Samuel A Van Vactor Ph D Plenary Presentation for

							                            The 2008 Global Financial Crisis
                                 Samuel A. Van Vactor, Ph.D.
                                   Plenary Presentation for the
                         International Association for Energy Economics
                                        Perth, Australia
                                       November 6, 2008

The four shockwaves of the financial crisis

The global financial crisis has seen three waves of what might ultimately be a four-
wave economic tsunami. The first wave concerned the U.S. sub-prime mortgage
market and the housing bubble. The accumulation of bad debt undermined a
number of key banks, putting them and their customers at risk. In the second wave,
the demise of Lehman Brothers and anxiety over the creditworthiness of many banks
and insurance companies led to a worldwide nationalization and bailout of the
financial industry. In the third wave, cash hoarding, frozen loans, and stock market
panic led to massive realignment of expectations that dooms the developed world to
a serious recession. In the final wave, if it happens, the contagion could spread to
emerging markets, which in the last decade have been the primary engine of global
economic growth.

The first wave – U.S. sub-prime mortgages

In the first phase of the crisis it was discovered that many mortgages written during
the housing boom were headed for default and that the mortgages themselves had
been repackaged and resold across the globe as if they were secure assets. In total,
these liabilities, once thought to be assets, totaled around $300 billion. All of this was
exaggerated by the fact that most of the repackaged mortgages lacked transparency.
The “toxic” assets could not be easily valued and thus resold at any price. Moreover,
the weak U.S. economy also put commercial loans, credit cards, and other mortgages
at risk. To offset the macro-economic impact, Congress authorized a tax rebate for
U.S. consumers, and the resulting bump in cash propped up the “real” economy
through the summer of 2008.

However, the illness was bound to spread. Like unwelcome woodland ticks, more
than a few toxic mortgages were embedded in banks, which operate on a thin margin
between assets and liabilities. As housing prices declined, the toxicity of mortgages
grew and the asset base dwindled. Banks overloaded with bad debt suffered as the
relentless pressure of the market drove down their stock prices. Major financial
institutions, such as Bear Sterns and IndyMac, were forced into unappetizing mergers
or dissolution, with the federal government accepting responsibility for much of the
bad debt. The broad scale of the problem became apparent on September 7, when
the federal government was forced to seize control of federally-sponsored mortgage
companies, Fannie Mae and Freddie Mac, which hold the majority of U.S. mortgages.

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The second wave – the growing risk of systemic default

As the crisis wore on and mortgage defaults mounted, a more serious problem
emerged. It turned out that insurance companies and investment banks had sold
trillions of dollars of Credit Default Swaps (CDSs). These swaps were not limited to
the housing market or to sub-prime mortgage loans, but covered a broad set of
investments funds, bonds, and other financial instruments. Banks that had been
weakened by sub-prime mortgage holdings, such as Lehman Brothers, had also issued
CDSs. Secretary of the Treasury Henry Paulson and other U.S. officials had borne
heavy criticism over the bailout of Bear Sterns earlier in the year. They were
persuaded by the “moral hazard” argument and were determined to demonstrate that
those who take risk must bear the responsibility. Likewise, potential buyers of
Lehman Brothers, noting that JP Morgan had acquired Bear Stearns’s assets while the
U.S. government underwrote the risk, backed away from any deal without a
partnership from the U.S. Treasury. Negotiations failed and Lehman Brothers
declared bankruptcy on September 15, which tripped obligations in many CDS
contracts. Within a few hours, the U.S. Treasury was forced to bail out American
International Group (AIG) with an $85 billion loan and acquisition of equity. Almost
immediately other dominos began falling around the globe. The resulting chaos set
off a global drop in stock markets, which further weakened the asset base of many
financial institutions.

The U.S. was not the only country that enjoyed a significant increase in housing
prices; it was to a large extent a worldwide phenomenon. In particular, the fastest
growing European countries had experienced housing price surges even greater than
those in U.S. Moreover, most European banks and insurance companies had been
involved in the CDS market. Over the weekend of September 27, the credit crunch
hit Europe full force. Within a few days Belgium and the Netherlands were forced to
bail out Fortis, the U.K. nationalized Bradford & Bingley, and Iceland took control of
its third largest bank, Glitnir.

As the financial stress deepened it became apparent that a piecemeal approach was
unworkable. The problem crystallized on September 30, when the Irish government
announced that it would guarantee all deposits in its banks, amounting to €400 billion
– twice its annual GDP. Although Ireland was a small country, it had adopted the
euro as its currency. This meant that Irish banks were the safest across the whole
eurozone. It did not take central bankers in Germany and other eurozone countries
long to realize they faced the threat of bank runs if they did not follow the Irish
example. Even though the U.K.’s currency was still in pounds sterling, it faced a
similar threat. By mid-October virtually every European country had adopted some
sort of deposit guarantee or bank nationalization.



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In the meantime, the U.S. groped for a strategy to save its banks. For a combination
of ideological reasons and previous experience with the U.S. Savings and Loan Crisis
in the 1980s, U.S. officials focused on pulling out the banks’ bad loans, rather than
recapitalizing them by direct investment. The plan, however, looked too much like a
bailout of Wall Street to Congress, and the House of Representatives squashed the
idea on September 28. Finally, on October 3, the basic plan (with a lot of sweeteners
and enhanced deposit insurance) passed both houses of Congress. Ironically,
however, as the Treasury sought to implement its buyback of toxic assets it shifted
strategies and began investing directly in major banks. In fact, Treasury officials had
little choice: without a clear demonstration of government guarantees, the
international market would quickly pull cash from any institution perceived to be
under-financed.

It is difficult to put together a precise accounting of the amount of government
support that has been necessary to shore up the global financial system. The direct
infusion of cash would appear to be more than $2 trillion and implicit guarantees are
worth at least another $2 trillion, so $4 trillion is not a bad estimate. The overall cost,
however, will be much greater as the global economy suffers through what could be
the worst recession since World War II.

The third wave – recession in developed countries

Despite the central bank infusion, it was obvious that developed nations’ economies
were in for a hard time. The IMF had pegged global economic growth at 3.8% for
2009, but a new forecast in early October dropped it to 3.0%. Within a few days,
however, pessimism deepened: Deutsche Bank, for example, dropped its 2009 global
GDP forecast to 1.2%, signaling the third wave of growing concern over the health
of the real economy. In response to the new pessimism, stock and commodity
markets plunged, as traders folded in the lowered expectations. The massive infusion
of cash may have short-circuited bank runs, but the banks have remained extremely
conservative in their lending.

The depth and length of the developed countries’ recession is unclear, but early
indicators are decidedly negative. There are also features of this recession that are
significantly different from anything experienced since the Great Depression. Most
importantly, there is already a massive asset deflation, in real property, stocks, and
commodities. This is in sharp contrast to the oil price shocks of the 1970s. In that
era stock prices dropped, but commodities and real estate values increased along with
general price inflation. Most economists would agree that aggregate consumption is
dependent on both income and perceived wealth. In this regard, consumers’
perceived wealth has just taken a substantial hit and it may take years to fully recover.
The asset deflation is exacerbated by the fact that there is huge debt outstanding
against these assets. Many homeowners are “underwater,” owing more than the
value of their home. Government treasuries are also depleted. Hopefully much of

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the cash infusion will be recovered as banks regain solvency, but some will be
permanently lost. This means that taxpayers will have to support a deadweight loss
for years to come. It is important to recall John Maynard Keynes’s critique of
German reparations following World War I. The excessive debt levied on Germany
caused extraordinary social, economic, and political upheavals. The relative cost here
is not that great, but the principle remains. Economic recovery will be burdened by
excessive debt, which reduces flexibility for both governments and consumers.

The possible fourth wave – a severe global recession

If there is a fourth wave it will concern emerging economies. China still expects
economic growth on the order of 8% in 2009 and its leaders have announced
infrastructure investments intended to support it. However, legitimate questions can
be raised about the viability of such plans when economies around the world are
faltering. After all, China has prospered by selling manufactured goods to consumers
in developed economies. China’s infrastructure investments had worked during the
Asian financial crisis, but then the problem was limited to one continent; now the
problem is global.

The swift rise in commodity prices, particularly crude oil, is partially responsible for
the meltdown. It was learned in the oil price shocks of the 1970s that the sudden
shift in cash from consumers to energy producers jolts the economy and provokes a
combination of inflation and recession. Oil is not as important to the overall energy
market now as it was in the 1970s, but it is still significant, particularly for the U.S. In
1974 the U.S. produced more oil than it imported, so much of the money associated
with higher prices recirculated. The situation is reversed today and most of the
money spent on oil flows out of the country – in inflation-adjusted terms the shock
of higher oil prices in 2007 and 2008 was about four times higher than it was in 1974,
when calculated in this way. As in the 1970s, rapid oil price increases meant a steady
buildup of cash reserves in oil-producing nations, particularly in the Persian Gulf.
Recently these reserves have been converted into investment vehicles in the form of
sovereign wealth funds. Again, the rapid shift in funds had a financial impact. In
effect, it withdrew liquidity from banks in the U.S. and Europe, making it difficult for
them to recapitalize.

The drop in demand for manufactured goods and commodities will reverse the
financial trends of the last few years. The countries with huge pots of cash now may
find the funds rapidly depleted over the coming months, in which case they too may
become vulnerable to the global contagion.

Perspective on derivatives

The question might be asked, how can a $300 billion set of liabilities end up causing a
global recession and requiring public funding and backup of $4 trillion? The answer,

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of course, is that derivatives can be used as leverage, and leverage magnifies either
profit or loss. The perfect tool for enhancing profits in a rising market can turn
swiftly around. Nonetheless, just as hedge funds are never supposed to take a loss,
derivatives are supposed to reduce risk. That they do, but for just one side of the
deal. By definition, if risk is removed from one party it is shifted to another. If the
parties that have accepted the risk are not prepared to back up their gamble when
markets turn, defaults can spread like falling dominoes. In this case, companies like
AIG, Lehman, Fortis, and others were far too leveraged to provide adequate capital
in the event of a systemic collapse of confidence.

According to the New York Times, the derivative market totals $531 trillion, just
about ten times global GDP. The market for CDSs has been about $55 trillion.
These figures are, of course, gross values; almost all these obligations have offsetting
counterparts – every loss creates a gain, etc. As long as the key players remain
solvent, the use of derivatives will have little or no impact on the real economy.
However, when volatility increases, market values change quickly, and in unexpected
ways, and these changes can be easily magnified if derivatives are not carefully
managed. The essence of finance is trust – to make a loan in the expectation of
repayment. Trust in turn depends on confidence in the institutions and traders in the
marketplace. Derivatives that are not transparent or inadequately backed by assets
have the power to undermine confidence and trust.

What Wall Street should have learned from Enron’s collapse

There were some important lessons to be drawn from Enron’s collapse that appear to
have been lost in the din of good times. First, Enron misused derivatives and
engaged in other manipulations to move suspect assets from its balance sheet and
cover up losses. It completed these transactions through a series of complex
maneuvers, the purpose of which was to obfuscate, rather than illuminate, their true
liabilities. It seems that the lesson to be drawn from Enron did not stick. No one on
Wall Street, including the bond rating agencies, questioned the veracity of the sub-
prime mortgage bonds, despite the complexity of the packaging, their opaque nature
and the flimsiness of their credit credentials.

Second is the interrelationship between derivatives, mark-to-market accounting, and
managerial bonuses. Most derivatives are traded in the over-the-counter (OTC)
market, but the concepts that underlie them are extracted from futures exchanges. In
a futures exchange, traders’ positions are marked to market at the close of each
trading day. Since buyers and sellers are allowed to purchase contracts on a margin, it
is essential to track their gains and losses. If a trader’s position erodes, then the
exchange, which is the counter-party, will either collect more margin or liquidate the
contract. There is no other way to treat a liquid and marketable asset; book value or
the price paid is irrelevant. Anyone who invests in a financial instrument that goes up
in value receives a “bonus.” The instrument does not have to be sold for the bonus

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to be recognized, because in a liquid market it can be sold in a few minutes time.
Problems arise, however, when the asset cannot be easily sold and its value has to be
estimated.

Enron frequently tied bonuses to the present value of future profits from freshly
negotiated deals. They even claimed a portion of the present value as a current profit
in their balance sheet. This is akin to mark-to-market accounting, except that the
contractual commitment is unlikely to be resold, thus valuation is subjective. This
incentive structure created two distortions. The company’s managers focused on
short-term deal-making rather than that long-term planning. Moreover, the booking
of theoretical profits was at variance with actual cash flow, so Enron had to borrow
money to make ends meet. And, of course, if anything went wrong with the
estimated flow of future profits, new deals would have to be made, more future
profits booked, and more money borrowed.

One of the most troubling aspects of the financial crisis is the way in which Wall
Street financial firms followed the Enron paradigm and ignored its consequences.
Large bonuses were paid out even if the firm retained the asset or a residual liability
associated with it. Most financial firms deal in paper and have limited physical assets.
The basis for their profitability is having clever people who need to be compensated
if they are to be retained. So, as all the bad paper rolled in, bonuses rolled out.
Banks simply did not keep the profits garnered in the mortgage writing frenzy, and
when the paper and other questionable assets turned toxic, liabilities grew,
necessitating a public-sector bailout. Once again, the banking sector proved “too big
to fail.”

Enron’s collapse also failed to raise a red flag about the danger of interdependence
associated with derivatives trading. Enron has been much maligned since its fall from
grace and it is seldom noted that its traders behaved very responsibly in unwinding
billions of dollars of energy contracts. The crown jewel of the Enron operation was
EnronOnline (EOL). This was a one-to-one electronic exchange. Unlike NYMEX,
which acts solely as an intermediary and never takes a position, Enron would agree to
almost any outright sale or purchase. EOL was hugely successful and at its peak was
thought to cover almost two-thirds of the over-the-counter (OTC) market for
financial and physical energy contracts in North America and Europe. As the risk of
an Enron bankruptcy filing grew, there was fear that it would provoke a financial
crisis as the various contracts fell apart in chaos. The crisis did not happen for
several reasons. First, the company’s traders made a diligent effort to sensibly
unwind the contracts. In addition, energy markets were experiencing reasonable
stability. The California crisis had ended a year earlier and energy prices were
moderate and not too volatile. Importantly, Enron was not intertwined with the
banking system. Thus, the unwinding of positions did not adversely impact banks’
balance sheets. Ironically, as Enron withdrew, much of the gap in the energy


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marketplace was filled by investment banks offering financial derivatives to
complement physical trading.

There has been no such luck associated with this financial crisis. When a rogue
trader at Société Générale lost $7 billion in derivatives trading, the bank was forced to
liquidate positions, beginning in Asian markets on a Monday in January 2008. The
result was substantial stock market turmoil – a precursor of what was to follow in
October 2008.

There is no question that the global system of derivatives trading needs to be
overhauled. Even its leading advocate, Alan Greenspan, acknowledges the problem.
The primary problem with OTC derivatives is not the trade or the objective of
placing risk on entities best suited to handle it, it is that the deals are usually not
cleared by a third party. Part of the reason is the cost. After negotiating a bilateral
contract, parties to an agreement could place the contract with a clearinghouse that
would provide a daily mark-to-market, monitor credit, and settle outstanding
balances. If, however, both parties have a good reputation and credit history, it is
cheaper to trust each other and settle up directly after the contract is executed. It is
unclear how this problem might be solved. Broad-stroke regulatory policies that
require third party clearing are likely to backfire because it will drive the activity
offshore where there is even less transparency and control. On the other hand, large
banks and key financial institutions should not be trading in risky assets unscrutinized
by a third party.

The consequence of financial crisis on the energy industry

Policy makers, traders, and investors are all trying to sort out the depth and duration
of the coming recession, but the impact on the energy industry is immediately
obvious. Since their peak in July 2008, oil prices have dropped by more than half.
There is a simple reason for the price decline: economic growth is now expected to
be a lot lower. With lower economic activity comes less demand for oil, and although
the difference is not great, it is sufficient to completely reverse market direction.

Although the drop in oil prices provides consumers a well-deserved break, it raises a
pointed question. Is the relief short- or long-term? The primary reason why
economic growth has stalled is that investment funds, particularly for risky industries,
have dried up. A lot of energy development projects are not dependent on short-
term financing. They are either funded by company cash flow or the project is a
multi-year endeavor and funds have already been committed. This is not, however,
universally the case. Natural gas development in North America, for example, has a
much quicker turnover; constant drilling is required to maintain production. One of
the reasons for the oil price drop has been the remarkable success of natural gas
developments in the U.S. – production increased by about 8% in 2008. If economic


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growth resumes and alternative fuels do not get developed, then oil prices could
easily resume their upward march.

One feature of oil market developments in the last few years is the speed at which
things can change. After the 1970s price run-ups, seven years passed between the
peak of oil prices in 1980 and their collapse in 1987. The price drop observed from
mid-July through October took only about 70 business days. Financial markets have
also taken on a similar speed, with a consequence that is yet to be fully understood.

Creditworthiness has become a major concern for all companies that depend on the
commodity and derivative trade. It should not be surprising that the credit issue has
greatly enhanced the demand for third-party clearinghouses. If companies trade
futures or options through NYMEX in New York or ICE in London, contracts are
automatically managed and cleared by the exchange. With third-party clearing there
is little risk of default. NYMEX also offers clearinghouse services to parties entering
into bilateral OTC contracts, where they are cleared in the same manner as exchange
contracts. Each day NYMEX obtains independent pricing for the OTC contract and
marks it to market, assuring that both parties to the transactions are calculating the
value of the asset accurately and that it has a transparent value. Given the present
environment, it can be expected that third parties will clear many if not most OTC
energy purchase and sale contracts.

However the financial crisis is judged, it is clear that a great deal of public money has
been used to bail out private interests and it would be naïve to expect that taxpayers
and their representative governments will not seek to reform the system. A variety of
reforms have already been suggested: greater regulation of banks, an enhanced role
for the Commodity Futures Trading Commission (CFTC), a streamlining of
regulatory bodies, an international clearing house, registration of derivative contracts,
etc. Officials in some countries are even seeking to completely overhaul the
international system of foreign exchange and trade, a “Bretton Woods II.” It is
important to recognize that there is a tradeoff between economic efficiency and
stability, just as there is between risk and return. Hopefully, the coming process will
get the balance right, but however it is sorted out, it will likely result in important
changes in how energy products are developed, traded, and consumed.

Like it or not, the financial crisis will enhance the role of National Oil Companies
(NOCs) and Government Sponsored Enterprises (GSEs). The movement of oil
around the globe, like the smooth workings of the international financial system, is
crucial to economic growth and prosperity. Many important private institutions have
collapsed in the last year, so it will be argued that the new reality necessitates a much
larger role for government. Recall the view of John D. Rockefeller, an unapologetic
monopolist. Oil is too important to the industrial economy to be left in the hands of
disorganized, fractured, and myopic private hands; it needs planning and control. In
contrast, consider Raymond Mikesell’s summary of the goals of the Bretton Woods

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conference and the post-war plan to restructure the international economy: “…free
and nondiscriminatory markets for currencies, capital, and goods.” The Bretton
Woods system has bestowed over sixty years of economic growth and prosperity. In
that context, the 2008 financial crisis has been only a minor setback.




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