If you’re interested…

I was asked to submit a brief paper about the origin of the financial crisis for an economics conference that will be held by one of my universities later this month.  Not an easy task given the multi-discipline nature of the event, but one I think more people (Ukrainians and Americans) could benefit by better understanding.  With that in mind, I tried to make it as straightforward as possible while hoping I didn’t simplify too much.  (Be warned, it’s four MS Word pages long.)

How the Financial Crisis Came to Ukraine

Introduction

Because no one can say with certainty when the current global financial crisis will begin to recede and due to a shortage of peer-reviewed empirical research about its origins and effects, it is difficult to contribute anything more than additional reflection and speculation to the already numerous, often narrow discussions taking place in newspaper editorials, finance ministries, and bank boardrooms all over the world.  However, as the pressures of the crisis reverberate internationally and generate new, increasingly complex economic challenges, it becomes progressively more difficult to identify the relationship between them.  Therefore it is useful to ask:  How exactly did the collapse of the residential housing market in the United States lead to a Ukrainian economy on the verge of default?

This paper traces the relationship of these two seemingly distant events in as clear and straightforward manner as possible.  It begins by describing how efforts designed to encourage home ownership in the U.S. created an unsupportable housing “bubble.”  The second section explains how the “toxic” debt supporting this bubble was spread all over the world.  The third section recounts the collapse of the U.S. housing market and resulting world economic downturn, while the final section analyzes the effects of the crisis in Ukraine.

1. Long-term increase in housing demand and prices

The origin of the financial crisis can, by most accounts, be traced back to a long period of growth in residential home ownership in the US during the 1990s and 2000s.  The U.S. government, in an attempt to stimulate home ownership rates that had been stagnant for several decades, began to relax standards required for a person to obtain a mortgage.  A mortgage is money borrowed to buy a home on the condition that home can be taken by the bank if the loan goes unpaid.¹ Essentially, GSEs began to loan money to people that earlier would not have qualified for a mortgage because, for example, they could not pay a significant initial down payment, their income was low relative to the size of the monthly loan payment, or they had a poor history of borrowing money and paying it back (a poor credit history).² Such mortgages are called “subprime” because they are extended to borrowers who lack one or more of the requirements of the ideal borrower, and thus entail more risk.

These efforts were quite successful in increasing the number of people that owned their own home, and, due to competitive pressures and social campaigns, private banks began emulating the GSEs and extending more and more subprime loans.  The resulting growth in the number of people buying homes significantly increased demand, which, in turn, increased prices.  This cycle of ever increasing demand and prices lasted from the mid-1990s until the mid-2000s, creating a perception among banks, real-estate agents, and consumers that it was acceptable for subprime borrowers to take out loans they could not afford, buy homes, and refinance on more affordable terms at a later date, after the value of their home inevitably (as was the conventional wisdom) increased.³

Increasing demand and prices for homes also brought speculation to the market.  Speculators wanted to buy homes in real-estate markets they believed would experience a rapid growth in demand (and thus prices).  If demand increased as anticipated, speculators could quickly sell homes for significantly more money than they paid for them. The ideal type of loan for home purchases in such cases was the adjustable-rate mortgage (ARM), which attracts borrowers by offering a small down payment and a low initial interest rate that later rises to match the higher market rate.  ARMs entail more risk for the borrower than more predictable fixed-rate mortgages (FRMs), because, unlike FRMs, the interest rate fluctuates with the market rate set by the federal government.  If the federal government decides to raise interest rates, ARM monthly payments can suddenly increase for the borrower.  At the time, this mattered little to speculators, as they were able to borrow an ARM at historically low interest rates, buy a home, and sell it for a healthy profit before incurring an interest rate hike.⁴

The rapid, unchecked growth of subprime lending and ARMs, especially during the early 2000s, led to unprecedented growth in home ownership and created a housing “bubble.”⁵ This means that the prices of homes were overvalued by the market.  In this case, the bubble relied on borrowers buying homes with mortgages they couldn’t afford.  As we will see, stagnation or a drop in home prices would burst the bubble to calamitous economic consequences.

2. Securitization of mortgages

A critical factor in understanding the worldwide impact of the collapse of the U.S. housing market is the securitization of mortgages.  Before the late 1980s, mortgages were mostly provided by banks with the money the obtained through savings deposits; so-called savings and loans banks.  Generally these savings and loans were made in the same geographical market, which was widely considered a disadvantage.  As Aalbers states:

The fact that the [savings and loans banks] only worked in local markets was seen as a problem:  what if the savings are available in one area, but loans are needed in another?; and what if a local housing market busts? The solution was to connect local markets and thereby to spread risk. Interest rates on loans would fall because there was now a more efficient market for the demand and supply of money and credit.⁶

After this move from local to national mortgage lenders, many began to argue that risk could be further reduced by securitizing mortgages.⁷

Securitization is the process in which a bank packages a group of financial assets such as home mortgages into an investment opportunity called a security and sells it to investors.  Investors, by purchasing the securities, take over the bank’s right to collect the interest on the mortgages.  Even though the bank loses some earnings from the interest of the mortgages it would have received if it waited until the loan was completely paid (usually after 30 years), it receives an immediate injection of cash that it can use to make further loans and generate more earnings.  Securities based on mortgages are called mortgage-backed securities (MBSs).⁸

Securitization of mortgages grew dramatically alongside the expansion of home ownership in the U.S. from the mid-1990s to the mid-2000s.⁹ Investing in MBSs was widely viewed as a low risk investment opportunity that still provided healthy earnings.  There was often little distinction between lower risk fixed rate mortgages and higher risk subprime and ARMs, and numerous types of investors bought them, including pension funds, mutual funds, insurance companies, and even foreign central banks.¹⁰ Banks increasingly turned to subprime and ARM lending, which was then packaged into securities and sold to investors all over the world.¹¹ As a result, mortgages with significantly underestimated risk were spread worldwide, often without investors even realizing they were putting their money in the U.S. housing market.

3. The housing bubble bursts

By 2006, two coinciding factors began to shake the foundation of the high risk securitized mortgages system described above.  First, federal interest rates were raised significantly between 2004 and 2006.¹² Throughout the early 2000s, especially in the wake of the September 11, 2001 terrorist attacks, the federal government kept interest rates low as an economic stimulation measure.  By 2006, the government was raising rates as part of its overall economic strategy.  These same rate hikes had the effect of making ARMs, the favorite mortgage of speculators, more expensive.  Second, a U.S. construction boom driven by the previous decade’s dramatic growth in home ownership finally began to catch up with demand.  This resulted in a surplus of homes that began to reduce, stagnate, or even decrease home prices in some markets.

This simultaneous fall in prices and rise in interest rates resulted in subprime borrowers not being able to refinance their homes as they anticipated they would be able to do and speculators getting stuck with homes financed with unaffordable (in the long-term) ARMs.  The result was an explosion of defaults and bank foreclosures on homes.

By late 2007, investors realized the risk of highly leveraged MBSs, in which numerous financial institutions such as mutual funds, pension funds, and insurance companies had invested heavily, had been seriously underestimated.  The resulting recalibration and high numbers of defaults and foreclosures resulted in banks writing off billions of dollars in assets and insurance companies being ruined.  This sudden decrease in bank capital began to radically decreased the amount of money banks were able to lend to companies and individuals (the so-called “credit crunch”), posing serious consequences for economic growth.¹³ Bank and insurance losses picked up speed through 2007 and 2008, culminating in the collapse of some of the largest financial companies in the world beginning September, 2008.  By this time, the U.S. government had decided to step in and save several large banks, but the damage was done.

Any illusions that the building crisis could be avoided had ended.  The days of easy access to credit, constantly increasing home values, and unregulated distribution of MBSs was effectively over.  This set off a substantial economic decline and dramatically decreased investor and consumer confidence worldwide.  Stock markets plummeted, investors not even aware they were investing in the U.S. housing market lost billions of dollars, and worldwide economic growth contracted sharply.

4. Influence of the crisis on Ukraine

Ukraine’s economic problems related to the financial crisis are the following:  a plunge in demand for Ukraine’s most important export goods, sharp currency devaluation, and dramatically reduced consumer and investor confidence.  Although each of these consequences are related to each other, it is difficult to conceive how these different problems could have arisen so suddenly without the collapse of the U.S. housing market and subsequent devaluation of MBSs.

First, as the international credit crunch dried up money available for loans for companies and individuals all over the world, demand for certain goods was hit especially hard.  This includes demand for industrial metals and chemicals, which comprised about 40 percent of Ukraine’s export earnings prior to the crisis.¹⁴ Plans for large scale construction projects and other capital intensive ventures were among the first to be scaled back in response to the increasingly poor economic outlook.¹⁵ Obviously, this reduced orders among Ukrainian steel and chemicals producers, which leads to decreased profits, which leads to lost jobs, which leads to less money in the domestic economy, which leads to lower government receipts, and so on.  Indeed, the fact that steel and chemicals made up such a large portion of Ukraine’s export earnings made the country particularly vulnerable to global economic instability.

Second, like its neighbors, Ukraine began to pursue a policy of currency devaluation.  This was a response designed to stimulate demand for domestic goods both within Ukraine and abroad, especially in light of the country’s declining export earnings.  In times of drastically falling exports, governments may choose to make their own currency cheaper relative to other currencies, resulting in lower prices and increased demand for domestically produced goods by foreign customers. Currency devaluation also makes foreign goods more expensive for domestic consumers, so people will prefer to buy domestic goods rather than foreign ones.¹⁶ However, there are costs to currency devaluation, as well.  Importers are particularly hard hit, as their cost of doing business is inversely related to changes in currency value.  In addition, an astonishing 50 percent of loans in Ukraine are dollar denominated.¹⁷ Any significant loss of the hryvnia against the dollar is bound to have a serious impact on the incomes and confidence of consumers, as was seen when the hryvnia lost more than 40 percent of its value from its summer high of 4.60 to the dollar.¹⁸ With exports falling and the hryvnia plummeting, Ukrainians and investors understandably began to lose confidence in the economy.  A run on already depleted banks further diminished money available for loans and economic growth, and the Ukrainian government has had to turn to the International Monetary Fund to stay solvent.¹⁹

At the time of writing, these issues remain the most serious challenges to economic stability in Ukraine.  Ukrainians are quick to blame political infighting for their economic problems, but, while such infighting certainly has an effect on consumer and investor confidence and economic recovery, the drop in export earnings and some sort of currency devaluation was almost inevitable in light of enormity of the international economic fallout related to the financial crisis.²⁰ This is supported by the similar problems experienced by virtually all of Ukraine’s neighbors, regardless of their political situation.

Conclusion

The nature of the Ukrainian economy makes it difficult to predict impending effects of the global financial crisis, let alone when things may begin to improve.  Regardless, it is clear that Ukraine, like many countries all over the world, is experiencing economic difficulties either harshly exacerbated or even shaped by the collapse of the U.S. residential housing market.  Part of any effective recovery strategy will examine the vulnerabilities exploited by the crisis, both to be sure it doesn’t happen again, as well as to anticipate future vulnerabilities of this type.

[1] Liebowitz, Stan J. (2008, October 3). “Anatomy of a Train Wreck: Causes of the Mortgages Meltdown.” Independent Policy Report, p. 4. [2] Taylor, John B. (2009, February 9). “How Government Created the Financial Crisis.” The Wall Street Journal. See also: Greenspan, Alan. (2009, March 11). “The Fed didn’t Cause the Housing Bubble.” The Wall Street Journal. [3] Supra, note 1, p. 17. [4] Driscoll, Jr., Jerald P. (2009, March 26). “Did the Fed Cause the Housing Bubble?” The Wall Street Journal. [5] Supra, note 2. [6] Aalbers, Manuel. (2009). “Geographies of the financial crisis.” Area, Vol. 41 No. 1, p. 35. [7] Shin, Hyong Song. (2009). “Securitization and Financial Stability.” The Economic Journal, 119 (March), p. 309. [8] Ibid., p. 310 [9] Blackburn, Robin. (2008). “The Subprime Crisis.” The New Left Review, 50 Mar-Apr, p. 63. [10] Supra, note 7, p. 310. [11] Supra, note 9. [12] Supra, note 2. [13] Chi, Li-Chiu. (2009). “How have banks fared during a borrower’s financial distress?” Economic Modeling, 26. [14] Sywenkij, Joseph. (2008, November 3). “As Ukraine Staggers, Its Leaders Quarrel.” The New York Times. [15] Sywenkij, Joseph. (2009, March 1). “Ukraine Teeters as Citizens Blame Banks and Government.” The New York Times. [16] Ayny. (2009, March 16). “Why do countries compete in currency devaluation?” eCommerce Journal. [17] Economist Intelligence Unit. (2008, December 1). “Currency collapse in Ukraine.” The Economist. [18] Ibid. [19] Supra, note 15. [20] Ibid.