Economic subjects | Finance » Ferenc Hegedűs - The Financial Crisis and its Impacts on the Global and Hungarian economic Policies

http://www.doksihu BUDAPEST BUSINESS SCHOOL FACULTY OF INTERNATIONAL MANAGEMENT AND BUSINESS INTERNATIONAL BUSINESS AND MANAGEMENT STUDIES INTERNATIONAL ENTERPRISES SPECIALIZATION THE FINANCIAL CRISIS AND ITS IMPACTS ON THE GLOBAL AND HUNGARIAN ECONOMIC POLICIES PREPARED BY: FERENC HEGEDŰS BUDAPEST, 2009 http://www.doksihu TABLE OF CONTENTS 1. SZINOPSZIS 4 2. SYNOPSIS 6 3. INTRODUCTION 8 4. THE FORMATION OF THE CRISIS 10 4.1 The Evolution of the American Housing Bubble 10 4.2 Developments in the structured financial markets 12 4.3 The bursting of the bubble – The evolution and extension of the American mortgage crisis 16 4.4 From the evaporation of liquidity to the collapse of Lehman Brothers - What if Lehman Brothers would have been saved? 18 4.41 The evaporation of liquidity 4.42 The collapse of Lehman Brothers 4.43 What if Lehman would have been saved? 18 20 22 4.5 The impacts of the crisis in the USA 22 4.6 The treatment of the crisis in the USA 29 5.

THE PHASING IN OF THE CRISIS TO EUROPE AND TO HUNGARY32 5.1 Bankruptcy of Iceland 32 5.2 Spillover to the EU - the EU’s efforts to handle the crisis 38 5.3 Why is Hungary more heavily affected than the Eurozone members? – Hungary’s economic situation 44 5.4 Management of the crisis in Hungary 48 5.41 Monetary tightening and gradual easing 5.42 Maintenance of the liquidity 5.43 Fiscal tightening (from the appointment of Mr Bajnai on) 48 50 51 6. A PRACTICAL PROBLEM: THE INCREASED IMPORTANCE OF HEDGING 54 2 http://www.doksihu 6.1 Introduction 54 6.2 Company Profile 55 6.3 Description of the existing situation 56 6.31 6.32 6.33 6.34 An overview of the Hungarian economic situation A few words about the financial culture in Hungary A practical example of the problem How to eliminate the effects of exchange rate fluctuations? 56 57 58 59 6.4 Desired Situation 61 6.5 Survey of demand for hedging 62 6.6 Conclusion of the problem 64 6.7 Recommendations 64 7.

CONCLUSION 66 8. REFERENCES 68 3 http://www.doksihu 1. SZINOPSZIS A jelenleg a világgazdaságot sújtó gazdasági és pénzügyi válság jelentős hatást gyakorolt az egyes nemzetgazdaságok teljesítményének alakulására. Ebből kifolyólag úgy gondolom, hogy a krízis kialakulásához vezető folyamatok, krízis hatásainak, és az azokra adott kormányzati reakciók elemzése és összefoglalása időszerű témaválasztásnak tekinthető, mivel ezekről egységes áttekintéssel kutatásaim során nem találkoztam. Dolgozatomat a témában megjelent tanulmányokra, szaklapok cikkeire, illetve kormányzatok által kiadott anyagokra alapozom, mivel ezeket naprakész és megbízható forrásnak ítélem meg. A dolgozat célja, hogy bemutassa, hogyan alakult az amerikai másodrendű jelzálogpiacról kiindult válság egy világméretű gazdasági és pénzügyi krízissé. Az amerikai ingatlanpiaci buborék kialakulásától kezdődően áttekintem a válság

kialakulásához vezető „utat”, különös tekintettel az értékpapírosítás folyamatának legfőbb tényezőire, amelyek hozzájárultak a válság kialakulásához és szétterjedéséhez. A további részekben áttekintem, miként érintette a válság az Egyesült Államokat, Európát és Magyarországot; valamint összefoglalom milyen okok vezettek Izland csődjéhez. Általánosságban elmondható, hogy a válság minden gazdaság számára lassulást, visszaesést hozott, melyet növekvő munkanélküliség és általános bizonytalanság követett a piacokon. A bizonytalanság leginkább a Lehman Brothers csődjét követően erősödött fel, melynek körülményeit szintén bemutatom a dolgozatban. Izland csődjét is úgy gondoltam, hogy bele kell foglalnom a dolgozatba, mivel az izlandi események jelentős hatással voltak Magyarország helyzetének alakulására, még pedig azért, mert számos elemző a két ország gazdasági helyzetét meglehetősen

hasonlatosnak találta. Ezek az összehasonlítások meglehetősen negatív hatással voltak Magyarország piaci megítélésére, ami 2008 októberétől kezdődően jelentős piaci zavarok formájában manifesztálódott, melyek azonnali és hatékony kormányzati beavatkozást tettek szükségessé, amit azonban az akkori magyar kormányzat politikai okokból nem tudott megvalósítani, így 2009 tavaszán egy új, válságkezelő kormány vette át az előd feladatainak megoldását. 4 http://www.doksihu Ezen beavatkozások mind fiskális, mind monetáris politikai intézkedéseket magukban foglaltak, azonban ha ezeket a nyugati államok (USA, EU tagállamok) válságkezelő intézkedéseivel összevetjük, azt tapasztaljuk, hogy bár céljuk azonos, a válság hatásainak csökkentése, az hozott intézkedések tartalma azonban meglehetősen eltérő. Erre talán a legjobb példa a kamatpolitika: az MNB 2008 októberében jelentős emelésre kényszerült, míg az

összehasonlításban szereplő többi ország esetében a monetáris politikai enyhítés volt a jellemző. Ennek okának a magyarázatát a magyar gazdaság válság előtti helyzetének áttekintése hivatott szolgáltatni. A dolgozat utolsó előtti fejezetében egy gyakorlati problémát mutatok be: a magyar kisés középvállalatok árfolyam-ingadozásból eredő problémáinak lehetséges megoldására mutatkozó igényeket mértem fel, és összegeztem. A probléma fontosságának szemléltetésére egy közelmúltbeli példa szolgál, mely a Lenti Olajipari Gépgyártó Vállalat csődbemenetelén keresztül mutatja be az árfolyamok ingadozásának potenciális negatív hatását. 5 http://www.doksihu 2. SYNOPSIS The current economic and financial crisis had serious impacts both on the individual economies and on the global economy as a whole. For this reason I think that the summary and the analysis of the precedents and the impacts of the crisis, as well as the

governmental responses given to them is an up-to-date choice of subject, since I haven’t found any comprehensive source during my investigations. My thesis is based on articles and essays published in the subject by journals and governments, which I deem reliable sources of information. The objective of the assignment is to demonstrate, how the subprime mortgage crisis developed into a global financial and economic turmoil. Starting from the American Housing bubble, I am going to look over the history of the crisis, with special attention to the securitization process’ most important factors, which contributed to the development of it into a financial and economic turmoil and to its expansion to the global markets. Furthermore, I am going to summarize, how the crisis affected the USA, Europe and Hungary; and I am going to present the reasons causing the bankruptcy of Iceland. Generally speaking, we can say that the crisis caused the slowdown and recession of most economies,

coupled with growing unemployment and a common uncertainty in the markets. The uncertainty exacerbated after the collapse of Lehman Brothers, the circumstances of which is going to be presented in the thesis as well. I think that the bankruptcy of Iceland is also necessary to be included in the paper, since the Icelandic events had serious impacts on Hungary’s economy, because numerous analysts evaluated the situation of the two countries to be largely similar. These comparisons had negative impacts on the judgement of Hungary, which manifested in the form of serious market disorders starting from October 2008, which required immediate and quick responses from the government. The government of that time, however, was not capable of carrying out the necessary measures; therefore a change of government took place in the spring of 2009, establishing a crisis management government. The above mentioned measures included both monetary and fiscal political steps, which compared to the

measures taken by western countries (USA, EU member states) show a rather different path of action, although their objectives are the same: the minimising of the impacts of the crisis. Perhaps the best example to this phenomenon is the interest rate policy applied by the Central Bank of Hungary (MNB): amid the market distortions of October 2008, the MNB had to 6 http://www.doksihu implement a monetary tightening (increase of the base rate), while in the above mentioned other countries the opposite of this was perceptible. The explanation for this is provided by the overview of the economic situation of Hungary in the years prior to the eruption of the crisis. In the last but one chapter of the thesis I will introduce a practical problem: the problems of small- and medium sized enterprises stemming from the exchange rate fluctuations, and a survey of demand for the possible solution of these problems. For the demonstration of the problem’s importance, I picked an example from the

recent past: the bankruptcy of Lenti Olajipari Gépgyártó Company, which was triggered by exchange rate fluctuations, thus illustrating the potential dangers of the phenomenon. 7 http://www.doksihu 3. INTRODUCTION As it is well-known, in 2007 a financial and economic crisis erupted in the USA, which then expanded to the whole world, affecting every country. The importance and actuality of this problem motivated me to deal with this problem in my thesis, since Hungary, a small and open economy, with a huge public debt is extremely concerned with it, and I think it is worth studying how the crisis developed, and what impacts it had on the U.S and the European economies, as well as on the Hungarian economic and monetary system. In the following pages I am going to provide an overview of the processes which lead to eruption of the global crisis. I will start from the formation of the US mortgage bubble, and will continue with its blow-out, which drew along the expansion of the

mortgage crisis. Then I will continue with the analysis of the collapse of Lehman Brothers, and its consequences to the global financial markets, which brought about a confidence crisis in the financial markets, ending up in a liquidity crisis, the results of which are borne by the whole world. Concerning the collapse of Lehman Brothers and its consequences, the question comes up, what if it would have been saved? I will attempt to provide an answer to this question. Still in the first part, I will provide a summary of the outcomes of the crisis, and the measures taken by the American government to ease the recession so far. The second main topic of my report is the crisis’ effects on Hungary, and on the Hungarian economic, and monetary policy. Before I would start with its analysis, I will review the European situation shortly: the European anti-crisis measures and the bankruptcy of Iceland. Following this, I will continue with the introduction of the Hungarian economic situation,

before the phasing-in of the crisis, which will show, why the effects of the crisis are more severe in Hungary, than in the Western European countries. After that I will summarize the Hungarian crisis management. I will be looking for factors which motivated the Hungarian regime to take measures quite different from the European and American practice. I will not only follow up the reactions of the National Bank of Hungary to reduce the effects of the crisis (interest rate policy, measures taken to maintain liquidity in the financial markets), but I will also include the most important 8 http://www.doksihu fiscal measures taken by the government to stabilize the country’s financial status as well (IMF loan, fiscal tightening). A limitation of the thesis is that there are hardly any textbooks dealing with the analysis of the crisis; therefore during the preparation of this assignment I will primarily use the publications of the Central Bank of Hungary, like minutes of the Monetary

Council’s meetings, the institution’s Quarterly Reports and other occasional papers. Besides these sources I will rely on analyses from other sources (e.g Wall Street Journal, The Economist, Bloomberg, BBC, CNN, credit rating institutions, etc.), and on the expertise of the employees of Buda-Cash ZRt. as well 9 http://www.doksihu 4. THE FORMATION OF THE CRISIS1 4.1 The Evolution of the American Housing Bubble From the beginning of the 2000s there had been numerous positive developments, which contributed to the growth of the global economy e.g the deconstruction of the economic barriers resulted in a higher level of economic cooperation all around the world. Many emerging countries, which changed their economic regimes to export oriented production in the previous decades, became providers of low-cost and wellqualified labour force, together with an environment, where the rule of law came to a more and more meaningful role. These factors together resulted in amazing economic

growth rates like in the case of China. Besides economic globalization, we should mention the globalization of the financial markets as well, which was a consequence of the aforementioned process. It manifested in the form of growing similarities both in regulations and in financial products; more and more favourable opportunities for providing services in foreign countries and - as an outcome of these - the increased volume and intensity of international capital flows. The strong international presence of emerging countries ended up in the change of the direction of capital flows, as these countries tended to achieve high savings rates, i.e they accumulated surpluses, meanwhile the developed world tended to consume more and more, financed primarily from credits. In the search for investment opportunities, emerging countries started to finance the developed world’s growing spending. The continuously maintained higher growth rates by the emerging countries (in some cases double than

that of the developed world) coupled with low-priced exports put globally downward pressure on inflation expectations, as well as on labour compensation in the developed world (Greenspan, 2007). These together led to the decrease of long-term interest rates and yields globally. The trend of declining longterm interest rates was typical of the markets since the early 1990s, but gained momentum in the 2000s. As an outcome of the low interest rates and yields, the motivation of investors to find new investment opportunities with higher returns 1 Chapters from 2.1 to 23 are based on: Király, J, Nagy, M, & Szabó E, V (2008, October) Contagion and the beginning of the crisis - pre-Lehman period. (pp5-28) 10 http://www.doksihu strengthened the search for yield and also contributed to the increase of investors’ risk tolerance. The above-mentioned factors facilitated the upward tendency of asset prices, which finally ended up in the creation of asset price bubbles. The soaring

asset prices meant that the asset sides of financial institutions’ balance sheets appreciated, which meant that shareholders’ equity increased as well. This made it possible for financial institutions to increase their leverage, which created opportunities to make new investments, causing a massive rise of liquidity, making everything cheaper in the financial market: the bid-ask spread narrowed; the volatility of prices decreased and the yield curves smoothened. These factors however, turned into a self-reinforcing process, which ultimately made increase the leverage of every actor in the financial market. The low interest rates and the abundance of liquidity served as the basis for the formation of credit booms in several locations in the world. The remarkable expansion of credit facilities and the growth of demand for mortgages increased the demand in the housing market, leading to the acceleration of housing prices. Graph 1: Changes in housing prices; prepared on the basis of

data collected from Standard & Poor’s (CaseShiller Home Price History, 2009) 11 http://www.doksihu The continuously emerging house prices together with the favourable credit opportunities made the credit volume grow, which in turn became the basis of further price increases. This was another self-reinforcing process, and - as it is well-known – ended up in a housing bubble (in the last 10 years housing prices in the USA doubled, in some cases the increase was even more than that, as it is shown by the Case-Shiller2 graph above). The continuous growth of housing prices made it possible for homeowners, to borrow even more money from banks, since their real estates’ value-growth provided the necessary collateral for the further credits. The additional amounts were added to the existing debts, and resulted in a slightly remarkable increase in the monthly mortgage payments. Practically the appreciation of real estates provided extra credit facilities to homeowners. Let’s

suppose that a real estate, which initially had a value of $ 100,000, and was burdened with a $ 100,000 mortgage loan. In the following year the house appreciated by 10%, i.e its value was $ 110,000; this price increase made it possible for the bank to provide an extra $ 10,000 to the debtor, and this process could repeat itself. Thus the same real estate was burdened with a larger and larger mortgage loan. From the perspective of the American GDP, housing wealth is of high importance, which is directly linked to the functioning of the credit market. For this reason, the healthy operation of it is of critical significance. The smooth operation of the credit market has been provided through securitization: investors were linked to borrowers through mortgage backed securities (MBS). It means that mortgages were practically financed by long-term investors. 4.2 Developments in the structured financial markets Numerous actors cooperate in the process of securitization in order to ensure

the proper functioning of it. These are mortgage brokers; credit institutions and Federal Home 2 Case-Shiller Index: The S&P/Case-Shiller Home Price Indices measures the residential housing market, tracking changes in the value of the residential real estate market in 20 metropolitan regions across the United States. (S&P/ Case-Shiller Home Price Indices) 12 http://www.doksihu Loan Banks; auxiliary institutions like Special Purpose Vehicles, mortgage servicers; and Government Sponsored Enterprises (GSE). Securitization is based on the originate-and-distribute (OAD) model, which is often blamed for being the efficient cause of the mortgage crisis, but as long as it is functioning adequately, it is beneficial for both the investors and the borrowers. In the OAD model, banks act as originators; they pass on the credit risk, and distribute it among investors. This is not problematic, since originators were concerned only with prime loans in order to obtain refinancing and

maintain investors’ confidence. It means that the outcome of the securitization is a prime security, which has a level of risk similar to that of government bonds. So originally the OAD model did not cause the distortion of the markets. The distortion comes from the fact that the American mortgage market is not only made up from prime loans, but there is the secondary segment, which can be characterised generally as loans embodying higher risks. The reason for it comes from the fact that these loans are usually issued to clients without a credit history, or with a problematic credit history. These loans cannot be securitized under the same conditions as prime loans, i.e they don’t have the same guarantee level as the prime ones In order to reduce the risks exemplified by these papers, their issuers purchased guarantees from institutions specialised in this field, and also, they asked well-known credit rating agencies to rate their products, and started to sell only the best quality

ones. This way, initially these papers did not cause a market distortion either. There were, however, potential sources of problems with these papers to emerge. These problems come from two origins: first, the ratio of sub-prime loans within the whole credit volume grew rapidly: while in the year 2001 sub-prime loans represented only 5% of total mortgages, in 2007 they accounted already for 15%, approximately 1500 billion dollars, most of which loans was securitized. The reason for this remarkable growth is that the conditions for sub-prime loans were less stringent: lower interest rates and faster credit assessment process, coupled with favourable payment terms (e.g in the case of the popular adjustable-rate mortgages). As a result of the expansion of subprime loans, it became harder and harder to distinguish good quality securities from the so called private MBS, which were issued by non government-sponsored enterprises, and represented higher risks. 13 http://www.doksihu The

second reason comes from the enormous growth of housing prices, which was fuelled by the abundance of liquidity and the loose credit conditions. As I mentioned before, these factors contributed largely to the building of the housing bubble, but they had a significant role in the overgrowth of securitization as well. Securitization provided banks and financial institutions with low-cost liquidity, which means that they were willing to provide cheap loans, which led to the growth of credit volume, which boosted housing prices further, motivating banks for additional securitization, making the whole process self-reinforcing. The result of the expansion of sub-prime loans was the spreading of private MBS, which finally made it more and more difficult to distinguish them from good quality securities. The OAD model was hurt, when the growth of sub-prime loans made securitizers think that everything can be securitized, i.e credit quality and risks were less taken into consideration. This

situation was triggered by the emergence of structured financial products. During the creation of these products, risks associated with original assets were allocated to three different tranches: the senior, the mezzanine and the equity tranche. The senior tranche represents the highest quality securities, with low default rates and expected losses, but even these are not protected from losses entirely. The next tranche is the mezzanine tranche, which represents somewhat lower-quality papers, and is more exposed to potential losses, in the case of the equity tranche’s (unrated securities, usually held by banks) inability to cover all the losses. One of the problems with structured financial products is that it does not guarantee payment at face value. Another problem is that, as I was referring to it in the previous paragraph, if the losses incurred are higher than the equity tranche, the other two tranches will suffer losses as well, first the mezzanine and following that the senior

tranche. This phenomenon is called the waterfall-mechanism The main problem comes from the fact that the loss function of structured finance products is not linear, which means that the same loss on the underlying assets will cause a higher loss in the case of structured products compared to traditional ones. Collateralized debt obligations (CDO) are a special type of structured finance products; they are practically the results of repackaging structured finance products3. These 3 CDOs are created by repackaging various assets generating cash flows: cash flows on high yield bonds, investment-grade bonds, high-risk loans or securities created through securitisation – mortgage or other asset backed bonds – are sliced and repackaged. In the beginning, only homogenous cash flows – either 14 http://www.doksihu papers theoretically represented lower risks coupled with higher yields. How is it possible? As the consequence of repackaging, the risks associated with the assets

providing the original cash flow decreased, which means that the financing of them became cheaper, meanwhile the same level of risks provided higher yields. Besides that, it provides incomes for the participants of the securitization process. Furthermore, CDOs could be created synthetically; by the use of credit derivatives, like credit default swaps (CDS)4. It means that the securitizer did not need to possess the assets generating cash flows, but it was enough for him to buy a claim for the cash flows. (Király, Nagy, & Szabó E, Contagion and the beginning of the crisis - preLehman period, 2008, p 16) This led to growing complexity and vagueness in the securities’ market, where customers could not explicitly assess the risks associated with the papers they were intending to buy, because there were no appropriate standards for the measurement of it. A suitable assessment of risks would have been of extremely high importance, since securities created through securitization were

so to say “synonyms” for safe investments. As we saw in turn, they weren’t Unfortunately this was recognised and acknowledged by rating agencies (Moody’s, Fitch) only later, when problems associated with these securities emerged. To summarize, we can say that the absence of proper quality management provided opportunity for taking higher risks through the enhancement of securities’ volume, which gradually transformed the OAD model to originate-to-distribute model (Király & Nagy, Jelzálogpiacok válságban: kockázatalapú verseny és tanulságok, 2008, p. 8) All in all, the extra revenues generated by structured finance securities were not the results of a brilliant innovation, but they came from the inappropriate risk-assessment. We should also note that there was another factor, which served as a basis for the overgrowth of securitization, and it was the continuous pressure to achieve growth. This mortgage loans (CMOs) or high-risk corporate bonds (CBOs) – were

repackaged; however, CDOs bundling together heterogeneous cash flows or claims for cash flows appeared in the 1980s. (Király, Nagy, & Szabó E., Contagion and the beginning of the crisis - pre-Lehman period, 2008, p 15) 4 CDS transfers credit exposure of fixed income products from one party to another. It can be regarded as a guarantee provided to the buyer of it. It can be purchased both in the case of government bonds as well as in the case of corporate bonds. In the case of governments bonds, it provides an assessment of risks associated with the given country. In the case of Hungary, the CDS premium increased to 6% in the most critical periods of the crisis, currently it is somewhat above 2%. 15 http://www.doksihu force motivated bankers to develop additional products, which can be marketed and thus generated incomes for their companies. 4.3 The bursting of the bubble – The evolution and extension of the American mortgage crisis As it could be seen in the previous

chapter, the securitization process was designed to a market situation, where growth was prevailing, therefore the risks of a possible downturn and the possible losses were practically ignored, or at least underestimated. When the continuous growth of housing prices came to an end during 2006 (see Graph 1 on page 7), difficulties started to pile up. The reason for the deceleration and the actual reversal of housing prices’ positive trend most probably comes from the fact that by 2006 the indebtedness of the American population was so high, that the growth of the credit volume could not be sustained, therefore it started to slow down, causing the shrinking of housing prices. The set-back of housing prices raised a serious problem: as the prices pushed to irrational heights in the preceding years (see Graph 1 on page 7) started to decrease, the incomes of financial institutions issuing loans were not ensured any more. In the years of upswing, growing prices served as a kind of

“guarantee” for institutions in the case of the client’s default, since it seemed to be highly possible that in the event of a foreclosure the institutions could sell the real estate at a higher price than the actual receivables expected from its client, as a result of the continuous housing price increase. This “guarantee” disappeared with the evaporation of demand for mortgages, implying that the demand for houses declined as well, which has a natural consequence: the decrease of prices. Previously I pointed out that amid the abundance of liquidity and the loose credit conditions the ratio of sub-prime mortgages increased significantly. These mortgages represented higher risks stemming from the problematic clients they were issued to. As the initially favourable features like in the case of adjustable-rate mortgages (ARM)5 5 A type of mortgage in which the interest rate paid on the outstanding balance varies according to a specific benchmark. The initial interest rate is

normally fixed for a period of time after which it is reset periodically, often every month. The interest rate paid by the borrower will be based on a benchmark plus an additional spread, called an ARM margin (Investopedia). The reason for the popularity of this kind of mortgage was the lower initial payments, but the risks of possible higher interest rates in the future were usually lacking proper emphasis. 16 http://www.doksihu started to disappear and payments started to increase, default ratio of sub-prime loans started to increase sharply (see Graph 2), causing the rise of foreclosures. This problem coupled with the declining demand for real estates gave further boost to the decrease of housing prices, deepening the problems of financial institutions. Graph 2: Source: Király, Nagy, & Szabó E., Contagion and the beginning of the crisis - pre-Lehman period, 2008, p. 12 The problematic mortgages were however only the tip of the iceberg. The huge growth of the credit

volume drew along the even bigger growth of securitization. Initially the securitization contributed to the increase of liquidity in the financial markets, since they made mortgages become marketable and tradable securities, but as we saw, securitization also contributed to the pollution of financial markets. As default rates on sub-prime mortgages started to increase, losses reached MBS’s mezzanine tranches, meanwhile in the case of CDOs; senior tranches were affected by losses as well. The growing losses as well as the expected further losses motivated rating agencies to revise the ratings of sub-prime mortgage-backed securities resulting in numerous downgrading, and numerous paper were given a negative outlook. As a result of the 17 http://www.doksihu depressing developments with ratings, investors stopped buying structured finance products, which therefore needed to be financed by banks through the purchase of credit default swaps (CDS). As a result of the growing demand for

CDS, their premium increased significantly, meanwhile their price dropped sharply. The appreciation of risks motivated investors to get rid of their risky investments, therefore the dismantling of high leverages began. 4.4 From the evaporation of liquidity to the collapse of Lehman Brothers What if Lehman Brothers would have been saved? 4.41 The evaporation of liquidity Amid the growing pressure to sell structured finance securities, their prices started to fall dramatically, generating considerable losses for investors. However the market of CDOs was not of substantial size, the crisis setting out from there had much more effects on financial markets, than anyone previously suspected. As problems were adding up, liquidity diminished, everyone was attempting to decrease its leverage, meanwhile risk premiums and banks’ losses grew considerably. This process created uncertainty in the markets, and envisaged the risk of fallback in economic growth rates. Closing the positions in

CDOs, was not an easy task, since these securities were usually held until maturity, therefore their pricing was not market based, but it was based on financial models, to be more precise, the price of the freshly issued CDOs served as a benchmark for pricing. Resulting from the sudden pressure to sell, investors had to revaluate their assets based on the changed conditions: the prices quoted for CDOs fell dramatically, meanwhile the bid-ask spread extended radically. Losses grew even more significantly (in many cases not only equity and mezzanine tranches, but senior tranches were affected by losses too), which caused distortions in the trade of CDOs, and the eventual stop of CDOs’ issuance, i.e the benchmarking function of CDOs’ price ceased to exist. 18 http://www.doksihu The crisis of CDOs extended to their financing institutions (conduits6 and SIVs 7). From August 2007, the short-term financing became more and more difficult, and in a growing number of cases inaccessible,

therefore these institutions needed to draw on banks’ credit lines in order to maintain liquidity. Parallel to this, structured financial assets were put on banks’ balance sheet in contrast to the preceding practice. Together with these events, the crisis setting off from the U.S CDO market had become international, since European and Asian institutions were affected as well (numerous foreign banks invested previously into CDOs). The drawings on banks’ credit lines indicated the beginning of funding liquidity8 crisis (in the case of conduits and SIVs), which was supplemented by huge losses on CDOs. The decline in leverages induced further liquidity problems, which in turn contributed to further depreciation of CDOs. The growing amount of drawings on banks’ credit lines served only as a temporary remedy for affected companies, and in fact they were only increasing banks’ prospective losses. Further problems associated with structured securities stem from the fact that there

was no information available either about banks’ exposure to mortgage loans or mortgagebacked securities, or about their roles in conduits and SIVs. The latter is of especially high importance, since banks were usually financers, and in numerous cases they had a partial ownership of these institutions, but these roles were out of regulators’ perspective, since they were off the balance sheets. Consequently, the size and distribution of banks’ losses could not be anticipated. This uncertainty around banks’ positions brought about the confidence crisis. This crisis manifested in the form of soaring overnight rates, which were actually endangering the functioning of the inter-bank market, not only in the USA, but internationally as well. The global nature of the problem is demonstrated by the fact that central banks had to manage liquidity problems not only in their domestic currencies, but foreign currencies as well, which in turn motivated central banks to conclude agreements on

foreign exchange swaps for the maintenance of liquidity. 6 Conduit: a class of financial intermediaries, financed by highly leveraged tradable securities and mainly established by commercial banks and investment banks. (Király, Nagy, & Szabó E, Contagion and the beginning of the crisis - pre-Lehman period, 2008, p. 18) 7 Structured Investment Vehicles: “a pool of investment assets that attempt to profit from credit spreads between short-term debt and long-term structured finance products such as asset-backed securities (ABS).” (Investopedia) 8 “The ability to settle obligations with immediacy“ (Drehman & Nikolaou, 2009) 19 http://www.doksihu 4.42 The collapse of Lehman Brothers9 The degree of uncertainty in the markets was illustrated very well by the instance of Lehman Brothers, the fourth largest investment bank in the USA. Lehman Brothers Holdings Inc. had been in operation for 158 years, until it filed for bankruptcy on 15 September 2008. During its history,

the bank survived numerous crises, among others the Great Depression in the 1930s, but in the prevailing financial and economic situation it could not carry on its functioning. The question may arise, how did the company come to this end after many years of successful operations? Under the direction of its last and longest-serving CEO, Richard Fuld the company managed to increase its profit between 1994 and 2007 from $ 113 million to $ 4.2 billion, and the price of the company’s shares grew 17 times (Robison & Onaran, 2008), but this incredible growth was not given for free: it came from investments into risky projects (mainly LBOs10). Although it closed its riskiest positions at the end of 2007, it still had a portfolio of $ 84 billion in mortgage-backed securities, which was enlarged further during the spring of 2008. In March, 2008, when Bear Sterns was bought-out by JP Morgan Chase at a price of $ 29 billion. At that time whispers took wind, saying that Lehman could be the

next in the row, but at these were rejected by Mr. Fuld In the following days however, he contacted Warren Buffett, the well-known investor with the aim of persuading him to become a strategic investor in the company. This plan eventually broke down, and Lehman issued preferred stocks in the value of $ 4 billion under more favourable terms than it could have done so in the case of an agreement with Mr. Buffett Problems emerged on 9 June 2008, when the Q2 results of the company were published (on 9 June only preliminary data were released, official publication was on 16 June 2008), announcing a loss of $ 2.8 billion (Lehman Brothers- Quarterly Earnings, 2008) Following the publication of this disappointing data, the management started to look for investors to finance its indebtedness. Potential investors were Bank of America, General Electric, Citic and the Korean Development Bank (KDB). The latter offered $ 22 per 9 Based on: Onaran, Y., & Scinta, C (2008, September 15) Lehman

Files Biggest Baknruptcy Case as Suitors Bank (Update4). 10 Leveraged Buyout: purchase of companies financed from credits. Lehman Brothers has been a participant in the competition started by commercial banks, following the abolishment of the GlassSteagall law in 1999 20 http://www.doksihu shares initially, and would have been ready to acquire a 25% stake in the company. A month later the offered price per share dropped to $ 8, but Mr. Fuld was reluctant to accept the offer, because of management issues (he did not want to provide a decisive role to the foreign investors), and he questioned the valuation of the mortgage portfolio. When it turned out that the parties did not manage to make an agreement (9 September 2008), the risk premium of Lehman’s debts rocketed to 500 basis points (a 200 points increase), which made the creditors of Lehman stop financing its debts. (Gaál, 2009) The last chance of the bank was the offer made by Barclays, which offered $ 5 per share, provided

that Lehman gets rid of its most problematic assets in the form of a new company. It wanted to get a federal guarantee in exchange for bailing out Lehman Brothers, but it didn’t manage to achieve it, therefore the company, after losing 94% of its market value (Onaran & Scinta, 2008) (see Graph 3), was forced to file for bankruptcy. Graph 3: Lehman Brothers stock price changes from 1 August to 31 October 2008 (Source: Yahoo! Finance) 21 http://www.doksihu The outcome was a complete market shock: Dow Jones Industrial Index plunged 504 points, and the financial markets froze. Inter-bank markets were only operating at the shortest maturities, and at irrationally high interest rates. The previously mentioned confidence crisis gained momentum: risk premiums were rising; stock prices were falling (especially in the markets considered as risky). Together with this process, gap between risky and safe markets widened, i.e investors were escaping from their risky assets into safe

investment opportunities, which actually meant that the previously started deleveraging process continued; furthermore it intensified. In this atmosphere German and American government bonds were the “safe harbours” (Király, Szép új világ: Válság és Valóság (Lehman előtt, Lehman után), 2009, p. 6) 4.43 What if Lehman would have been saved? It is likely that the bailing out of Lehman Brothers would have reduced somewhat the uncertainty in the financial markets, since it would have had the message that the U.S government and the FED would protect markets from such shocks. If Lehman had been saved, probably the magnitude of the crisis would not have grown so large, and possibly the management of the crisis would have not required such enormous resources from the governments of the affected countries. On the other hand, Lehman’s escape from bankruptcy could have the implication to other market participants that they could continue their operations without changes. This

potentially includes the risk that later on they could get into the same situation, i.e U.S Government and the Fed would have to devote much higher amounts of money for bank-bailouts, which is already unbelievably high in fact. 4.5 The impacts of the crisis in the USA As the crisis, which originates from the U.S secondary mortgage market, became a global economic and financial turmoil, it is natural that it drew along a series of consequences in numerous segments of the economy. In this chapter I am going to summarize its main impacts on the financial markets, and will highlight a few phenomena accompanying the crisis in the economy and society. 22 http://www.doksihu As I was referring to it before, the overgrowth of securitization together with the loose credit conditions boosting the increase of credit volumes, created potentially high losses, which has actually materialized. According to the International Monetary Fund’s estimation, losses incurred by U.S and European banks

in the period from 2007 to 2010 could be as high as $2.8 trillion, most of which is a result of bad loans (two thirds), and the remainder comes from securities (Cutler, Slater, & Comlay, 2009). The enormous amount of loss incurred and the evaporation of confidence made banks less and less willing to provide loans to other banks, corporations and individuals; a credit crunch came into being. It means that it is practically impossible to obtain a loan; meanwhile the available credit facilities are significantly more expensive than they would be under normal circumstances. This implies two things: as corporations were hardly able to finance their operations, they either stopped functioning or laid off (part of) their workforce. Both scenarios contribute to the increase of unemployment rate and to the decrease of GDP growth: the U.S unemployment rate rose to 102% (157 million people) in October 2009, which is the highest rate since April 1983 (Employment Situation Summary, 2009). The

high unemployment rate is especially problematic in the case of the USA, since personal consumption of U.S citizens provides 70% of the American GDP (National Income and Product Account Tables, 2009), and people without incomes cannot contribute through the increase of consumption to the growth of GDP (Graph 5 illustrates the relationship of consumption and GDP growth). Graph 4: U.S annual GDP growth rate and annual consumption growth (Source: US Department of Commerce (National Income and Accounts Table, 2009)) 23 http://www.doksihu When talking about unemployment, we should mention that minorities (e.g: Hispanic) are hit worse by the crisis than non-minority citizens, since their rate of unemployment (13.1%) is higher than that of the other parts of the population (95%) (Employment Situation Summary, 2009). The reason for it comes from the fact that most immigrants are employed in the construction sector, which has shown a dramatic fallback as well. Furthermore, almost half of

mortgage loans held by Hispanics are subprime, which means that their financial situation could become especially severe: their monthly mortgage payments are increasing, while the likelihood of losing their jobs is higher than that of non-minority citizens (Garcia, 2008). Thus, there were many concerns whether immigrants could be blamed for the eruption of the subprime crisis: Mexican and South American (either legal or illegal) immigrants were offered the most subprime mortgages, since they usually did not have a credit history. Even if they had the same background as a U.S citizen, their chance of getting a prime loan was lower As a consequence of the depressing results of banks, stock markets tumbled as well. Both S&P 500 and Dow Jones Industrial Average (DJI) indices lost more than 50% of their values (see Table 1). Table 1: Percentage Changes in S&P 500 and DJI 1 October 1 October 2008 2007 Value Value S&P 1547.04 500 DJI 10487.55 Percentage Minimum (9 March

2009) Value Percentage 1161.06 change11 -25 676.53 change12 -55% 10831.07 -23 6547.05 -53% Own calculations based on data collected from Yahoo! Finance (Dow Jones Industrial Average Index Chart, 2009) (S&P 500 Index, RTH Index Chart, 2009) 11 12 Compared to 1 October 2007 value Compared to 1 October 2007 value 24 http://www.doksihu As banks’ losses increased, their willingness to provide loans to the public decreased significantly, which contributed to the decrease of demand in the housing market as well, therefore prices started to decrease as well, in some cases price drops were more than 40% (see Table 2). Table 2: Percentage Changes Case-Shiller Index Maximum Minimum Percentage change Los Angeles, CA September 2006 273.94 May 2009 159.18 -419% Miami, FL December 2006 280.87 May 2009 144.59 -485% New York, NY June 2006 215.83 April 2009 17067 -209% Own calculations based on data collected from Standard & Poor’s (Case-Shiller Home Price

History, 2009) As I mentioned before, starting from 2007 there was a slowdown perceptible in the inter-bank markets, which means that banks were less and less willing to provide loans to each other, or under much more unfavourable conditions than they did before the eruption of the crisis, i.e confidence crisis was prevailing TED Spread13 illustrates very well the increasing perception of credit risk in the economy (see Graph 4 below), which eventually peaked on 10 October 2008 at 465 points. 13 The price difference between three-month futures contracts for U.S Treasuries and three-month contracts for Eurodollars having identical expiration months. The Ted spread can be used as an indicator of credit risk. This is because US T-bills are considered risk free while the rate associated with the Eurodollar futures is thought to reflect the credit ratings of corporate borrowers. As the Ted spread increases, default risk is considered to be increasing, and investors will have a preference

for safe investments. As the spread decreases, the default risk is considered to be decreasing (Investopedia) 25 http://www.doksihu Graph 5: TED Spread during the last 3 years (Bloomberg: Personal Finance, 2009) Another indicator of the markets’ volatility is the VIX index, which shows “the market’s expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and puts. The VIX is a widely used measure of market risk and is often referred to as the "investor fear gauge".” (Investopedia) The higher its value, the higher the anticipated volatility of the markets, which implies a higher premium on options. If we have a look at the chart of the VIX’s movements (see Graph 6), we can see that during 2008, it surged several times, showing the high level of uncertainty in the markets. As to Investopedia’s definition, 30

or greater VIX values indicate high volatility in the markets as a result of fear or uncertainty. As we can see from the graph below, starting from mid-September 2008 (collapse of Lehman Brothers), until mid-May 2009 its value was continuously higher than 30 points, moreover, it hit 80 points two times during 2008. 26 http://www.doksihu Graph 6: Movements of VIX during the previous two years (Source: Yahoo! Finance) This uncertainty was the source of numerous financial institutions’ problems, because in the absence of proper inter-bank financing, many of them could not renew its short-term debt, therefore they needed financial assistance from the government or the central bank (in case of the U.S Fed is regarded as the central bank) According to the Federal Deposit Insurance Corporation (FDIC) more then 150 banks have gone bankrupt (FDIC: Failed Bank List, 2009). As investors started to take out their money from risky mortgage-backed securities, and looked for safer investment

opportunities, they moved from the equities’ market to the commodities’ market. This movement of this money contributed (together with other factors not discussed here) to the temporary increase of food and raw material prices, thus inducing crisis, especially among those parts of the population, who live under modest conditions (Mother of all bubbles prepares to burst, 2008). 27 http://www.doksihu Graph 7: Oil price changes from January 2007 to November 2009 (Source: Buda-Cash) The upsurge of raw materials’ prices, however, came to an end in the second half of 2008, because the soaring prices were induced largely by speculation, i.e there was no growth of demand behind them. A good example to this phenomenon is the development of oil prices in the previous two years. As the speculative pressure on the oil price decreased, it started to plummet (see Graph 7): from more than $ 140/barrel (June, 2008) it fell below $ 40/barrel (December 2008). To summarize the impacts of the

current crisis to the USA, we can say that as housing prices started to decline, the model built up by financial institutions, which was based on the continuous growth of housing prices, failed. This failure caused large losses to them; therefore they became increasingly cautious concerning the issuance of new credits, this caution was increased to such a high level that it became a credit crunch. As a result of the freeze of financial markets, individuals and corporations could not renew 28 http://www.doksihu their short or long-term credits. As a result of this, individuals’ consumption decreased, while corporations lacking financial sources either stopped their operations or to reduced the number of employees, either ways chosen, the unemployment started to increase. The increasing unemployment resulted in a decreasing demand, contributing this way to the decrease of GDP. 4.6 The treatment of the crisis in the USA The main source of the deepening of the crisis is that

financing opportunities disappeared from the market, generating a series of further problems: freeze of financial markets, increasing number of foreclosures, increasing unemployment, decreasing demand and eventually the decrease of GDP. The US government implemented numerous measures in order to minimize the impacts of the crisis. These measures included regulatory changes as well as actions aimed at restoring liquidity to the financial markets. In this chapter I am not intending to describe all these provisions, I am only going to provide an overview of the U.S government’s efforts to stabilize money markets, and their costs. Due to the enormous losses incurred by financial institutions, their stabilization stood at the focus of numerous actions. Emergency Economic Stabilization Act of 2008 (enacted on 3 October 2008) created the Troubled Asset Relief Program. The program authorized the Department of Treasury to purchase or insure up to $ 700 billion of troubled assets (The

Troubled Asset Relief Program: Report on Transactions Through June 17, 2009, 2009). From the committed $ 700 billion, $ 4036 billion has already been spent in numerous fields. Examples of these fields include among others Automotive Industry Financing Program, Consumer and Business Lending Initiative and Making Home Affordable and Targeted (Goldman, 2009). The intervention of the government into the economic life was first largely discussed by economists, but later on its necessity became evident. The assistances provided to the financial institutions have positive outcomes, since in many cases the investments made into party or fully nationalised banks generated profit for the state budget. Furthermore, the presence of the state in the economic life may contribute to the recovery of business 29 http://www.doksihu confidence, thus it may help the restart of lending, which is essential for the healthy functioning of the economy. The government introduced numerous programs as well;

these programs’ main objective is to save existing jobs and create new ones, and to move the economy back from the recession to growth. The amount devoted by the government to achieve these purposes is $ 1.2 trillion, from which $ 5778 billion has been spent so far (Goldman, 2009). Concerning banks, we should mention that more than 150 banks have gone bankrupt by 13 November 2009, which generated a cost of $ 45.4 billion to the FDIC (FDIC Failed Bank List, 2009). At the same time, the number of bailed out banks is several times more than that of taken over by FDIC, the cost of which is more than $ 133 billion (Treasurys bank bailout list, 2009) Federal Reserve has spent already $ 1.5 trillion on rescue efforts, which are aimed at restoring money market liquidity. These included among others the purchase of GSEs’ debts and mortgage-backed securities in order to reduce rates on home loans; Term Auction Facility (Fed takes illiquid assets as collateral and provides commercial banks

with cash in exchange) and the purchase of U.S government bonds (in order to support Treasury market and keep interest rates on consumer loans down) (Goldman, 2009). 30 http://www.doksihu Graph 8: Federal Funds Rate (Source: Federal Reserve Bank of New York (http://www.newyorkfedorg/charts/ff/)) Besides spending enormous amounts of money on stabilizing measures, Fed also implemented an interest rate policy aimed at helping the markets to recover from the credit crunch (see Graph 8). During the years housing prices’ growth it gradually increased the Federal Funds Rate, with an aim of slowing down the growth of mortgages’ volume, but when the growth turned into a slowdown, furthermore into a recession, it decreased the Rate within a much shorter time to zero (to be more precise, it is decreased to a Target Range of 0.00%-025%) 31 http://www.doksihu 5. THE PHASING IN OF THE CRISIS TO EUROPE AND TO HUNGARY 5.1 Bankruptcy of Iceland Although Iceland is a small country both in

terms of area (103 000 km2) and in terms of population (approximately 306 000 people) (Central Intelligence Agency, 2009), we have heard a lot about it recently. Iceland can be regarded as the country most seriously affected by the current financial and economic crisis. In the following pages I am going to provide an overview of how Icelandic banks, which previously contributed to the increase of the population’s wealth, induced a national financial and economic catastrophe. Iceland showed a significant economic development during the 20th century. Originally the main economic activities were linked to fishing, and fishery products, but in the recent decades a diversification of the national economy could be observed: biotechnology, software production and services (especially financial services) became the providers of an increasing share of Iceland’s GDP. Prosperity started during the 1990s, when the prime minister, David Oddsson implemented reforms, with the aim of decreasing

the country’s exposure to the wobbles of fishing, and the price volatility of fisheries products. These reforms included privatisations of numerous companies (including banks), and was followed by the deregulation of banking services, this way easing the conditions of lending. Following these improvements, the previously mentioned diversification of the economy gained momentum, and numerous new investments were made (e.g: Ossur hf, an Icelandic maker of artificial limbs, grew into a global supplier of high-tech prosthetics). Banking sector was the most rapidly evolving sphere: the three largest banks (namely Kaupthing Bank, Glitnir Bank and Landsbanki) together accounted for approximately 73.2% (Definitive List of Constituents in OMXI15 index, 2008) of the value of the Icelandic Stock Exchange, and they had credits (inter-bank loans and foreign deposits) and other assets, which exceeded several times the national GDP (Forelle, 2008). 32 http://www.doksihu How could banks become

so big within just a few years? Icelandic banks financed their expansion from debts, which is illustrated by Graph 9 below. Concerning the graph, I would like to emphasize that 90% of these amounts were piled up by the three largest Icelandic Banks. The main motivating factor for the inflow of money was the environment of high interest rates compared to that of the western European countries, which provided favourable opportunities for those intending to deposit their money (e.g: Kaupthing’s subsidiary was offering 715% on one-year deposits), ie the so called carry trade generated continuous demand for the Icelandic krona (ISK), which kept the it strong. Graph 9: Deposit Money Banks, figures in M. ISK (Source: Central Bank of Iceland) The strong currency made imported goods cheap, and motivated for borrowing in foreign currencies, like Swiss Franc, or Japanese Yen. In this respect, Iceland can be compared to Hungary, where credits denominated in foreign currencies were very popular

as well. The media often communicated that the situation of Hungary and Iceland shows many similarities, and for this reason there were numerous articles about the likelihood of a prospective Hungarian bankruptcy. There was however a main difference. Iceland was intending to become a financial centre; therefore the magnitude of the banking sector compared to the size of the national economy was enormous: as I mentioned above, their debts exceeded the country’s GDP several times. 33 http://www.doksihu The banking system could operate only as long as the money was flowing into the country. When inter-bank financing started to stall, Icelandic banks found themselves in a more and more difficult situation, as they could hardly solve the problem of refinancing their outstanding debts. Following the drying up of financial markets in September 2008, Icelandic banks could not handle this problem any more. The situation got especially severe, when the bonds previously issued by

Iceland’s third largest bank, Glitnir Bank, matured, and the company should have had to pay € 600 million, but it did not have the necessary amount of money to do so. It attempted to apply for a loan in the inter-bank market, and it tried to liquidate its Norwegian assets as well, but neither of these measures succeeded. When the difficulties of Glitnir bank were revealed internationally, the exchange rate of the Icelandic Krona fell radically. Further problems emerged, when Glitnir asked Bayerische LB for allowance to be late with its € 150 million loan payment due on 24 September, but it did not get it. Following the unsuccessful attempts to raise money for the payment on the matured bonds, Glitnir turned to the Central Bank of Iceland for help, but the Central Bank’s foreign currency reserves were rather limited: it had primarily reserves in Icelandic Krona, and had only 2 billion Euros, which, compared to the external debts of the country (€ 49.9 billion), can be

considered a negligible amount Besides this, we should not forget that by that time, the demand for Icelandic Krona was next to nothing. The main question was how Iceland should use its Euros, to achieve the best solution possible amid the given circumstances. The final decision was to take a 75% stake in Glitnir Bank for € 600 million. Following the announcement of this measure on 29 September, the price of Icelandic bank shares plummeted (see Graph 10). 34 http://www.doksihu Graph 10: Movements of the OMXI 15 Index until 29 September 2008 The reaction of the foreign depositors was that they attempted to take their deposits out from the banks, worsening the banks’ solvency problems. Banks really needed to find any kind of solution to raise Euros, but they did not manage to. After £ 200 million of deposits were taken out from Landsbanki’s British subsidiaries, and as it was lack of further reserves of foreign currency, there was no other choice, than to take it under

governmental control (7 October). The government guaranteed Icelandic depositors’ money, but there was nothing said concerning foreign depositors’ money. Kaupthing Bank’s situation seemed to be the most solid, since it was not experiencing such outflow of foreign currency as its competitors did, and it got the necessary € 500 million loan it needed to maintain its solvency. Unfortunately, it did not mean that Kaupthing could survive: the British government worried about Kaupthing’s British subsidiaries’ solvency; therefore it applied an anti-terrorism law, and froze the bank’s British assets, serving as a protection for the bank’s British depositors. After this event, Kaupthing could not continue its operation, as a result of which it was taken under governmental control (8 October). As a result of the above mentioned measures, main rating agencies downgraded Icelandic banks as well as Iceland itself by 2-3 levels on average (see Table 3), and gave Iceland’s sovereign

debt rating a negative outlook. 35 http://www.doksihu Table 3: Iceland’s Downgrading Previous rating (end of Modified rating (end of Fitch Ratings September) A- October) BBB- Moody’s Investors Service Aa1 A1 Standard & Poor’s A- BBB Agency Source: Central Bank of Iceland (http://www.sedlabankiis/?PageID=789) The crisis induced by the banks affected Iceland’s stock exchange relentlessly as well. As I mentioned before, the three largest banks accounted for more than 70% of the Stock Exchange’s value, and since these shares practically lost their values, the OMX Nordic Iceland Exchange lost most of its value as well (see Graph 7 on the previous page). Trading on the Icelandic stock exchange was suspended several times, with the aim of preventing huge slumps, but it wasn’t a successful attempt. On 6 October the trading of six financial institutions’ paper (Glitnir banki hf., Kaupþing banki hf, Landsbanki Íslands hf., Straumur-Burðarás

fjárfestingarbanki hf, Spron hf and Exista hf.) was suspended by the Financial Supervisory Authority (FME), which was followed by the suspension of all trading activities on the stock exchange from 9 October to 13 October. On 14 October when the market was reopened, the Icelandic index, OMX Iceland 15 stood at 678.4, 30046 points lower than before the closure On 9 December two (Straumur–Burðarás and Exista) of the six suspended papers resumed to trading, their value dropped sharply, lowering the index by further 40% to 394.88, meanwhile trading with the shares of Kaupthing and Spron remained suspended. As I mentioned before, the Icelandic krona was kept strong by the international demand, but as demand together with the confidence evaporated, the exchange rate of ISK fell like a stone. The currency lost 35% of its value against the Euro between January and September 2008, and the situation became even worse, when the problems of Icelandic banks were revealed (see Graph 11). 36

http://www.doksihu Graph 11: The movements of EUR/ISK exchange rate First the Central Bank attempted to peg the exchange rate to the Euro at 131 ISK/EUR, but they were unsuccessful in doing so. By 9 October, the exchange rate was already 340 ISK/EUR, when the trading of the currency was suspended, which was followed by the implementation of restrictions on the purchase of foreign currencies against the krona, at the same time the new regulation obliges every citizens to put any foreign exchanges they have to deposit at any of Iceland’s banks. From 15 October until 3 December, the Central Bank of Iceland implemented currency trade auctions in order to facilitate the trade of the national currency, while the trading of ISK was restarted on 28 October, at a significantly higher exchange rate (240 ISK/EUR) than that prevailing in the auctions (first auction’s exchange rate was 150 ISK/EUR). As a result of the auctions, the Central Bank’s foreign exchange reserves fell by $ 289

million during October 2008. Following the last auction on 3 December, the inter-bank market of Iceland was reopened with three participants, all of which was under governmental control. During the crisis, Iceland took a step it was not intending to do previously: it submitted its accession request to the EU. It became evident for the management of Iceland that a 37 http://www.doksihu country of this small size is exposed to the wobbling of economic cycles, and can only avoid that, if becomes a member of a large economic community. To summarize, I’d like to quote from one of The Economist’s articles, which was concerned with Icelandic crisis: “Iceland’s rapid rise and even faster fall has been viewed from afar as a parable of greed and hubris, in which a nation of farmers and fishermen borrowed too much and are paying the price. But that is to draw false comfort. Although Iceland represents an extreme case of a huge financial system towering over a small economy, other

states suffer from similar imbalances.” (The Economist, 2008) 5.2 Spillover to the EU - the EU’s efforts to handle the crisis Initially, European experts expected the crisis not to affect the EU. As we already know, they weren’t right. At the end of September 2008, the phasing in of the crisis started to become more and more observable, motivating the EU to address the problem at community level. To achieve this goal, starting from October 2008 EU members elaborated the regulatory framework of the necessary community-level and national measures in order to minimize the costs and negative effects of the financial turmoil. In this chapter I am going to provide an overview of the most important measures taken by the EU. During October 2008, numerous principles were elaborated with the intention of shaping the EU’s financial crisis management. First and foremost, the EU emphasized the importance of a community-level action plan (Az eurózóna vezetői Londonból vették a

megoldás ötletét, 2008), however later on this idea was supplemented by the comment saying that each member state should choose the most appropriate way to address the problems. With regard to the difficulties of financial institutions, the European Committee eased the conditions under which governments can provide assistance to problematic banks. This easing included that governments can provide a guarantee on deposits for two years, as well as on inter-bank loans for five years, and – if necessary – governments can recapitalise banks; this way the EU is attempting to restore liquidity in financial 38 http://www.doksihu markets. Furthermore, the Committee proposed a liquidity injection to European banks, and the revision of the prevailing accounting standards14. Following the phasing in of the crisis numerous European banks faced liquidity problems, therefore many of them needed to be bailed out. This motivated EU legislators to publish a list of recommendations with regard

to the avoidance of gaining competitive advantage from taxpayers’ money. “Government support must be temporary, clearly defined, limited in scope and not based on nationality. Shareholders cannot benefit at the taxpayer’s expense, and banks should contribute to the cost of the assistance.” (Playing by the rules, 2008) During October 2008, a G20 meeting was held; where parties agreed on further principles with regard to promote the quick recovery from the economic downturn. They agreed on that protectionism should be abandoned; and the affected countries should take all the necessary actions to minimize the effects of the crisis. Participants agreed to help poorer countries, and expressed a desire that the international financial institutions and regulations should be reviewed. By 26 November 2008, the EU shaped its European Economic Recovery Plan, a € 200 billion stimulus package, the main aim of which is to provide a framework for EU member states to tackle the crisis. The

amount devoted to this plan represents approximately 1.5% of the EU’s GDP, and it comes from two parts: member states’ should devote 1.2% of their national GDP (altogether approximately € 170 billion), the remaining € 30 billion is financed by the EU and the European Investment Bank. The plan was approved on the 11-12 December 2008 European Council meeting in Brussels (A Bizottság 200 milliárdos terve, 2008). The plan allows Member States to temporarily exceed the 3% margin of budgetary deficit, but this easement can only be in justified cases and of a reasonable excess. Any time a member state utilizes this opportunity, the EU prepares a report about the situation. Within the framework of the plan, the European Council supports various initiatives with regard to the boost of the EU economy. These initiatives include the support of 14 According to the proposal the so called mark to market technique should be suspended periodically. In the mark to market system assets are

valued more often (daily) at market prices. Eg: In case of futures clearing houses value assets at the end of each day, and either credit the profit or debit the loss on clients’ accounts. (MNB Jegybanki Szótár, 2009) 39 http://www.doksihu small- and medium sized enterprises, investments made into renewable energy sources, clean transport, support to the European automotive industry; simplification of procedures and faster implementation of programmes financed by the Cohesion Fund, Structural Fund and the European Agricultural Fund for Rural Development to boost investments in infrastructure and in energy efficiency. Further fields are the development of infrastructure (broadband internet), support employment with special attention to small enterprises, and encourage labour force mobility (11 and 12 December 2008 Presidency Conclusions, 2009). As regards the process of crisis management, the EU is willing to approve any national initiative within 24 hours, provided that it is

non-discriminatory with regard to the other Member States. “In addition to the non-discriminatory principle, the guidelines also require that banks receiving state support should cover "at least a significant part of the cost of assistance granted" and pay "an adequate remuneration" for the money received” (EU eases state aid rules for national rescue plans, 2008). As the car industry (and its suppliers) is providing jobs to millions of people, the proper functioning of the industry is of high significance. For this reason, the EU has established the CARS 21 process, which is a new partnership among industry, trade unions and Member States, designed to accompany the common crisis response. The Temporary Framework for State aid measures is established with the intention of allowing governments to provide aids to car makers facing difficulties as a result of the crisis. European Investment Bank allocates € 68 billion to address the problems of the car industry

(EU support to fight the crisis in the automotive sector, 2009). As the EU’s main goal is to revitalize money markets, it addresses the treatment of banks’ impaired assets (impaired assets include every kind of assets generating losses for financial institutions). Main objective is to restore confidence among money market participants so that lending, the “engine” of the economy would restart. To achieve this goal, the EU has set the principles of the treatment of impaired assets. These principles put emphasis on transparency; on the proper identification and valuation (at real economic value) of eligible assets; on burden-sharing of the costs related to impaired asset between the shareholders, the creditors and the State; on adequate remuneration of the state (at least equivalent to the remuneration of the state capital); on the coverage of losses resulting from the valuation at real economic value; motivation of banks to 40 http://www.doksihu participate in the programme

and appropriate restructuring followed by an assessment. Member States are free to choose the way they are intending to treat impaired assets; it can be either asset purchase, insurance, swap, guarantee or hybrid models (State aid: Commission provides guidance for the treatment of impaired assets in the EU banking sector, 2009). Since the crisis started off from the structured finance products’ market, the EU puts large emphasis on the reform of both the regulation of these products and the supervision of the financial institutions. In order to ensure macro-financial stability, a new body will be established: the European Systemic Risk Council (ESRC), the main duties of which should be continuous collection and analysis of macro-financial data, and the issuance of warnings and recommendations. Besides this, national supervisory authorities will be complemented by a European System of Financial Supervision, which would grant more power to the existing three committees: CEBS15, CESR16,

and CEIOPS17 (Ministers and Governors agree on principles for financial supervision reform, 2009). The latter measure would be carried out in two steps: in 2009 and 2010 preparations are to be made, and in 2011 and 2012 the elaboration of its legal system (Összefoglaló a „The High-Level Group on Financial Supervision in the EU” (De Larosiere Bizottság) 2009. február 25-én megjelent jelentéséről, 2009) The main idea of these new measures concerning supervision is to restore confidence and establish a financial environment in which the quality and intensity of supervision is improved and coordinated at EU level. To achieve this goal ESRC will be cooperation with national central banks and supervisory authorities will be strengthened. Besides the institutional changes, EU legislators emphasized the importance of strengthening the independence of the supervisory system as well as the harmonization of national standards in order to achieve financial stability (Ministers and

Governors agree on principles for financial supervision reform, 2009). Besides regulatory changes, the EU has provided financial assistance in numerous cases in cooperation with international organizations like International Monetary Fund (e.g in case of Hungary, Serbia, Armenia, etc.), World Bank or other member states within the EU. The objective of the assistances provided to the needy countries has always been to 15 Committee of European Banking Supervisors Committee of European Securities Regulators 17 Committee of European Insurance and Occupational Pensions Supervisors 16 41 http://www.doksihu help them to carry out reforms in order to stabilize their economies and to cushion the effects of the current economic crisis. Table 4 on the next page summarizes the series of financial assistances provided to different countries. Following the perception of the financial markets’ slowdown, as we could see, the Fed started to cut its base rate to increase the amount of money in

the market. The management of the European Central Bank reacted in the same way, and starting from October 2008, it gradually cut the interest rate of the main refinancing operations, as a result of which the interest rate on main refinancing operations was lowered to 1.00% (in effect from 13 May 2009), and the rates on marginal lending facility and deposit facility were lowered to 1.75% and 025% respectively Graph 12: European Central Bank Key Interest Rates (Source: BBC) Concerning the graph depicting the interest rate changes, I would like to mention that starting from 15 October 2008; the weekly main refinancing operations are carried out through a fixed rate tender procedure with full allotment at the interest rate on the main refinancing operation. Furthermore, as of 9 October, the ECB reduced the corridor of standing facilities from 200 basis points to 100 basis points around the interest rate on the main refinancing operation (Monthly Bulletin September 2009 Annex I, 2009).

42 http://www.doksihu Table 4: Financial aids provided by the EU 18 Country Amount of EU assistance Hungary € 6.5 billion Latvia € 3.1 billion Romania € 5 billion Serbia* Armenia* € 200 million € 65 million Georgia* € 46 million Ukraine* € 500 million Bosnia and Herzegovina* € 100 million Note It is complemented by the IMF (€ 12.5 billion) and by the World Bank (€ 1 billion). Its aim is to help stabilize the Hungarian economy and restore investor confidence It is a part of a multilateral assistance package amounting to € 7.5 billion19 It is complemented by the IMF (€ 13 billion) by the World Bank (€ 1 billion), by the EBRD and other creditors (€ 1 billion). The proposed assistance comes on top of the EU budget support in the form of €100 million in grants agreed in August under the IPA – Instrument of PreAccession programme. The € 65 million loan together with the € 35 million grant support the adjustment programme agreed

between Armenia and IMF. The € 46 million grant is a part of an EU package of up to €500 million to support Georgias economic recovery I following the conflict with Russia, and will support the adjustment programme agreed with the IMF. The assistance supports, and is conditional on the respect of the adjustment programme agreed between Ukraine and the IMF. The loan of € 100 million supports, and is conditional on the respect of the adjustment programme agreed between Bosnia and Herzegovina and the IMF. Source: European Commission – Economic and Financial Affairs (Financial Operations and Instruments, 2009) 18 Assistance of the countries marked by * are only proposals for the time being, and are to be carried out within the framework of the macro-financial assistance programme. 19 € 7.5 billion is a sum of assistances from the EU (€ 31 billion), IMF (€ 17), the Nordic Countries (Sweden, Denmark, Finland, Norway and Estonia – altogether € 1.7 billion, the World Bank

(€ 04 billion), EBRD, Czech Republic and Poland (together € 0.4 billion) 43 http://www.doksihu 5.3 Why is Hungary more heavily affected than the Eurozone members? – Hungary’s economic situation As the subprime mortgage crisis developed into a global financial turmoil, and reached Europe, Hungary became affected by it as well. In this chapter I am going to provide an overview of the Hungarian economic situation with the aim of answering the question asked in the title: why is Hungary more heavily affected than the Eurozone members. The problems of Hungary stem from various sources. As it is communicated by the current government’s one-year crisis-management plan, the three most important factors which contributed to the worsening of the country’s judgement are the high public debt, low growth rates and the lack of confidence towards the country. These three components were exaggerated by the current economic crisis (especially after the collapse of Iceland), and

created a situation where the government had to stop postponing the necessary reforms. From the beginning of the 2000s, Hungary’s public debt had been growing, by the end of 2007 it was 65.9%, and by the end of 2008 it grew to 73% of the national GDP (MNB: az államadósság a GDP 73 százaléka volt tavaly , 2009). The continuous growth of the deficit is attributable to the size and the structure of the budget: the Hungarian social and public expenditures are significantly higher than that of the neighbouring countries’ average. Because of the size of the state, the structure of redistribution and the lack of reforms, the country has been on a low-growth path. Also as a result of the size of public sector, tax levies are high, which has a negative effect on productivity as well as on competitiveness, meanwhile the low employment level coupled with the high rate of dark economy comprises further impediments to growth. Budgetary problems and the political instability together

contributed to the decrease of confidence towards Hungary, which became extremely severe following the collapse of Iceland from October 2008. Before the events of last autumn Hungary had been the objective of investors looking for higher yields, since the Hungarian base rate has been kept high by the Central Bank of Hungary (see graph 10) with the aim of achieving its primary objective: price stability. 44 http://www.doksihu Graph 13: Hungarian Base Rate (Source: Mti-eco) However the country was recognized as relatively risky, the high interest rates (compared to developed countries) a high demand for Hungarian Forint (HUF) in the previous years: amid the abundance of liquidity in the international money markets, risks were hardly taken into consideration. As long as this positive atmosphere was prevailing in global markets, the demand for the national currency was continuous; therefore the Forint remained relatively strong (see Graph 14 on the next page). When the risk appetite

of foreign investors started to decline, they started to withdraw their money from the Hungarian market: they sold their Hungarian assets. This process began after the collapse of Lehman Brothers, and accelerated after the bankruptcy of Iceland, when risks were revaluated, and investors started to get rid of their risky assets. This suddenly resulted in a downward pressure on the Forint’s exchange rate, because the supply of Forint denominated assets increased considerably, and there was practically no demand for them, which weakened the Hungarian currency. Following the collapse of Lehman Brothers a confidence crisis emerged, which resulted in the drying up of interbank markets. This phenomenon meant that banks operating in Hungary could hardly get any financing from foreign sources. 45 http://www.doksihu Graph 14 Exchange rate movements of the Forint against the Euro from January 2007 to October 2009 (Source: Buda-Cash) As I was referring to it before, Hungary has a large

public debt, a high external debt (45% of GDP) and a high foreign net obligation (110% of GDP). On 9 October 2008 the crisis became extremely severe in Hungary: the FX swap market stopped functioning, and there was no demand for Hungarian government securities. On the very same day the CDS premium of Hungary soared above 600 basis points, i.e the financing of the government became more and more expensive. Practically the Hungarian money market broke down. These factors created a situation, in which the ability of Hungary to serve its foreign debt became doubtful not only in the long run, but in the medium- and short run as well. During October 2008 the exchange rate of the Forint started to depreciate significantly, and reached the 280 HUF/EUR rates, which – at least at those times – was considered to be extremely high. As we know today, it wasn’t so high: during March 2009, the Forint depreciated even further: 1 Euro cost more than 316 Hungarian Forints. This was the highest

exchange rate against the Euro, we have ever seen. 46 http://www.doksihu The extreme volatility of the exchange rate was rather problematic, since mortgages denominated in foreign currencies are very popular in Hungary (similarly to Iceland), because these loans have lower interest rates. Numerous borrowers got into a inconvenient situation, since monthly payments of these loans grew significantly, because of the depreciation of the Forint. Besides financial and exchange rate problems, the country has to face another difficulty: the slowing economic growth of the EU has a negative impact on Hungarian economic performance as well, because Hungary has a small, opened, export-oriented economy. More than 80% of all exports are oriented to the EU, i.e the declining demand in the EU lowers the demand for Hungarian export products, which results in the fallback of the national GDP. This implies that the Hungarian economy cannot recover from recession as long as EU has not recovered (see

Graph 15). Graph 15: Hungarian vs. EU GDP growth (2009-2011 data are forecasts) (Source: Eurostat) The declining GDP, the increasing costs of financing the public debt and the lack of confidence towards the country created such problems, the solution of which could not be postponed. Realising this, the Hungarian government and the Central Bank of Hungary had to take series of steps to prevent the worsening of the situation. 47 http://www.doksihu 5.4 Management of the crisis in Hungary 5.41 Monetary tightening and gradual easing20 The main objective of the Central Bank of Hungary (MNB) is to achieve price stability, i.e to curb inflation In order to achieve price stability, the base rate has been kept high (see Graph 13 on page 39), which made the Forint become relatively stable against the Euro. Prior to the phasing-in of the crisis, the base rate was standing at 85% (between 28 April and 22 October 2008), which was quite high, compared to the neighbouring countries’ rates,

but it was deemed to be necessary to protect price stability. As we could see from the exchange rate graph, the Forint was relatively stable against the Euro; furthermore, it appreciated from February to July 2008, and remained strong until the end of September 2008. We have to add that the exchange rate movements of the Hungarian Forint are largely influenced by the international business atmosphere, which was positive in the above mentioned period. By October 2008, the crisis had already hit Hungary, which manifested in the form of the depreciation of the Forint, money market disturbances, etc. The “larger than fundamentally justified downward pressure” (Negyedéves Jelentés 2009. január 15, 2009, p. 4) on the exchange rate of the Forint motivated the MNB to intervene: on 22 October 2008, the Monetary Council decided to raise the base rate by 300 basis points to 11.5% (22 October 2008), with the aim of preventing further falls in the exchange rate and making the speculation

against the Forint more expensive. It is interesting to compare the Hungarian base rate to any of the Western countries, since most countries were following the policy of cutting interest rate to make money “cheaper”, and as such, to contribute to the maintenance of liquidity in the market. In contrast to this, the Monetary Council decided to do the opposite in the defence of the currency, and the economy. As it was communicated by the MNB, they managed to defend the Forint from speculative attacks. To some extent, there could have been an attack against the national currency, but in my opinion the depreciation of the Forint was rather a natural phenomenon: any time the demand for a product decreases; its price tends to decrease as well. In the given 20 This chapter is based on the quarterly reports issued by the MNB. 48 http://www.doksihu situation, Forint can be regarded as the “product”: as I wrote in the previous chapter, amid the confidence crisis, investors tried to

sell all their Forint-denominated assets, which meant that the supply was high, but the demand for it was practically zero. If we have a look at Graph 16 on the next page, we can see that the Forint did not start to appreciate immediately following the increase of the base rate, it began only later and temporarily, together with the other currencies in the region. Following the easing of the downward pressure on the Forint’s exchange rate, MNB started to cut the base rate gradually (see Graph 13 on page 39), and communicated to the public that it is intending to continue this practice as long as the perspectives of financial stability and the continuity of capital flows allow it. Besides the gradual decrease of the base rate, starting from 1 December 2008, the MNB decreased the rate of reserve requirements from 5% to 2%, with the aim of increasing Forint liquidity in the market. Furthermore, the MNB extended the range of acceptable collaterals to bonds issued by local municipalities

denominated either in Forint, Euro or Swiss Frank (20 February 2009). The motivation of this action was that the Central Bank wanted to ensure that there is no impediment to the satisfaction of the increased demand for loans, because of the lack of appropriate collaterals. 49 http://www.doksihu Graph 16 Exchange rate movements of the Forint, the Czech Korona and the Polish Zoloty against the Euro from mid-June 2008 to January 2009. The vertical red line represents 22 October 2008, the day of the 300 points increase in the Hungarian base rate (Source: Buda-Cash) 5.42 Maintenance of the liquidity21 On the same day with the 300 basis point increase in the base rate, a series of negotiations began, which resulted in a € 20 billion stand-by loan to Hungary. This amount was provided by the European Union, the International Monetary Fund (IMF) and the World Bank. Its aim was to provide Hungary with the ability to prevent further serious distortions, because this stand-by loan

contributed to the increase the foreign exchange reserves of the Central Bank and at the same time made it possible to serve of the public debt even under the most severe economic conditions. The loan managed to achieve its objective: the exchange rate was stabilized (permanently; see Graph 13 above). 21 This chapter is based on the quarterly reports issued by the MNB (Q2, Q3, and Q4 2008; Q1, Q2 and Q3 2009) 50 http://www.doksihu Prior to the application for the loan, MNB introduced FX-swap quick tender to increase liquidity of the Forint and the Euro (it was abolished on 18 May 2009 due to the low participation and the favourable developments in the market). The Central Bank also struck an agreement with the European Central Bank, as a result of which they introduced a one-day FX-swap availability to increase Euro liquidity. Also in October, the MNB agreed to strengthen the demand side of the government securities’ market. Following the events of October 2008, the Central Bank

paid special attention to the maintenance of liquidity; therefore it introduced further tenders aimed at achieving this goal. These measures are summarised in Table 6 below Table 6 EUR/CHF foreign 28 January 2009 exchange swap agreement Increase Foreign exchange with the Central Bank of liquidity Switzerland Introduction EUR/HUF 2 March 2009 9 March 2009 FX-swap tender with 6 Decrease the possible month maturity disturbances as a result of Introduction EUR/HUF ease tensions in corporate FX-swap tender with 3 month maturity the low level of liquidity; lending. 5.43 Fiscal tightening (from the appointment of Mr Bajnai on) Following the resignation of Mr. Ferenc Gyurcsány, the prime minister of Hungary between 2004 and 2009, Mr. Gordon Bajnai was appointed to Prime Minister on 14 April 2009. He is leading a so called “crisis management” government As it is declared by the members of the government, they are not working for gaining popularity, but they want to make all

the necessary steps to stabilize the Hungarian economy and to set it on a path of growth. 51 http://www.doksihu Since his appointment, the government managed to pass a series of reforms, which are recognized and appreciated by the EU as well as by other international organizations. The measures taken are focusing on the decrease of the budget deficit and the public debt, and at the same time to save jobs, families and small enterprises from the effects of the crisis. The “crisis management” government has been in office for more than half a year, during this time, it managed to carry out the following measures: It approved a package, which is designed to decrease public spending by HUF 1300 billion within two years. To achieve this improvement, the package contains the following elements: o The members of the current government get a salary decreased by 15%. o The government asked the leaders of the public companies to devote the portion of their monthly gross salaries which is

above HUF 2 million to the Crisis Fund aimed at helping needy people. o Decrease of foreign per diems. o 50% decrease of costs associated with the public companies’ boards of directors and supervisory board memberships. o Abolished the jubilee prizes for prime minister, ministers and undersecretaries. o Public salaries are fixed for two years, and 13th month benefits are abolished. In the social sphere, the government fixed the amounts of family allowance for two years, and it maximises the time allowed for the children nursing in two years. The government decided about the gradual increase of retrial age to 65 years, and abolished the 13th month pensions. The income tax system has been revised as well: from 2009 on, upper limit of the lower tax bracket is HUF 1.9 million; from 2011 the lower tax bracket will impose a 17% tax on people and its upper limit will be set at HUF 15 million, while the upper tax bracket will represent a 32% tax burden (compared to the current 18% and 36%,

respectively). 52 http://www.doksihu A real estate tax will be introduced from 2010, together with the increase of excise duties on gasoline and tobacco and the imposition of further taxes on luxury items (cars, boats, airplanes). Besides these measures the government is addressing the problems of vocational training and the maintenance of the current level of employment. Further measures are taken in numerous other fields as well, like tourism, agriculture, automotive industry, logistics and construction. These measures are aiming to improve the employment in these sectors and their competitiveness internationally. 53 http://www.doksihu 6. A PRACTICAL PROBLEM: THE INCREASED IMPORTANCE OF HEDGING 6.1 Introduction I accomplished my 20 week-long internship at Buda-Cash ZRt., a Hungarian brokerage company. During this period I had the opportunity to get familiar with the operation of the company, with the products it offers, and to some extent with the clients of the company as

well. I have also followed the movements of stock exchanges and foreign exchanges, as well as the trading in various types of products. As the current financial and economic crisis reached Hungary, the exchange rate of the Hungarian Forint became rather volatile, causing a lot of problems for those companies, which are doing business on an international level, i.e they have either incomes or costs in Euro, Dollar, or any other foreign exchange. Since the level of financial education in Hungary is lower than in Western European countries, most of small and medium-sized enterprises (SME) cannot handle this volatility of exchange rates; therefore it potentially causes a lot of problems for them. My idea is that Buda-Cash could contact a bunch of SMEs, which are doing (at least part of their) business internationally (e.g: procurement of raw materials, import, export, etc.), and make a investigation if they have encountered problems as a result of exchange rate volatility, and if they

did, how did they treat those problems, if they did handle it at all. Those companies, which had problems stemming from exchange rate fluctuations, and haven’t handled it yet, can be regarded as potential new clients to Buda-Cash. The objective of the report is to find out if there is a demand for the services offered by Buda-Cash for the prevention of financial problems stemming from exchange rate fluctuations. I think that it is worthwhile to deal with this question, since it could be useful for both SMEs and Buda-Cash as well. SMEs could calculate with fixed 54 http://www.doksihu costs/incomes, while Buda-Cash could gain extra turnover by extending its business contacts. In the following pages of the report I am going to introduce how hedging works, and what kind of benefits can it provide to SMEs, then I am going to provide information on the results of the telephone interviews we have made with SMEs to gather information about the demand for Buda-Cash’s services. In the

conclusion part I am going to summarize my findings, and after that I am going to give recommendations based on my findings. During the preparation of the report, I did not manage to gather data neither about the turnover of Buda-Cash nor about the exposure of the contacted companies to exchange rate fluctuations (i.e I do not have quantitative data about it) Furthermore, the telephone interviews were made with SMEs located in Székesfehérvár (or close to it), which is my hometown. For this reason, the results cannot be regarded as representative for the whole country, they are only typical of that location, but I have to add, that the results of a country-wide research would generate approximately the same results. 6.2 Company Profile Buda-Cash ZRt. is a brokerage company situated in Budapest, Hungary The company has been in operation since May 1995, and has been the member of the Budapest Stock Exchange since then. Buda-Cash was founded with a registered capital of HUF 50

million By 1996 the company’s capital grew to HUF 143 million, and its balance sheet footing was tripled. From 1997 on, the company has been functioning as a company limited by shares. Buda-Cash is a provider of various kinds of investment facilities ranging from stocks (both domestic and international markets), to options, warrants, and currencies; but it is mainly concentrating on presence in the stock markets. In the recent years the services offered by the firm have been supplemented by an online trading facility. The company has been showing a tendency of growth since its foundation, both in terms of company size and turnover even in the years of 1997 and 1998, when markets were contracting. Buda-Cash is currently operating 12 subsidiaries country-wide and is planning to 55 http://www.doksihu expand its business to Central Eastern Europe (the first subsidiary was opened in Bratislava in February 2008). As regards the market positions of Buda-Cash, it is among the leading

investment companies of Hungary, especially in terms of futures trade, whereas it handled the largest turnover in 2006. Considering total stock exchange turnover, the company was ranked 7 th in 2006 6.3 Description of the existing situation 6.31 An overview of the Hungarian economic situation The current financial and economic crisis, which has extended from the U.S subprime mortgage crisis to a global turmoil, is affecting Hungary more severely than it affects other more developed European countries. The reason for this worse situation comes from numerous sources, like political instability, high social and public expenditures, continuously maintained budget deficit and growing public debt. These factors together with the low potential growth rate of the country resulted in the lack of confidence towards the country. Before the eruption of the crisis, Hungary has been an attractive place for financial investments, since the Central Bank of Hungary kept the Hungarian base rate high

compared to the base rates of other central banks, therefore the demand for Forintdenominated assets was high, which means that there was a continuous demand for the Hungarian currency, i.e its exchange rate was relatively stable This situation changed all of a sudden, when the confidence crisis generated by the shocking news about the developments in the U.S financial market has phased in to Europe and to Hungary The worst hit came after the collapse of Lehman Brothers, the 4th largest investment bank in the United States. This event gave a further impetus to the exaggeration of the confidence crisis, which had severe implications for countries regarded as risky: as the confidence evaporated from the money markets, investors started to revaluate risks, and suddenly started to get rid of their assets in markets regarded as risky (e.g Hungary) The lack of confidence manifested in the form of a sudden downward pressure on the exchange rate of the Hungarian Forint against all major

foreign exchanges (e.g Euro, 56 http://www.doksihu American Dollar) as the confidence crisis has hit the country. As a result of the vulnerability of the Hungarian economy, the exchange rate of the Hungarian currency became rather volatile. While the Forint was relatively strong during 2007 and was appreciating until July 2008; it started to depreciate from October 2008, and reached its lowest value against the Euro in March, 2009 (see Graph 14 on page 40). The suddenly increased volatility was regarded by the Central Bank of Hungary as a result of speculative attacks from foreign investors, which is partly true, but from another perspective, it can be regarded as a natural phenomenon: as the demand for any product decreases, its price tends to decrease as well. In the current situation the Forint is to be regarded as the “product”: as investors were withdrawing from the Hungarian market, the demand for Forint decreased significantly, which resulted in the depreciation of the

currency. To prevent the fluctuations of the exchange rate the Central Bank of Hungary and the Hungarian government have taken numerous measures. These measures contributed to a gradual appreciation of the Forint, and to the decrease of the risks associated with the country, this way the recent movements of the exchange rate have been relatively narrow. Although the government has made significant efforts to stabilize the economy, we should note, that the movements of the Forint’s exchange rate are still largely influenced by the international market sentiments, since Hungary is a small and opened economy. For these reasons, it is possible that the volatility of the Forint will increase again in the future. In some cases however, it is not the news about the Hungarian economy, but the news about any other country in the region (Czech Republic, Poland, Latvia, Ukraine, etc.) that triggers the exchange rate fluctuations 6.32 A few words about the financial culture in Hungary In Hungary

the average level of economic and financial education is low, compared to that of Western countries. As a survey on the financial culture of the 14-17 and 18-30 years old population showed, only 40% of borrowers inquired about the conditions and fees associated with the loans, and only 25% of borrowers studied thoroughly the conditions of the loans. Even more undesirable is the fact that 10% of the interviewed people said that they compare only the main features of the banking products, since they 57 http://www.doksihu are more or less the same, and 8% of the interviewees did not look up the conditions and fees at all (Pénzügyi kultúra fejlesztése (Development of Financial Culture), 2006). The survey revealed similarly low levels of knowledge of pension funds, the use of bank- and credit cards, and about terms related to financial products. The Central Bank of Hungary (MNB) is putting emphasis on the improvement of the financial culture, but it is still lagging behind the

Western European standards. The lack of education generates numerous problems, e.g many people undertake such loans, which they actually cannot pay back, the overwhelming majority of Hungarian citizens do not have any kind of investment (Gfk: a magyar lakosság 72 százalékának nincs befektetése, 2009), many people have a negative attitude towards financial issues etc. Given this data I tend to think that small- and medium sized enterprises (SME) are somewhat in the same situation. In many cases, Hungarian SMEs do not have either the opportunity (lack of appropriate financial background) or the intention to hire a professional financial expert; therefore the management of finances is assigned to an employee who already has other duties as well and has no financial qualification, i.e this person can be regarded as a person with an average knowledge of finances, the level of which is – as I wrote it before – far from desirable. The lack of financial qualification can be especially

problematic in the case of those SMEs, which are doing business at an international level, e.g: they procure raw materials from abroad, import or export goods, etc. These companies are encountering the effects of exchange rate movements, which may have positive and negative effects as well, because it may induce the increase of revenues, but it may increase the expenditures as well. In case of the dramatic increase of expenditures the volatility of the exchange rate may cause the bankruptcy of the companies, therefore I think it is really worthwhile to investigate the opportunities of these companies to cope with this problem. 6.33 A practical example of the problem In order to demonstrate the up-to-timeliness of this problem, I would like to mention the case of Lenti Olajipari Gépgyártó ZRt. (LOG) The company has been a producer of oil industry machines for more than 10 years, and had been the most successful Hungarian company within its field. The company was previously a supplier

of MOL and the 58 http://www.doksihu nuclear power station of Paks, and it exported its products to the USA, Russia, and to oil-producing Arabic countries. 70 percent of the company’s income stemmed from the USA; therefore it gained its incomes in U.S Dollars (USD) The average turnover of the company was approximately HUF 1 billion, and the net profit was around HUF 30-50 million starting from 2001. The first shock hit the company in 2004, when as a result of the depreciation of the USD, their income shrunk by 30%. This was followed by further exchange rate fluctuations in the past two years, which, together with the lack of new financing facilities lead to the collapse of the enterprise (Elintézte a forint a Lenti Olajipari Gépgyártót, 2009). I think that this example shows the importance of managing the effects of exchange rate movements. If such a successful company went bankrupt, then it is obvious that any other could be a victim of exchange rate volatility. For this

reason, my idea was that Buda-Cash could contact SMEs, offering hedging, an effective solution for the problems stemming from the volatility of the Forint, with the aim of making their cash flows more predictable. Virtually every company which is making at least part of its business internationally can be a potential new client to Buda-Cash. These new relationships would be beneficial both for SMEs and for Buda-Cash. SMEs could calculate with fixed sums, when they are planning their budgets based on their receivables, or payables denominated in foreign currencies; meanwhile Buda-Cash could gain some extra turnover by making little efforts, since the company is a provider of various financial products, including futures and options, which are the two most commonly used transactions to eliminate the effects of exchange rate fluctuations. 6.34 How to eliminate the effects of exchange rate fluctuations? There are numerous products offered by banks and financial institutions for the

prevention of exchange rate fluctuations’ negative effects. In this chapter I am going to summarize the main features of futures and options, as these are the two most common alternatives to address the problem. The descriptions below do not contain every single detail of the transactions, my intention is to demonstrate, how they can contribute to the protection of SMEs. 59 http://www.doksihu Futures A futures contract is a standardized agreement between two parties, obligating the buyer to buy or the seller to sell an asset at a specified time in a specified quality and quantity. It is widely used by hedgers to hedge their positions either in the stock or in the commodity market. Let’s suppose: we know that we will have to pay a considerable sum in Euros in 90 days. If we expect the Forint to depreciate against the Euro (ie One Euro will cost more Forints), then we should buy futures contract to purchase Euros in 90 days; this way we can lock in the exchange rate, thus the

costs in Euros will become a calculable sum in Forint. In another case, if we have receivables in Euro, but our company has expenditures in Hungarian Forint, and we expect the forint to appreciate against the Euro, it would mean that we will get less Forints for the same amount of Euros, which would be obviously unfavourable. To avoid this situation, we should open a futures position to sell Euro against Forint, thus we can fix the “price” of the Euros, which provides the opportunity to calculate with a fixed sum of Hungarian Forints. These were only simplified examples for the illustration of how futures contracts can be used for hedging purposes. It should not be forgotten the fact that the purchase of futures contracts has its fees and special conditions. There is a so called margin requirement, which is at least 1% of the transaction (or more, depending on the liquidity of the asset), which is required from the buyer. Furthermore, the contracts are marked to market, which means

that every futures contract is cancelled at the end of each day, and new contracts are issued at the current futures price. This is the so called daily settlement: the loss is debited, and the profit is credited on each party’s margin account. When the amount of money on the margin account falls below the so called maintenance margin, the investor will be hit with a margin call (i.e it has to provide extra money for the maintenance of the position). Clients also have to consider the transaction costs associated with hedging. Futures are embodying an obligation, which means that the buyer of the futures has to fulfill its obligation as regards the purchase or sale of the given asset. As a result of this, futures do not contribute to the increase of the company’s profit, but they are ensuring predictability, thus their proper application contributes to the increase of stability of the company. 60 http://www.doksihu Options In contrast to futures, options give the right, but not

the obligation to buy (Call option) or sell (Put option) an asset in a specified quantity at a specified price (strike price) within a given time period (American option) or at a given date (European option). Since it is not obligatory to use the option, it may contribute to the increase of profit: it provides protection against unfavourable price movements, but leaves the opportunity of realizing profit, if market conditions are making it possible. The drawback of this way of hedging positions is that the buyer of the option has to pay an option premium, which is a fixed and relatively high amount, and it is not given back either the purchaser of the option uses the option or not. The premium can only be reduced, if the purchase of the option is at a higher strike price, but in this case the option provides a lower level of protection. 6.4 Desired Situation Based on the telephone interviews made with the managers of numerous SMEs, BudaCash should develop a strategy, by the

application of which it could convince managers of the necessity of protection against exchange rate movements for the benefit of their enterprises. Following the successful negotiations with SMEs, Buda-Cash could solve their exchange rate related problems, which would generate extra turnover for BudaCash, as well as predictability to its new clients. As I mentioned in the Company Profile chapter, Buda-Cash carried out the largest futures trade in Hungary in 2006. By attracting SMEs as new clients, it could increase further its turnover, without making large investments, since it already has the infrastructure required to handle these kinds of transactions, the only necessary effort to be made is possibly the employment of some new staff, if necessary. I know that in the current situation most companies are more likely to reduce the number of their employees, but in this case I think that an extra employee in the Veszprém local office (which is handling the Veszprém and

Székesfehérvár location) would be reasonable to manage hedging transactions, since the growth of the turnover would probably cover the extra costs (depending on the number of new clients). 61 http://www.doksihu 6.5 Survey of demand for hedging As I mentioned in the introductory part, we chose randomly 124 small and mediumsized enterprises, which are located in Székesfehérvár, or close to it. Our intention was to find out if there is a demand for hedging services among these enterprises. To achieve our goal, we put together a questionnaire, which served as the basis of the telephone interviews. In this chapter I am going summarize the results of the interviews First we obviously introduced our company, if it was necessary, and in some cases, it was the moment when the interview was broken off, since the interviewee hung up as he/she had heard that an employee of a brokerage company wants to make an interview with him/her. During the 124 interviews, it happened 11 times,

which is almost ten percent of the sample. I would like to recall the results of MNB’s survey, which showed that there is a part of the population who is afraid of, or has a negative attitude towards financial issues; therefore their natural reaction to such an initiative is rejection. In these interviews we did not have even the chance to enquire about the effects of exchange rate fluctuations on the operations of the enterprise. Graph 17: Answers to Question 1 (Source: own survey) Most of the interviewees were paying attention to our short introduction, and was willing to answer our questions. First we were enquiring whether the interviewee’s company had ever been affected by exchange rate movements, either in the form of growing expenditures or declining incomes. As it can be seen from Graph 17 above, 50% was not affected, or not realized any changes in his/her company’s cash flows. 62 http://www.doksihu This relatively high rate of “Not affected” answers is most

probably the result of the fact that the enterprises we were interviewing were randomly chosen and this way many companies were taken into then sample, which have no international connections. This error could have been eliminated, if we had had a database of those companies, which are making business internationally. Those 51 persons, who answered that their companies were affected by the exchange rate volatility, were asked, whether they are interested in the protection of their cash flows. The results are shown in the graph below Graph 18: Answers to Question 2 (Source: own survey) As it can be seen from Graph 18, almost 70% of our interviewees were not interested in our offer to solve the problem of incalculable cash flows stemming from exchange rate fluctuations, and only 8% percent of them answered no, because their company had previously handled this problem. This high rate of unreceptive answers may be the result of the previously already discussed lack of financial

intelligence, which generates a distrust of financial institutions. We also enquired, in what way the exchange rate volatility affected their cash flows, and 76% of our respondents said that it manifested in the form of growing expenditures, resulting from importing activities. In numerous cases it was emphasized, that the cash flows affected by fluctuations are rather small in comparison to the turnover of the 63 http://www.doksihu company, and this is the reason why the management of some SMEs didn’t deem it necessary to treat this issue. Those 16 companies, which indicated that they would be interested in hedging, were given an overview about the available transactions to decrease risks. Later on, (if they demanded) they were provided all with all the necessary details of hedging techniques, including its conditions and fees within the framework of a personal meeting. Following these negotiations 5 of these companies has shown an interest in making such transactions in the

future; the rest of the interviewees have provided no information about their intentions as regards the services offered by Buda-Cash yet. 6.6 Conclusion of the problem As it could be seen from the results of the survey, there were hardly any companies which applied hedging techniques for the defence of their cash flows; therefore I would say that there is a potential market for hedging services among Hungarian SMEs, but there are some obstacles to be overcome. These obstacles are stemming from the low level of financial education, and the lack of trust towards financial institutions. In my opinion these problems are to be handled at a national level, and are already handled, but the results shown so far indicate that there is a lot more work to do. In my opinion it would be worthwhile to Buda-Cash to investigate more thoroughly this field, because it may provide numerous opportunities to increase its turnover in the following years. 6.7 Recommendations As I mentioned above, many

Hungarian people are having negative attitudes towards financial institutions, in many cases, managers of SMEs belong to this group as well. For this reason, I think that Buda-Cash should contact an association of SMEs, which has a direct contact to these companies, thus the leaders of these companies trust in these organizations; therefore they are probably more willing to take their advices than the advices of a complete stranger. This way the strategy could be more effective 64 http://www.doksihu In cooperation with this union, Buda-Cash should elaborate a series of presentations, in which its experts could attempt to persuade the leaders of SMEs to consider the importance of hedging. In these presentations the main emphasis should be put on security, which is highly appraised nowadays. 65 http://www.doksihu 7. CONCLUSION The favourable developments in the international economic relations during the recent years (i.e markets became more globalized) contributed largely to the

growth of several nations’ economics, and at the same time it caused difficulties for numerous countries, which are not able to stand the international competition. The current financial and economic crisis could be summarized as the result of the continuous pressure to increase profits and the cutthroat competition in the financial sector. Through securitization banks could provide their clients with cheaper loan as well as their depositors with safe yields. It was based on the Originate- and Distribute model (OAD), which, however, became distorted, since after a while it became focused on the increase of volume instead of keeping risks at a reasonable level. Following the considerable increase of the subprime mortgages’ volume, the model did not distribute the risk, but rather exacerbated it. (Király, Nagy, & Szabó E, Contagion and the beginning of the crisis - pre-Lehman period, 2008, p.38) The securitization process, and especially the structured finance products’

market was lack of proper regulation, therefore the conditions, under which this market could operate, were not specified. This lack of regulations led to increasing complexity and vagueness. The ignorance of potential risks implied by the innovations, together with the continuous growth of the structured finance products’ volume created a crisis, which was first deemed to be only a national economic problem of the USA, but later on it turned into a global financial and economic turmoil. Previous years’ globalization, which used to be useful for most economies, contributed largely to the quick expansion of the crisis: although it was “created” by the developed world, it has hit such countries as well, which hadn’t benefited from the temporary profits of the innovations, but they were affected by its negative impacts in several ways. The confidence crisis expanded throughout the whole world, as a result of which there have been financing problems all around the world. The

enormous losses and the increased uncertainty and instability required something, which was unprecedented in the previous years: the intervention of governments. It 66 http://www.doksihu could take either the form of nationalizations or financial assistance to problematic institutions, but without the intervening measures damages made by the crisis could have been much higher. The distortions induced by the crisis revealed the deficiencies of regulations, which drew along numerous reforms, aimed at establishing stricter and more up-to-date regulations and a more precise and coordinated supervision of market processes. All the regulative changes are aiming at one goal, namely the avoidance of a similar crisis in the future. From the perspective of Hungary, I would say that, however the crisis had really severe effects on the Hungarian economy, it had a positive effect as well: the political regime could not postpone the necessary budgetary reforms, thus according to EU and IMF

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