was initiated because the buyer wants to mitigate risk.
In practice however, many of the sellers, some of which are hedge funds, did not abide by this rule. For example, a small hedge fund company in the United States was willing to make such a transaction with a large Swiss bank without abiding by the collateral requirements.
This posed a serious counterparty risk to the Swiss bank which finally canceled the contract. In quiet times, which is descriptive of the United States for many years, things can carry on quite smoothly. But once the waters got rough, the system started cracking.
What made these issues more serious were excesses in these types of transactions. Since there was no tracking mechanism, the transaction could be made repeatedly.
Sometimes a transaction to insure Bond A held by Institution X was done more than five times by the sellers with other parties without a bond.
Therefore, if things go sour, it will be difficult to track down the defaulted amount. Legal wrangling through litigations and counter litigations will take place just to resolve one transaction.
Things can become very messy. The ultimate monster in the current financial crisis is the CDS. Since there is no transparent way to disclose this instrument, people predict that the amount involved may be as high as US$42 trillion, more than three times the US GDP.
Lehman Brothers were a victim of this instrument. The same occurred to other institutions which were eventually bailed out.
In a crisis of this magnitude, confidence building becomes a very critical element of the game.
Regardless of market reactions, the US governments actions deserve praise. While details of the rescue plan are still under discussion, people can believe that their money in the banks is safe.
They have seen that if something does happen with the banks, either FDIC, or the Treasury or the Federal Reserve will take prompt action to solve the problem.
Legislation authorising the actions is currently underway in Congress, but people realise that things have been taken care of. This confidence will prevent any bankruns.
In order to unload the banks toxic mortgage assets, officials are also weighing the benefits of setting up a new agency such as the previous Resolution Trust Company or determining what they can learn from the experience of the Swedish authorities during the ERM crisis of the early 1990s.
Learning from the Indonesian experience based on the last crisis, which closely copied the Swedish experience (Indonesia was assisted by Dr Stefan Ingves, currently the governor of the Swedish Central Bank, during the preparation of the Indonesian Banking Restructuring Agency and the blanket guarantee scheme of 1998), the US authorities should develop a strong legal base to avoid litigations later on.
The writer is Rector of ABFII Perbanas. He can be reached at charinowo2002@yahoo.com
The Jakarta Post/ANN
The breadth of the bailout is not entirely clear, but as of now a number of issues have surfaced. However, coming to the rescue of the financial system at this stage can be considered a preemptive move before things get out of hand.
This is also the reason why the amount, US$700 billion, is considered adequate to prop up confidence in the financial system. The amount itself is a show of how serious the US government is in tackling the situation. If the authorities are late in making the move, the financial system may experience bankruns (similar to what happened at the Northern Rock Bank in UK) which would change the current situation into an entirely different game. If that happens, the total bill will be much greater than currently proposed.
However, the prompt actions by the US government were also driven by the concerns regarding the integrity of the banking system. Through various interbank and capital market transactions, letting these institutions go will trigger a domino effect in the banking system.
The financial crisis was initially driven by a subprime mortgage crisis. The housing boom (or bubble) created an atmosphere for the financial system to expand very rapidly, including loans to non-creditworthy customers. In the US system, these mortgages were then bundled, repackaged and sold to the capital market in the form of mortgage-backed securities (MBS) and its variant collateralised debt obligations (CDO).
Therefore, while the initiators of the mortgages were commercial banks, savings and loans companies and mortgage companies, the investment banks became involved because of their MBS and CDO portfolios which they purchased from the capital market. Fannie Mae and Freddie Mac also played an active role as the bridge in securitising these loans.
Because of this role, the two institutions often ended up with some securities in their portfolio. Since these assets were rated triple A by agencies such as Standard and Poor and Moodys, this could easily happen.
If the problem was limited to that issue, things would still be manageable. Both MBS and CDO are portfolios with underlying assets. Therefore, any problems with the underlying assets, which were mortgages, could still be deciphered by the authorities. However, things became blurred once other factors surfaced under the name of credit default swap (CDS). This is a new animal in this complex game.
CDS is a new instrument created in the 1990s to provide insurance to the financial system when their bonds, loans or other assets are in default. The seller of this instrument provides a guarantee if the bond or other asset is in default.
For this purpose, the buyer of the instrument has to pay annually for the life of the contract period, say for five years. For this purpose, in return, the sellers have to set aside a certain amount in assets as collateral.
If the transaction follows this mechanism, things can still proceed smoothly because the risk is measurable. In fact, the transaction was initiated because the buyer wants to mitigate risk.
In practice however, many of the sellers, some of which are hedge funds, did not abide by this rule. For example, a small hedge fund company in the United States was willing to make such a transaction with a large Swiss bank without abiding by the collateral requirements.
This posed a serious counterparty risk to the Swiss bank which finally canceled the contract. In quiet times, which is descriptive of the United States for many years, things can carry on quite smoothly. But once the waters got rough, the system started cracking.
What made these issues more serious were excesses in these types of transactions. Since there was no tracking mechanism, the transaction could be made repeatedly.
Sometimes a transaction to insure Bond A held by Institution X was done more than five times by the sellers with other parties without a bond.
Therefore, if things go sour, it will be difficult to track down the defaulted amount. Legal wrangling through litigations and counter litigations will take place just to resolve one transaction.
Things can become very messy. The ultimate monster in the current financial crisis is the CDS. Since there is no transparent way to disclose this instrument, people predict that the amount involved may be as high as US$42 trillion, more than three times the US GDP.
Lehman Brothers were a victim of this instrument. The same occurred to other institutions which were eventually bailed out.
In a crisis of this magnitude, confidence building becomes a very critical element of the game.
Regardless of market reactions, the US governments actions deserve praise. While details of the rescue plan are still under discussion, people can believe that their money in the banks is safe.
They have seen that if something does happen with the banks, either FDIC, or the Treasury or the Federal Reserve will take prompt action to solve the problem.
Legislation authorising the actions is currently underway in Congress, but people realise that things have been taken care of. This confidence will prevent any bankruns.
In order to unload the banks toxic mortgage assets, officials are also weighing the benefits of setting up a new agency such as the previous Resolution Trust Company or determining what they can learn from the experience of the Swedish authorities during the ERM crisis of the early 1990s.
Learning from the Indonesian experience based on the last crisis, which closely copied the Swedish experience (Indonesia was assisted by Dr Stefan Ingves, currently the governor of the Swedish Central Bank, during the preparation of the Indonesian Banking Restructuring Agency and the blanket guarantee scheme of 1998), the US authorities should develop a strong legal base to avoid litigations later on.
The writer is Rector of ABFII Perbanas. He can be reached at charinowo2002@yahoo.com
The Jakarta Post/ANN
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