From UPSC perspective, the following things are important :
Prelims level : CDS, CDO, ABS, MBS
Mains level : Paper 3- Difference between 2008 financial crisis and financial crisis caused due to Covid-19.
Not all financial crises are the same. And this is more so about the two crises that we have been witness to – the 2008 Global Financial Crisis (GFC) and the current Corona Financial Crisis (CFC). The author points out the four key difference in the two crises. These four difference also mean that the solution for 2008 GFC may not be the solution for the present CFC. But why is it so? Read to know more…
1. Origin of the two crises
- The GFC originated in the financial sector.
- In GFC, banks and financial intermediaries got carried away by irrational exuberance and recklessly piled on risk.
- CDS, CDO, MBS, ABS and various other became the villains in the GFC drama as it unfolded in the rich countries.
- As people lost their wealth and savings in the financial meltdown, demand collapsed and growth slumped.
- The contagion, which originated in the financial sector, spread to the real economy.
- In contrast, the CFC came from outside the economic system.
- The first impact came by way of a supply shock as China-centred supply chains broke down.
- And then as countries ordered lockdowns and economies shut down, demand slumped.
- The ensuing distress in the real economy led to distress in the financial system.
So, how origin of the crisis matter for its resolution?
- Restoring the faith in the financial system was key to the resolution of GFC.
- Which meant rescue and rehabilitation of banks and other financial institutions.
- Once that task in the financial sector was accomplished, repair of the real economy fell in place.
- The demand came back, supply resumed and growth picked up.
- In contrast, the central challenge in the resolution of the CFC is to beat the pandemic, and that solution has to come from science.
- Only when there is public confidence that the incidence of the pandemic has been brought down to a low-level equilibrium, will there be a resolution in both the real and financial economies.
- We are seeing that even during this crisis, just like in 2008, governments are coming out with fiscal stimulus packages and central banks with monetary stimulus packages.
- But these are not solutions to the pandemic; they are just holding operations till the central problem is resolved.
2. No one country hold key to solution
- The second difference between the two crises arises from the asymmetry of the solutions.
- The GFC originated in the subprime mortgage sector of the US and then, rapidly engulfed the world.
- The CFC originated in the Hubei province of China and rapidly engulfed the world.
- But the similarity ends there.
- For the resolution of the GFC, restoring financial stability in the US was necessary, and a sufficient condition for restoration of financial stability everywhere.
- But the situation with the CFC is different.
- Every country needs to control the pandemic within its borders.
- But that is not sufficient because the virus can hit back from across the border.
- No country is safe until every country is safe.
3. Policy interventions involve a dilemma
- How the policy interventions interact with one another makes for the third difference between the two crises.
- During the resolution of the GFC, solutions in the financial sector and in the real economy reinforced each other.
- For example, to mitigate the crisis, the RBI cut rates and intervened in the forex market, the government extended special concessions for housing and real estate sectors to provide stimulus in the real economy.
- There was synergy in these actions.
- In contrast, in managing the challenge of the CFC, what we are seeing is tension between the various sets of policy actions.
- The effort to contain the pandemic is exacerbating the challenges in both the real economy and the financial sector.
- The more stringent the lockdown to save lives, the more extensive the loss of livelihoods.
- Managing this tension is by far the biggest dilemma for governments battling the crisis.
4. No single large economy to keep the world afloat
- The global financial crisis, although it was called “global” did not affect all countries equally.
- China was less affected even as all rich countries were in a financial meltdown.
- In fact, one of the less acknowledged facts of the 2008 crisis is that it was the stimulus provided by China that kept the global economy afloat.
- In contrast, now all rich and big economies are weighed down by the virus, and there is not a single large economy to keep the rest of the world afloat.
Consider the question “Analyse the key differences in the Global Financial Crisis of 2008 and the financial crisis caused by the Covid-19.”
If pandemics are going to be more frequent, as is now suspected, it is all the more important that there is a more enforceable global protocol on early warning and information sharing. For all their differences, the GFC and CFC are similar in one respect — they both teach us life-enhancing lessons. The GFC forcefully reminded us that greed and avarice will only bring tears in the end. The CFC is teaching us that the force of nature is bigger than the combined force of our science and technology.
Back2Basics: Credit Default Swap (CDS)
- A credit default swap (CDS) is a type of credit derivative that provides the buyer with protection against default and other risks.
- The buyer of a CDS makes periodic payments to the seller until the credit maturity date.
- In the agreement, the seller commits that, if the debt issuer defaults, the seller will pay the buyer all premiums and interest that would’ve been paid up to the date of maturity.
Collateralised Debt Obligations (CDO), MBS and ABS
- To create a CDO, investment banks gather cash flow-generating assets—such as mortgages, bonds, and other types of debt.
- These assets are then repackaged into discrete classes or tranches based on the level of credit risk assumed by the investor.
- These tranches of securities become the final investment products: bonds, whose names can reflect their specific underlying assets.
- For example, mortgage-backed securities (MBS) are comprised of mortgage loans.
- And asset-backed securities (ABS) contain corporate debt, auto loans, or credit card debt.
- CDOs are called “collateralized” because the promised repayments of the underlying assets are the collateral that gives the CDOs their value.
- Mortgage-backed securities played a central role in the financial crisis that began in 2007 and went on to wipe out trillions of dollars in wealth, bring down Lehman Brothers, and roil the world financial markets.
- In retrospect, it seems inevitable that the rapid increase in home prices and the growing demand for MBS would encourage banks to lower their lending standards and drive consumers to jump into the market at any cost.