Foday Drammeh

By Foday Drammeh

England, United Kingdom

Introduction

Whether personal, organisational (business) or national level, Innovation plays an important part in all areas of life. It is one of the key elements that bring about success. Its contribution cannot be under estimated in a modern society. As globalization intensifies through improved technology, communication and competition, traditional approaches on their own have become inadequate in satisfying customer needs. New and contemporary methods are needed to be combined using strategic methods in order to surpass expectations and to get the desired results. With increasing market sizes as a result of increasing demand, innovation has become a fundamental issue to meet the challenges of customer dynamics. What then is financial Innovation?

Simplistically, it means continuous improvement; it can also be referred to as new ways or methods of doing things within the financial industry to improve cost efficiency. Furthermore, it can be said to be new financial instruments, products or services introduced as a result of technological change to reduce cost and as well minimise risks (E D Solans, 2003). Some authors have linked it to a marketing strategy applied to attract customers to particular brand of product. They may not necessarily be a newer product as such but because they are either re-designed or restructured to attract attention. Similarly, it may also be a newer product with additional features in line with technology or security that are more cost effective.

One of the sectors that have been greatly affected by innovation is the finance and banking. A number of products have emerged in the last decade or so. Among them includes: - Mortgage-Backed securities, Collateral Debt obligation (CBO), Credit Default Swaps and Securitization. Their effects have been the focal points of discussions in national televisions, radio stations, parliamentary meetings, board meetings to mention but a few.

This paper explore how financial innovation, have worsened the sub-prime crisis in the United States.  Chronologically, part one explains some financial products and how they operate, part two highlights the US sub-prime crisis and how it unfolds, part three states the role of financial innovation and its effects and part four gives some recommendations and conclusion.

PART ONE

Types of financial products

A wide range of financial products/services have been offered to customers from the mid 1990’s to date and some of these are outlined below.

1.Mortgage-Backed Securities

These are financial instruments issued by public corporations with fixed rate of interest over a specific period of time. They consist of a pool of mortgages purchased from mortgage issuing companies that are further sold to investors in chums. Investors get their returns from the monthly premiums paid by individual home owners. The advantage of this type of investment is that the creditworthiness is not based on one individual but on the entire group of home owners an as long as interest rates is low and home owners are able to afford their repayments, it is saved. It also allows borrowers to re-mortgage their properties for larger loans.  However, where interest rates starts rising and home owners started to default, the problem can be severe.

2.Credit Default swaps

These are policies that individual investors or companies buy to safeguard their investments/corporations against liabilities of some forms of risks that might happen. It is like an insurance policy and in most cases, it is used to protect against defaults from bonds issued by corporations. Credit default swaps operate by investors selling their risks to one another. The seller makes periodic payments to the buyer who in turns agree to pay a specific amount to the seller should there be a default in payment from the original bond issuer

4.Collateralized Debt Obligation (CBO)

These are similar to mortgage-backed securities but unlike mortgage-backed securitises, Collateralised debt obligations are made up from a combination of different types of debts such as credit cards, mortgages repayments, personal loans etc. They attract higher rate of interest. This is due to the amount of risk involved. CBO’s are packaged into different categories such as highly risk, moderate risk and low risk by credit rating agencies. This determines the rate of interest investors receive on each package. Example the rate of interest on an “AAA” package will be lower than a packaged rated as “AAB”. This is because the rate of default is more likely in the later than the former.

3.Securitization

This is a financial product that helps to re-distribute risk to a pool of investors and as well serves as a source of income to the issuer. It allows the primary issuer to combine his debts and sell them in smaller pieces. They may be sold at discount rates or as per value.

PART TWO

How the US sub-prime Crisis unfold and its effects

The term Prime is a borrowed word from Latin meaning first. In the English language, it means the main or number one factor; and hence sub means below, a combination of the two to form sub-prime would mean something that is below standard (Oxford dictionary.) 

From the financial point of view, sub-prime is used to refer to poorly rated customers. These are customers who have difficulty in proving their income either because of their past histories of financial difficulties, defaults in loan or credit card repayments, or may be because social/domestic problems with their families. As a result, the likelihood of such customers getting a loan to purchase a car or house is very minimal. Thus loans offered to such customer have high interest rate because of their risky nature. Below are a number of factors that have contributed to the US sub-prime crises.

Low Interest Rates:- From the geneses of 2000 recession and the aftermath of the 11^th September terrorist attack, comes the offspring of sub-prime customers. During this stage, the economy was not in good form and one of the strategies applied by government planers in the Federal Reserve to stimulate its speedy recovery was to cut down interest rates. In doing so, borrowings become easier and investors were able to obtain further capital that they re-invest for higher returns. This process kick starts the economy by creating job opportunities for millions of people who were made redundant.

Poor Lending:­- it is believed that prior to the terrorist attack in September, 2001; almost all potential customers who could afford a house of their own have got one. Which literally means that the demand for houses have started to fall. In tackling such a dilemma, mortgage lenders decided to down grade the number of credit points required to qualify for a mortgage. In so doing, a number of sub-prime customers automatically qualified and where issued mortgages after applying. With the hope that house prices are not likely to go down and where customers can no longer afford the re-payment, their assets will be re-possessed and sell. However, what exactly happened in reality was far fetch from anyone’s expectation.   

High Interest Rates:-As the economy began recovery, government regulators increase interest rates to discourage borrowings as a method of regulating the economy. This increase automatically increases the monthly repayment amount. With the fact that most mortgages were issued to sub-prime customers, most customers started to default and end up loosing their houses. However corporation could not sell most of the re-possessed homes because they were over valued at the time of issuing the loan.

Greed:- Since the primary objective of commercial banks is to make profit, the low interest rates creates a conductive atmosphere for most customers as they were able to cope with their repayments without much hassle. However, this was viewed differently by financial institutions. With the intention of profit maximisation, more and more sub-prime customers were given mortgages; while others were allowed to re-mortgage their houses not realising the effect it might cause when interest rates change. It can be said therefore that Investors and bankers had compromise profitability in the short term to the long term effects on financial institutions.

Effects

The collapse of the sub-prime market resulted in the following.

Unemployment: - Many small organisations such as insurance companies, investments banks, pension’s funds and commercial banks lost a grater percentage of their investments and therefore run into liquidity problems. With no other source of finance, they had to apply alternative measures such as redundancy and insolvency.

Collapse in Inter-bank market: - The inter-bank market used to be a reliable source of income for financial institutions. Soft loans are being issued to without the need of securities. However the crisis changed that dimension as no organisation was prepared to take further risks.

Lost of Trust and Confidence: - Prior to the 2007/8 credit crises that nearly brought the world economics onto its knees, it could be argued that financial institutions were “the most trusted institutions” among all; customers have the confidence of leaving their life savings with these institutions without being worried of major upsets. However, this is not the case any more. Families’ had their dreams shattered and pension schemes completely wiped off. Consumers no longer have trust in these institutions as such investments are at their lowest. It was until government intervention was made by the bail out plan that recovery began but yet still, individual investment is low.

PART THREE

The need for Financial Innovation and how it worsened the sub-prime crisis

Over the last decade, there has been a massive increase in the use of financial products/services which are as a result of innovation; and as such, one may tend to ask why the need for such an increase within a short duration? A number of factors have contributed to the massive inflow of financial products among them includes the following: - regulation, competition, technology and risk management.

Regulation: - is among the principal causes of financial innovation. It is true to say that the purpose of any regulation is to safeguard the interest of the public (business participants) within every sector. As one of the functions of central banks is to regulate the monetary policy and control the inflation rate. In the same way, bankers, mortgage lenders and other financial institutions are trying to be innovative to come up with new ideas of how to find loop holes with the law in order to maximise profit. This has resulted in the creation of a number of financial products to surpass the law thereby maintaining profitability. A typical example is the Basel one and Basel two accord, which recommend banks to keep a certain percentage of their capital as security to the amounts of loans given out.  As Basel one was created, commercial banks became more innovative thus rendering Basel one incomplete. This leads to the creation of the Basel two accords.

Technological Improvements: - have also contributed in financial innovation. With the invention of sophisticated computer programmes, tonnes of data can be collected, processed analysed and stored within a short duration. This has made it easier for financial institutions and credit rating agencies to assess risks associated with particular customers/investments and to make decisions in minutes. This has improved the cost efficiency of the business. Similarly, it has made it easier to transfer large amount of date without the need of carrying files. Technology has removed geographical boundaries in the business world thus making open the doors of competition.

Competition: - As a result of technological advancement, competitions have become a daily issue in all sectors, thereby making innovation a practical issue of our daily lives. Financial products and services can now be purchased in almost all major supermarkets in the United States and Europe. Thus the invention of some new products to satisfy customer needs.

Risk Management:-Since the business nature of financial institutions has something to do with managing risks in order to make profit, banks, insurance and mortgage companies have come up with new products that will lower the burden of risk on them by passing it on to third parties. This has also contributed to the amount of financial instruments being created in the last few years.

Credit Building/Repairing:-The creation of sub-prime customers can also be viewed as a method of increasing the customer base of financial institution by giving a second chance to those customers who cannot prove their credit worthiness and those without credit history was a clear testimony of innovation. However, since the risk associated with these customers is high, it is been compensated by charging high interest rates. What it failed to consider was what to do in situations where majority of the customers default payment.

How the crises got worsened

Even though financial innovation is not the only cause of the sub-prime crisis, it could be regarded as the catalyst to the crisis. It has lead to the creation of some new financial products (securitization methods) geared to minimise risks and as well optimise profitability. As it unfolds, it was not clear as to the extent of the damage and for how long the crisis is going to last because its effects have surpass expectations of all professional forecast and predications. The following are some of the ways in which financial innovation worsened the sub-prime crisis in the US:

Financial products such as the Collateral debt Obligation (CDO), Mortgage Backed Securities, Credit defaults swaps and securitization techniques have created new dimensions in the way sub-prime customers are being viewed in the US. Bankers believe that with these techniques, risks are well managed and financial institutions are well secured. But since these products have improve the profit margin of the institution that makes use of them, they became much popular and were widely accepted in all areas of life, sub-prime customers therefore became the target customers for profit maximising. 

In addition, since the above mentioned products were created on sub-prime customers, their creation had opened the US financial market to some volatility. As such, when customers began defaulting on their loans, every sector of the economy was affected even though sub-prime customers only form part of the crisis but since financial institutions are somehow interlinked that is to say they deal in the same market, with the same or similar customers with one motive, insecurity or market reaction will make a reaction of chain to other sectors.

To compound matters, the crisis was worsened when most of the credit rating agencies down graded the rate of some financial companies such as Moody (MDC), and Standards and Poor and Fetch, as of the same case in the recent crisis in Greece. Many believe that these agencies have indeed misled consumers by overstating their rating of financial institution.

Since the collapse of these instruments have led to financial instabilities within the economy, which is directly linked on how the money market will react, it has indirectly caused the fall in share prices of companies listed in the stock market. This is one of the main reasons why, the UK is greatly concern of how long it might take for the politicians to come to terms in forming a new government. Since a delay might affect markets shares. Similarly, recent times have witness a fall in BP share prices because of the spillage in US.

PART FOUR

Recommendations

The free market economy believed that there should be less government intervention in regulating the economy as the price mechanisms do regulate themselves from the forces of demand and supply. However, it can be said that there are cases when government intervention is necessary as the above statement does not represent the whole truth. To safeguard the interest of the population, government intervention is necessary in order to minimise and as well protect citizens from greedy investors. Therefore, to avoid another credit crisis, the following changes needs to be put in place.

• The roles of central banks have become too demanding in regulating the economy and as well acting as supervisory body. To minimise the burden, a separate entity should be charged with the responsibility of monitoring the activities of commercial banks and other financial institutions.
• There should be new and tough regulation on the operation of financial institutions (increase in licence fee and as well on the amount to be deposited in the central bank as reserve.
• Where a bail out will be required, government should be able to choose which of the investments/ contracts to honour and disregard. And as well payment of bonuses should be authorised by authorities such as the financial service authority (FSA) in UK.  
• The sizes of banks should also be looked at since it is one of the biggest issues that are making them difficult to fail. Measures should be put in place that will limit their size and this may be operating as separate entities under one umbrella.

Conclusion

Although a number of factors have contributed to the United States sub-prime crisis, financial innovation served as the defining force behind the meltdown; as it paved the way for the creation of newer financial product/services geared towards profit maximising without adequate measures as to what needs to be done should there be a problem. As a result, the collapse of these instruments leads to a complete fiasco in the industry because of their inter link.  It has been said that “when America sneezes, the rest of the world catches cold” this is certainly true as the 2008-2009 credit-crunch was a clear testimony.

Moreover, since regulation and innovation are positively correlated as one leads to the other; it is as well difficult to draw a line of distinction between the two. As technology continue to improve, banks will always come up with new ideas/methods of maximising profits as the industry is filled up with intellectuals who are highly paid with “fat” allowances. To match the aforementioned challenges, governments would have to match the standards of the industry with similar incentives that will attract competent and highly experienced people who can deal with the continuous dynamics of the industry.