In 1995, a 25-year old mathematics graduate of Cambridge University devised a method of insuring against loan defaults - later named credit default swaps (CDS) -- that, within a decade, became the financial derivative of choice for banking and financial institutions around the world, particularly in USA and Europe. Banks, investment houses, and insurance companies, reaped rich rewards from holding copious amounts of CDS which served as insurance cover for US mortgage-backed securities that were packaged and sold around the globe.
In addition to CDS, the world's financial markets saw the growth of exotic financial instruments such as collateralized debt obligations (CDOs), and collateralized loan obligations (CLOs), all being some form of derivatives of securitized home-mortgage loans. Warren Buffet, the world's most astute investor, described these esoteric financial instruments as nothing short of financial weapons of mass destruction (WMDs). The problem is that these instruments held sway over much of the developed world's financial sector, except Japan. The going was great as long as US homeowners continued to pay their mortgage.
Until they didn't. In 2007, the housing bubble burst, giving rise to the sub-prime crisis. The rest is history.
All said and done, we are facing the worst economic crisis since the Great Depression (GD). A valid question before us is: how did a sub-prime mortgage failure in the US housing market trigger a financial meltdown of global scale? Analysts blame CDS as the principal catalyst of the crisis. As of September 2008, the face value of total CDS outstanding was estimated by the International Swaps and Derivatives Association (ISDA) at nearly $55 trillion. That was more than world GDP of $53 trillion. Almost half of this was held by institutions in Europe. CDS worth $13 trillion was held by the top 25 US banks, which included Bank of America, Citibank, JP Morgan Chase and Wachovia, as reported by the US Comptroller of Currency. Even a leading bank in the United Arab Emirates was left holding CDS in the amount of $2.0 billion. The problem is that the entire derivatives market was unregulated, and under-capitalized. One thing became clear. Financial globalization had taken deep roots, but regulation was weak to nil.
It takes an economic crisis of major proportions to shake things up and bring systemic change. The clear consensus now is that the global financial system cannot be left to its own devices any more. Governments now own or control big chunks of the financial system. If it was a failure of regulatory oversight, then they have all the levers of power to set things right.
That brings us to the forthcoming economic summit in Washington. The US President, George W. Bush, in the twilight of his tenure, has succeeded in convincing global leaders to come to a summit in Washington in November. This could be the first of a series of summits. The goal would be to thrash out the rubric of a more functional and lasting financial architecture by drawing lessons from the present crisis. Given the remarkably coordinated and coherent set of policy actions the world witnessed in the past few weeks from both sides of the Atlantic, it would not be far-fetched to surmise that perhaps something like a Bretton Woods II might be in the offing for the financial markets. Suffice it to say that Bretton Woods I, convened in 1944, long after the Great Depression, aimed to prevent a repeat of GD. It gave the world a new economic order that lasted for over 60 years, while generating enormous wealth and prosperity for a large part of the globe. Is it still relevant for the globalized economies of the 21st century?
If at all, this would be Bretton Woods II with a lot of difference.
