Download PDF: where-will-the-next-bubble-burst_
by Kevin Yulianto
It has been eight years since the last global financial crisis rocked the world, yet today the world’s economy hasn’t fully recovered to what it was before. Many believe that a crisis is looming on the horizon and we are simply waiting for one of the bubble to burst, and there is lots of it. There are three interrelated topics discussed in this paper, namely the securitization of student loan, Eurozone and Sovereign Debt Crisis, and danger of derivatives product. In order to understand the similarity of how a crisis evolved, first we need to look back and learn the factors contributing to past crisis.
Same Old Same Old
At the turn of the century, various events happened particularly in United States. Among them are Internet bubble, Middle East war and 9/11 tragedies, these events forced the Federal Reserve to push the interest rates increasingly lower, from 5% level in 2000 to below 2% in 2003. Due to the low interest rates that was meant to stimulate growth in spending and business activity, investors turned away from fixed income, such as US bonds, into a higher yielding assets such as stocks and real assets. As a result, from 2003 until the first semester of 2007, S&P increased by 60%. In the same period the median house price increase from $195.000 to $247.900, confirming the market believes that house price will continue to increase indefinitely. Market was surprised when the Federal Reserve raised the interest rates rapidly in the second semester of 2005 until 2006, triggering the failure of debtors in servicing their debt and showing how fragile the financial system works.
In the period of rising stock market and house price, financial institutions were packaging Mortgage Backed Securities (MBS) and insurance companies were selling Credit Default Swap (CDS), a guarantee in case of MBS default. With believe that home price will continue to increase, investors were motivated to buy a house with highly leveraged Loan-to-Value. Some people even buy second and third house when the loan of his/her first house hadn’t fully repaid due to his/her ability to take bigger loan from increasing house equity. A significant portion of these people was not qualified for the loan in the first place, so when the monthly payment was increased, default rates increased dramatically and home price slumped, triggering further default in national scale.
There are several reasons why the 2008 Global Financial Crisis happened. First, the Federal Reserve was too slow in increasing the interest rates, forcing them to increase it more rapidly later on and inflating the price of assets. Investors are attracted to high yield assets; in the period of low return, they increasingly seek for assets with higher risk and lower liquidity, therefore creating a systemic risk in the long run. Second, there are inherent conflicts of interest among financial institutions, among them banks that securitize mortgages to sell them to investors, therefore not bearing the risk involved. Credit agencies also play a role in determining the rating of issued securities; in the process they were incentivized to issue the highest rating possible due to their faulty business model. The availability of loan and credit facility has fueled people to spend money they don’t have to acquire and speculate on assets, among them house and stocks. Creditors, on the other hand, were deceived by the highly favorable ratings issued by the agencies, therefore willing to provide larger and larger funds without acknowledging the risks involved. Third, the root of all mania is irrational exuberance in the market, the expectation that price will always increase and that as long as there are people willing to buy at higher price, an asset is thought as undervalued. But as economic 101 taught us that when any asset’s price is high, supply of such asset will increase and drives down the price back to equilibrium price. Any speculators buying above the equilibrium price will suffer from losses, and imagine the impact of millions of debt-fueled speculators defaulting at nearly the same time. Remember these three things that always present in every financial crisis, search for yield, availability of credit, and irrational exuberance.
Where We Are Now
Fast-forward eight years from the beginning of financial crisis, financial condition looks great around the world, especially in US. The stock market has been at all time high, surpassing the pre-crisis level by 33%. It took only four years for the S&P to recover to pre-crisis level (Feb 2009 – Feb 2013) after bottoming in 2009, thanks to the aggressive rate cut around the world and quantitative easing that prop up the price of all financial assets. However, there are untold stories behind the superficially looks good condition.
A sign of consumer demand above supply, inflation has been low for years in developed countries such as United States, Germany, France and other European countries; even Japan’s inflation rate has been declining since 2014 and turned negative for the last five consecutive months. Year-on-year inflation rate in US, Eurozone, and Japan are currently at 1.1%, 0.3%, and -0.4%. These figures for years has been below 2%, the inflation target of their central banks, despite the huge amount of monetary stimulus ranging from interest rate cut to quantitative easing worldwide. Negative interest rates by European Central Bank and Bank of Japan failed to drive inflation and business activity higher, while the Federal Reserve is acknowledging the possibility of negative interest rates should the economy worsen. Meanwhile the year-on-year GDP growth of US, Eurozone, and Japan stands at 1.1%, 1.8%, and 0.2%.
The negative interest rates are punishing savers while benefitting borrowers, an unsustainable practice in the long-term and whose effect is questionable. The very low interest rates around the world has made investors becoming more aggressive in searching higher yield, the practice of securitization has continue past the GFC and more exotic instruments are developed by financial engineers. The derivatives market has been flourishing despite the regulation to control Over The Counter (OTC) market with Central-Counterparty (CCP). Low interest rates has also increase the availability of cheap money (credits) that drives investors to speculate again, this time the assets may be different than MBS, although MBS still has considerable risk. In July 2016 the median house price is $294.600, well above its high of $262.600 in March 2007, just before the financial crisis happened. Securitization of student loan in US also possessed a significant systemic risk with $1.3 Trillion in size, not to mention other Asset Backed Securities (ABS) such as credit card debt and auto loan. The third effect that potentially contributes to the next financial crisis is irrational exuberance in the market and countries, as what happened to Portugal, Ireland, Greece and Spain (PIGS). The government spending of PIGS are too high relative to the GDP, even though in Maastricht Treaty the European Union put a cap on the debt-to-GDP to 60%, accounting tricks cover it up so that they qualify to join EU. These countries are reluctant to cut its spending until they are forced to do so, since joining EU means they can’t print money as they would like to, triggering a confidence crisis that they would default on their sovereign bonds, leading to the recent European crisis.
Securitization of Student Loan
The amount of people having student loan in United States is currently about forty three million, with dollar amount of $ 1.3 Trillion. Student loan was meant as a way for American citizen to borrow money for college and repaying the balance from monthly salary within 10 years after graduating. University tuition fee has been rising faster than inflation for the last decades and the number of American that could pay for it is decreasing. There is little problem with 18-year olds borrowing $25.000 for their college, since most of them are able to pay afterwards with significantly higher salary than high school graduates. The problem lies in people borrowing money and not completing the college they enrolled to, these people tend to be older and come from disadvantaged, middle-income families. With the debt amount increasing with interest every year, it gets harder for them to repay the balance.
Today it took on average 13.4 years for graduates to repay their loan, an 80% increase compared to 7.4 years in 1992. Loan delinquency has also doubled to 12% in 2014 from 6% in 2003. Meanwhile default rates for 2005, 2007, and 2009 school-leaving cohorts have reached 25%. According to New York Federal Reserve data, only 29% of graduates-borrower are repaying with decreasing balance, meaning that 71% are having difficulty in paying. 34% are paying the loan but their balance is increasing, 20% are repaying with history of problems and 17% are in default. Perhaps this was also caused by the slow increase in wages and salary in the US and the rest of the world. On the bright side, only two third of college student takes student loan to complete their four-year degree, and one fourth of those who take the loan graduate with less than $20.000 balance.
Let us take a look of the case from the perspective of why securitization of student loan could trigger a systemic crisis, using three points mentioned before, search for higher yield, credit availability, and irrational exuberance. Banks are repackaging bundles of student loans; in the same way they securitize MBS and other ABS, dividing them into tranches and sell them to investors. High-rated tranche could yield up to 1.75% – 2.25% higher compared to the current 10-yr US Treasury bonds yielding 1.7%. As long as there are investors willing to buy the asset, banks are going to continue securitize student loan and the loan requirement itself may gets easier so that there are more assets available to be securitized. This leads to a bubble similar to the 2008 GFC, the difference is that the crisis may be triggered by student loan instead of mortgage, but I’m confident that default in one sector would spread into another sector including mortgage as well.
The issue also lies in the borrower that may not actually eligible to ask for loan, but was accepted anyway, analogous to the sub-prime mortgage of MBS. These sub-prime borrower are going to college because they can, but not necessarily graduate and work later on to repay their loan. If current condition is sustained, higher default rates will eventually drive the price of ABS to go down and may trigger a panic as MBS did in 2008.
Eurozone and Sovereign Debt Crisis
While economic condition has been recovering especially in United States, other regions such as Europe and Japan have been experiencing a very slow recovery. Due to the contagion effect of the sub-prime mortgage crisis in US, a crisis of confidence also emerged in the other part of the world, Iceland, whose external debt at 2007 was seven times it’s GDP, was the first having difficulties in refinancing their short-term debt. Eventually three of the biggest banks in Iceland were liquidated and foreign depositors money were lost. The crisis then spread to the European countries with high percentage of debt-to-GDP, such as Greece, Ireland, and Portugal. In 2009, Greece government revealed that the previous government had been misreporting its budget data, causing bond spreads to rise dramatically and credit rating agencies downgraded the sovereign bonds to junk, which worsen the financial condition of the whole Eurozone. As a result, investors demand higher interest rates from Eurozone states with high level of debt and budget deficit, making it harder for these countries to finance their deficits. Even though the European Central Bank, IMF, and other financial institution have been negotiating with these countries to take strict measures in reducing government spending and raising taxes, until today the problems are still acute.
European countries are currently vulnerable to another confidence crisis if a financial crisis occurs in other parts of the world, banks would having difficulty in refinancing their debt and liquidity would vanish as in 2008, forcing ECB to do more quantitative easing and lowering the interest rate further in the negative territory. Figure 1.1 shows that at the end of 2015, seven countries in EU were having debt-to-GDP above 90%, in order for the these countries to pay their debts, ECB have to print significantly more Euro and decreasing its value in the long-run, which may further questioned the sustainability of common currencies. It would took a very long time for the European Union to restore the countries to a healthy state, due to the growth slowdown in the world and lack of confidence in the sustainability of European Monetary Union, as recently United Kingdom showed by voting to leave the EU.
Combined with high level of debt-to-GDP, Greece, Spain, Portugal, and France are also having a budget deficit above the 3% benchmark. Figure 1.2 shows the budget balance of European countries in December 2015, with Germany the only country running a surplus. In order to decrease the budget deficit below the benchmark, governments have to cut its spending in unproductive sector such as pension liability and raise taxes, an unpopular action for any politician. Greece deficit is alarming, doubling in one year to an unsustainable level; meanwhile other countries are taking measures to balance their budget.
Figure 1.3 shows the unemployment rates of European countries, Greece and Spain are doomed to deep recession and chaos if financial institution stopped lending money to the government, layoff in private and public sector would increase and these countries could possibly end up like countries in Latin America. Currently, the prospect of Eurozone is bleak, ECB is pumping money to the system by QE, and negative interest rates have an unknown effect in the long-run, and may actually lead to collapse of banks due to squeeze in profit. The bubble will burst, but one couldn’t predict whether it would be the first one that burst, or simply burst from contagion effect elsewhere.
Danger of Derivatives Product and Bank Capitalization
Eight years after the collapse of Lehman Brother in September 2008, banks are still having an enormous amount of derivatives contract outstanding. According to Bank for International Settlements, in the peak of derivatives contract at 2012, the amount of derivatives outstanding in the world is $700 trillion, for comparison, the world GPD was $75.59 trillion at the time, according to the World Bank. Today, they are worth more than $500 trillion, a decrease compared to the peak but still a considerable amount nonetheless. But that was not a risky figure when we take into account the fact that most derivatives contracts are netted and cancel each other.
The biggest derivatives holder currently is JPMorgan; in 2015 annual report it is shown that JPMorgan has exposure worth $50.6 trillion, with net exposure of $6.9 billion. The second largest in 2015 was Deutsche Bank, with exposure of $46.8 trillion, but higher net exposure of $18.2 billion. The rating of Deutsche Bank has been downgraded along with the 45% decrease of its stock price year-to-date. As a comparison of how things have changed for big banks before 2008 GFC, Deutsche Bank stock was traded at $145 at the peak of April 2007, bottoming at $24.48 in February 2009, then rebounded to $60 level in 2010-2011, before slipping to $13 as of now. The slide of Deutsche Bank stock price is exacerbated by US Department of Justice claim of $14 billion as settlement to a probe related to MBS issuance and underwriting from 2005-2007. Other banks under similar investigation include UBS, Credit Suisse, RBS, and Barclays. Figure 1.4 shows the amount of settlement of banks tied to MBS investigation.
The exact mechanism of how the issue will blow up the financial system is still vague, but further loss in MBS and other ABS combined with huge fine may leave the firms undercapitalized. Liquidity in the MBS market may dry up and the whole market scrambling for safe heaven such as government bonds. According to SocGen’s analyst, any settlement above 5.4 billion Euros for Deutsche Bank will put the European biggest lender significantly undercapitalized. That was only counting for MBS and fine from DOJ, not to mention the bad debt involved. Banks across Europe are currently facing huge amount of bad debt, with Italy having $401 billion of bad debt, equivalent to one fourth of Italy’s GDP. There were little the government could do to capitalize these banks, since the government debt itself amount to 132% of its GDP. The collapse of one Global Systemically Important Bank will, without doubt, trigger another crisis.
Clearly European banks are facing a significant issue of insolvency should things go south further, especially in Greece, Spain, Italy, and Portugal. Governments are also faced with the burden of its debt and budget deficit while trying to stimulate growth domestically. Undercapitalization among European banks is a real challenge that needs the attention and proper involvement of ECB and the government in particular. The honeymoon period of extravagant government spending and imprudent debt issuance are over for a long time, today, troubled European countries are facing the sin of its predecessor.
Impact to Indonesian Economic
What are the possibility that could happen to Indonesian economy should another financial crisis happened? Actually the impact to financial market is going to be quite similar regardless of the caused of the crisis. We know the equation:
(S-I) = (G-T) + (X-M)
Where S represents savings, I represent investment, G represents government spending, T represents tax collection, and X-M represents net export. First, let’s take a look at Indonesian trade data with the rest of the world. Indonesian exports are mainly concentrated with Asian countries, amounting to $136 billion. European countries combined amount to $24.4 billion, the second largest export destination, meanwhile export to North America amount to $21.7 billion.
This means that Indonesia is most vulnerable to crisis or economic slowdown in Asia, and moderately impacted in terms of trade during crisis in Western countries. Indonesia has been experiencing trade surplus recently since 2015, after suffering from trade deficit during 2012-2014. More specifically, Indonesia has a trade surplus with United States, leaving the country most vulnerable to demand shift in US. If the world economic is slowing while Indonesian economy expand at moderate pace, Indonesia has the risk of trade deficit, since import for domestic use would be higher than export to rest of the world.
The (G-T) equation is going to be less affected during crisis from western countries, since government spending and tax collection depend on Indonesian fiscal policy rather than external factors. However, tax collection may decrease due to decrease in tax of imported goods. Indonesian government is currently running 2.53% budget deficit, slightly below the 3% ceiling. Should GDP falls further during the crisis period, budget deficit as percentage of GDP could surge above 3% and government will have to reduce spending, spiraling the GDP further down.
From (S-I) equation, savings would decrease during crisis as people are fired from their job. The decrease in savings would decrease the investment inside the country as well as slowing down the economy further.
In the 2008 GFC, IHSG dropped by 54%, from its 2688 high in November 2007 to 1241 low in November 2008. Meanwhile, during Asian crisis in 1998, IHSG dropped 62% from its high of 721 to 276 in September 1998. It highlighted the greater impact of Asian crisis compared to the GFC in 2008. It is likely that the next possible crisis that erupt from western countries would trigger an outflow of money from equity to safe haven instrument such as gold, yen, and swiss franc. And correction in equity market would happen as usual, but perhaps it would look more like 2008 rather than 1998.