What if the Egyptian Pound was the Official Currency of the Suez Canal?

I know a lot of people who think that if Egypt changes the official currency of the Suez Canal to Egyptian Pounds, the EGP value would “increase” as the demand on the Egyptian currency would increase, and therefore would push its value higher. If you are one of them, then I apologize for bursting your bubble…that’s just not true!

Here’s why..
For simplicity, let’s analyze and compare the difference between Egypt’s income vs “expenses” from the balance of payments of the first quarter of 2011. Given Egypt’s current account deficit of 62% (meaning that we are paying out more USD than we are receiving) we can confidently simplify our analysis by using only the revenues from export and the Suez canal and the value of imports to portray the “cash flows” of the economy without affecting the “economic logic” behind our analysis. The following analysis is simplified to the logic behind economics.

The Suez Canal, Tourism and exports are the main sources of foreign currency (used to finance our necessary imports). Summing them all up, Egypt is still faced with a current account deficit of almost 60% (meaning that we are paying more than we are receiving/ consuming more than producing, etc).

The Suez Canal receipts in Q1 of 2011 totaled US$ 1.3 billion, while the value of Egyptian exports amounted to US$ 6.1 billion. This simply means that Egypt’s income of foreign currencies from both activities had totaled US$ 7.4 billion.
On the other hand, the value of Egypt’s imports stands at US$12.7 billion, or almost 1.8 times Egypt’s income.

Let’s assume that we DID change the official currency for the Suez Canal receipts into EGP. Knowing that for-ex rates are influenced by the market forces (supply and demand), we can assume that the value of the EGP would slightly increase due to the increased demand caused by the change of the official currency of the Suez canal…in this case, an extra demand of USD 1.3 billion. Now, we know that we buy our imports in USD, and we also know that our income in USD has decreased by USD 1.3 billion, and that we are also short by USD 6.6 billion (instead of only $5.3 billion which already pressures our EGP)

Assuming that the supply of USD is relatively infinite (or simply larger than that of the EGP) on the short run (for simplification) while the supply of EGP is fixed on the short run, when paying for our imports, we will be required to “buy” $6.6 billion instead of $5.3 billion (and sell EGP) to pay for our imports, and according to the laws of supply and demand, the value of the EGP would decrease accordingly.

So by changing the currency used at the Suez Canal in attempt to raise the value of our national currency, we will help accomplish exactly the opposite, and exert more pressure on the Egyptian pound.

Please feel free to criticize, ask questions or comment on the analysis. More thoughts about the issue would be treasured.

For reference, go to http://www.cbe.org.eg/public/Press_Release_for_BOP_July-September_FY_2010-11_EN.pdf

Clean Energy in Egypt

Click on the link below to view file.

Clean Energy in Egypt

The Egypt Crisis, the IMF and the “New Middle East”

The Egypt Crisis, the IMF and the “New Middle East”

Source:http://www.engdahl.oilgeopolitics.net/

Egypt’s Revolution-Creative Destruction For A ‘Greater Middle East’? by F. William Engdahl

Mohamed Bahaa: “It might be another conspiracy theory,but isn’t there 1% chance that it might be true? Would you risk it all just because you refused to read this? We freed Egypt from Mubarak, let’s not accept any type of foreing intervention. Let’s start thinking logically, lets think INDEPENDENTLY, not as masses. Sit alone and think things over by yourself. Don’t be a follower. Its not bad to be too suspicious when it comes to conspiracy theories. Just follow the logic, and be open to everything”

Egypt’s Revolution-Creative Destruction For A ‘Greater Middle East’? by F. William Engdahl

Fast on the heels of the regime change in Tunisia came a popular-based protest movement launched on January 25 against the entrenched order of Egypt’s Hosni Mubarak. Contrary to the carefully-cultivated impression that the Obama Administration is trying to retain the present regime of Mubarak, Washington in fact is orchestrating the Egyptian as well as other regional regime changes from Syria to Yemen to Jordan and well beyond in a process some refer to as “creative destruction.”
The template for such covert regime change has been developed by the Pentagon, US intelligence agencies and various think-tanks such as RAND Corporation over decades, beginning with the May 1968 destabilization of the de Gaulle presidency in France. This is the first time since the US-backed regime changes in Eastern Europe some two decades back that Washington has initiated simultaneous operations in many countries in a region. It is a strategy born of a certain desperation and one not without significant risk for the Pentagon and for the long-term Wall Street agenda. What the outcome will be for the peoples of the region and for the world is as yet unclear.
Yet while the ultimate outcome of defiant street protests in Cairo and across Egypt and the Islamic world remains unclear, the broad outlines of a US covert strategy are already clear.

No one can dispute the genuine grievances motivating millions to take to the streets at risk of life. No one can defend atrocities of the Mubarak regime and its torture and repression of dissent. No one can dispute the explosive rise in food prices as Chicago and Wall Street commodity speculators, and the conversion of American farmland to the insane cultivation of corn for ethanol fuel drive grain prices through the roof. Egypt is the world’s largest wheat importer, much of it from the USA. Chicago wheat futures rose by a staggering 74% between June and November 2010 leading to an Egyptian food price inflation of some 30% despite government subsidies.

What is widely ignored in the CNN and BBC and other Western media coverage of the Egypt events is the fact that whatever his excesses at home, Egypt’s Mubarak represented a major obstacle within the region to the larger US agenda.
To say relations between Obama and Mubarak were ice cold from the outset would be no exaggeration. Mubarak was staunchly opposed to Obama policies on Iran and how to deal with its nuclear program, on Obama policies towards the Persian Gulf states, to Syria and to Lebanon as well as to the Palestinians.[1] He was a formidable thorn in the larger Washington agenda for the entire region, Washington’s Greater Middle East Project, more recently redubbed the milder-sounding “New Middle East.”

As real as the factors are that are driving millions into the streets across North Africa and the Middle East, what cannot be ignored is the fact that Washington is deciding the timing and as they see it, trying to shape the ultimate outcome of comprehensive regime change destabilizations across the Islamic world. The day of the remarkably well-coordinated popular demonstrations demanding Mubarak step down, key members of the Egyptian military command including Chief of General Staff Lt. Gen. Sami Hafez Enan were all in Washington as guests of the Pentagon. That conveniently neutralized the decisive force of the Army to stop the anti-Mubarak protests from growing in the critical early days.[2]

The strategy had been in various State Department and Pentagon files since at least a decade or longer. After George W. Bush declared a War on Terror in 2001 it was called the Greater Middle East Project. Today it is known as the less threatening-sounding “New Middle East” project. It is a strategy to break open the states of the region from Morocco to Afghanistan, the region defined by David Rockefeller’s friend Samuel Huntington in his infamous Clash of Civilizations essay in Foreign Affairs.

Egypt rising?

The current Pentagon scenario for Egypt reads like a Cecil B. DeMille Hollywood spectacular, only this one with a cast of millions of Twitter-savvy well-trained youth, networks of Muslim Brotherhood operatives, working with a US-trained military. In the starring role of the new production at the moment is none other than a Nobel Peace Prize winner who conveniently appears to pull all the threads of opposition to the ancien regime into what appears as a seamless transition into a New Egypt under a self-proclaimed liberal democratic revolution.
Some background on the actors on the ground is useful before looking at what Washington’s long-term strategic plan might be for the Islamic world from North Africa to the Persian Gulf and ultimately into the Islamic populations of Central Asia, to the borders of China and Russia.
Washington ‘soft’ revolutions
The protests that led to the abrupt firing of the entire Egyptian government by President Mubarak on the heels of the panicked flight of Tunisia’s Ben Ali into a Saudi exile are not at all as “spontaneous” as the Obama White House, Clinton State Department or CNN, BBC and other major media in the West make them to be.
They are being organized in a Ukrainian-style high-tech electronic fashion with large internet-linked networks of youth tied to Mohammed ElBaradei and the banned and murky secret Muslim Brotherhood, whose links to British and American intelligence and freemasonry are widely reported.[3]
At this point the anti-Mubarak movement looks like anything but a threat to US influence in the region, quite the opposite. It has all the footprints of another US-backed regime change along the model of the 2003-2004 Color Revolutions in Georgia and Ukraine and the failed Green Revolution against Iran’s Ahmedinejad in 2009.
The call for an Egyptian general strike and a January 25 Day of Anger that sparked the mass protests demanding Mubarak resign was issued by a Facebook-based organization calling itself the April 6 Movement. The protests were so substantial and well-organized that it forced Mubarak to ask his cabinet to resign and appoint a new vice president, Gen. Omar Suleiman, former Minister of Intelligence.
April 6 is headed by one Ahmed Maher Ibrahim, a 29-year-old civil engineer, who set up the Facebook site to support a workers’ call for a strike on April 6, 2008.
According to a New York Times account from 2009, some 800,000 Egyptians, most youth, were already then Facebook or Twitter members. In an interview with the Washington-based Carnegie Endowment, April 6 Movement head Maher stated, “Being the first youth movement in Egypt to use internet-based modes of communication like Facebook and Twitter, we aim to promote democracy by encouraging public involvement in the political process.” [4]
Maher also announced that his April 6 Movement backs former UN International Atomic Energy Aagency (IAEA) head and declared Egyptian Presidential candidate, ElBaradei along with ElBaradei’s National Association for Change (NAC) coalition. The NAC includes among others George Ishak, a leader in Kefaya Movement, and Mohamed Saad El-Katatni, president of the parliamentary bloc of the controversial Ikhwan or Muslim Brotherhood.[5]
Today Kefaya is at the center of the unfolding Egyptian events. Not far in the background is the more discreet Muslim Brotherhood.
ElBaradei at this point is being projected as the central figure in a future Egyptian parliamentary democratic change. Curiously, though he has not lived in Egypt for the past thirty years, he has won the backing of every imaginable part of the Eyptian political spectrum from communists to Muslim Brotherhood to Kefaya and April 6 young activists.[6] Judging from the calm demeanour ElBaradei presents these days to CNN interviewers, he also likely has the backing of leading Egyptian generals opposed to the Mubarak rule for whatever reasons as well as some very influential persons in Washington.
Kefaya—Pentagon ‘non-violent warfare’
Kefaya is at the heart of mobilizing the Egyptian protest demonstrations that back ElBaradei’s candidacy. The word Kefaya translates to “enough!”
Curiously, the planners at the Washington National Endowment for Democracy (NED) [7] and related color revolution NGOs apparently were bereft of creative new catchy names for their Egyptian Color Revolution. In their November 2003 Rose Revolution in Georgia, the US-financed NGOs chose the catch word, Kmara! In order to identify the youth-based regime change movement. Kmara in Georgian also means “enough!”
Like Kefaya, Kmara in Georgia was also built by the Washington-financed trainers from the NED and other groups such as Gene Sharp’s misleadingly-named Albert Einstein Institution which uses what Sharp once identified as “non-violence as a method of warfare.” [8]
The various youth networks in Georgia as in Kefaya were carefully trained as a loose, decentralized network of cells, deliberately avoiding a central organization that could be broken and could have brought the movement to a halt. Training of activists in techniques of non-violent resistance was done at sports facilities, making it appear innocuous. Activists were also given training in political marketing, media relations, mobilization and recruiting skills.
The formal name of Kefaya is Egyptian Movement for Change. It was founded in 2004 by select Egyptian intellectuals at the home of Abu ‘l-Ala Madi, leader of the al-Wasat party, a party reportedly created by the Muslim Brotherhood. [9] Kefaya was created as a coalition movement united only by the call for an end Mubarak’s rule.
Kefaya as part of the amorphous April 6 Movement capitalized early on new social media and digital technology as its main means of mobilization. In particular, political blogging, posting uncensored youtube shorts and photographic images were skillfully and extremely professionally used. At a rally already back in December 2009 Kefaya had announced support for the candidacy of Mohammed ElBaradei for the 2011 Egyptian elections.[10]
RAND and Kefaya
No less a US defense establishment think-tank than the RAND Corporation has conducted a detailed study of Kefaya. The Kefaya study as RAND themselves note, was “sponsored by the Office of the Secretary of Defense, the Joint Staff, the Unified Combatant Commands, the Department of the Navy, the Marine Corps, the defense agencies, and the defense Intelligence Community.” [11]
A nicer bunch of democratically-oriented gentlemen and women could hardly be found.
In their 2008 report to the Pentagon, the RAND researchers noted the following in relation to Egypt’s Kefaya:
“The United States has professed an interest in greater democratization in the Arab world, particularly since the September 2001 attacks by terrorists from Saudi Arabia, the United Arab Emirates, Egypt, and Lebanon. This interest has been part of an effort to reduce destabilizing political violence and terrorism. As President George W. Bush noted in a 2003 address to the National Endowment for Democracy, “As long as the Middle East remains a place where freedom does not flourish, it will remain a place of stagnation, resentment, and violence ready for export” (The White House, 2003). The United States has used varying means to pursue democratization, including a military intervention that, though launched for other reasons, had the installation of a democratic government as one of its end goals.
However, indigenous reform movements are best positioned to advance democratization in their own country.” [12]
RAND researchers have spent years perfecting techniques of unconventional regime change under the name “swarming,” the method of deploying mass mobs of digitally-linked youth in hit-and-run protest formations moving like swarms of bees.[13]
Washington and the stable of “human rights” and “democracy” and “non-violence” NGOs it oversees, over the past decade or more has increasingly relied on sophisticated “spontaneous” nurturing of local indigenous protest movements to create pro-Washington regime change and to advance the Pentagon agenda of global Full Spectrum Dominance. As the RAND study of Kefaya states in its concluding recommendations to the Pentagon:
“The US government already supports reform efforts through organizations such as the US Agency for International Development and the United Nations Development Programme. Given the current negative popular standing of the United States in the region, US support for reform initiatives is best carried out through nongovernmental and nonprofit institutions.” [14]
The RAND 2008 study was even more concrete about future US Government support for Egyptian and other “reform” movements:
“The US government should encourage nongovernmental organizations to offer training to reformers, including guidance on coalition building and how to deal with internal differences in pursuit of democratic reform. Academic institutions (or even nongovernmental organizations associated with US political parties, such as the International Republican Institute or the National Democratic Institute for International Affairs) could carry out such training, which would equip reform leaders to reconcile their differences peacefully and democratically.

“Fourth, the United States should help reformers obtain and use information technology, perhaps by offering incentives for US companies to invest in the region’s communications infrastructure and information technology. US information technology companies could also help ensure that the Web sites of reformers can remain in operation and could invest in technologies such as anonymizers that could offer some shelter from government scrutiny. This could also be accomplished by employing technological safegaurds to prevent regimes from sabotaging the Web sites of reformers. ” [15]
As their Kefaya monograph states, it was prepared in 2008 by the “RAND National Security Research Division’s Alternative Strategy Initiative, sponsored by the Rapid Reaction Technology Office in the Office of the Undersecretary of Defense for Acquisition, Technology, and Logistics.
The Alternative Strategy Initiative, just to underscore the point, includes “research on creative use of the media, radicalization of youth, civic involvement to stem sectarian violence, the provision of social services to mobilize aggrieved sectors of indigenous populations, and the topic of this volume, alternative movements.” [16]
In May 2009 just before Obama’s Cairo trip to meet Mubarak, US Secretary of State Hillary Clinton hosted a number of the young Egyptian activists in Washington under the auspices of Freedom House, another “human rights” Washington-based NGO with a long history of involvement in US-sponsored regime change from Serbia to Georgia to Ukraine and other Color Revolutions. Clinton and Acting Assistant Secretary of State for Near Eastern Affairs Jeffrey Feltman met the sixteen activists at the end of a two-month “fellowship” organized by Freedom House’s New Generation program.[17]
Freedom House and Washington’s government-funded regime change NGO, National Endowment for Democracy (NED) are at the heart of the uprisings now sweeping across the Islamic world. They fit the geographic context of what George W. Bush proclaimed after 2001 as his Greater Middle East Project to bring “democracy” and “liberal free market” economic reform to the Islamic countries from Afghanistan to Morocco. When Washington talks about introducing “liberal free market reform” people should watch out. It is little more than code for bringing those economies under the yoke of the dollar system and all that implies.
Washington’s NED in a larger agenda
If we make a list of the countries in the region which are undergoing mass-based protest movements since the Tunisian and Egyptian events and overlay them onto a map, we find an almost perfect convergence between the protest countries today and the original map of the Washington Greater Middle East Project that was first unveiled during the George W. Bush Presidency after 2001.
Washington’s NED has been quietly engaged in preparing a wave of regime destabilizations across North Africa and the Middle East since the 2001-2003 US military invasions of Afghanistan and Iraq. The list of where the NED is active is revealing. Its website lists Tunisia, Egypt, Jordan, Kuwait, Libya, Syria, Yemen and Sudan as well, interestingly, as Israel. Coincidentally these countries are almost all today subject to “spontaneous” popular regime-change uprisings.
The International Republican Institute and the National Democratic Institute for International Affairs mentioned by the RAND document study of Kefaya are subsidiary organizations of the Washington-based and US Congress-financed National Endowment for Democracy.
The NED is the coordinating Washington agency for regime destabilization and change. It is active from Tibet to Ukraine, from Venezuela to Tunisia, from Kuwait to Morocco in reshaping the world after the collapse of the Soviet Union into what George H.W. Bush in a 1991 speech to Congress proclaimed triumphantly as the dawn of a New World Order. [18]
As the architect and first head of the NED, Allen Weinstein told the Washington Post in 1991 that, “a lot of what we do today was done covertly 25 years ago by the CIA”[19]
The NED Board of Directors includes or has included former Defense Secretary and CIA Deputy head, Frank Carlucci of the Carlyle Group; retired General Wesley Clark of NATO; neo-conservative warhawk Zalmay Khalilzad who was architect of George W. Bush’s Afghan invasion and later ambassador to Afghanistan as well as to occupied Iraq. Another NED board member, Vin Weber, co-chaired a major independent task force on US Policy toward Reform in the Arab World with former US Secretary of State Madeleine Albright, and was a founding member of the ultra-hawkish Project for a New American Century think-tank with Dick Cheney and Don Rumsfeld, which advocated forced regime change in Iraq as early as 1998.[20]
The NED is supposedly a private, non-government, non-profit foundation, but it receives a yearly appropriation for its international work from the US Congress. The National Endowment for Democracy is dependent on the US taxpayer for funding, but because NED is not a government agency, it is not subject to normal Congressional oversight.
NED money is channelled into target countries through four “core foundations”—the National Democratic Institute for International Affairs, linked to the Democratic Party; the International Republican Institute tied to the Republican Party; the American Center for International Labor Solidarity linked to the AFL-CIO US labor federation as well as the US State Department; and the Center for International Private Enterprise linked to the free-market US Chamber of Commerce.
The late political analyst Barbara Conry noted that,

“NED has taken advantage of its alleged private status to influence foreign elections, an activity that is beyond the scope of AID or USIA and would otherwise be possible only through a CIA covert operation. Such activities, it may also be worth noting, would be illegal for foreign groups operating in the United States.” [21]

Significantly the NED details its various projects today in Islamic countries, including in addition to Egypt, in Tunisia, Yemen, Jordan, Algeria, Morocco, Kuwait, Lebanon, Libya, Syria, Iran and Afghanistan. In short, most every country which is presently feeling the earthquake effects of the reform protests sweeping across the Middle East and North Africa is a target of NED. [22]
In 2005 US President George W. Bush made a speech to the NED. In a long, rambling discourse which equated “Islamic radicalism” with the evils of communism as the new enemy, and using a deliberately softer term “broader Middle East” for the term Greater Middle East that had aroused much distruct in the Islamic world, Bush stated,
“The fifth element of our strategy in the war on terror is to deny the militants future recruits by replacing hatred and resentment with democracy and hope across the broader Middle East. This is a difficult and long-term project, yet there’s no alternative to it. Our future and the future of that region are linked. If the broader Middle East is left to grow in bitterness, if countries remain in misery, while radicals stir the resentments of millions, then that part of the world will be a source of endless conflict and mounting danger, and for our generation and the next. If the peoples of that region are permitted to choose their own destiny, and advance by their own energy and by their participation as free men and women, then the extremists will be marginalized, and the flow of violent radicalism to the rest of the world will slow, and eventually end…We’re encouraging our friends in the Middle East, including Egypt and Saudi Arabia, to take the path of reform, to strengthen their own societies in the fight against terror by respecting the rights and choices of their own people. We’re standing with dissidents and exiles against oppressive regimes, because we know that the dissidents of today will be the democratic leaders of tomorrow…” [23]
The US Project for a ‘Greater Middle East’
The spreading regime change operations Washington from Tunisia to Sudan, from Yemen to Egypt to Syria are best viewed in the context of a long-standing Pentagon and State Department strategy for the entire Islamic world from Kabul in Afghanistan to Rabat in Morocco.
The rough outlines of the Washington strategy, based in part on their successful regime change operations in the former Warsaw Pact communist bloc of Eastern Europe, were drawn up by former Pentagon consultant and neo-conservative, Richard Perle and later Bush official Douglas Feith in a white paper they drew up for the then-new Israeli Likud regime of Benjamin Netanyahu in 1996.
That policy recommendation was titled A Clean Break: A New Strategy for Securing the Realm. It was the first Washington think-tank paper to openly call for removing Saddam Hussein in Iraq, for an aggressive military stance toward the Palestinians, striking Syria and Syrian targets in Lebanon.[24] Reportedly, the Netanyahu government at that time buried the Perle-Feith report, as being far too risky.
By the time of the events of September 11, 2001 and the return to Washington of the arch-warhawk neoconservatives around Perle and others, the Bush Administration put highest priority on an expanded version of the Perle-Feith paper, calling it their Greater Middle East Project. Feith was named Bush’s Under Secretary of Defense.
Behind the facade of proclaiming democratic reforms of autocratic regimes in the entire region, the Greater Middle East was and is a blueprint to extend US military control and to break open the statist economies in the entire span of states from Morocco to the borders of China and Russia.
In May 2009, before the rubble from the US bombing of Baghdad had cleared, George W. Bush, a President not remembered as a great friend of democracy, proclaimed a policy of “spreading democracy” to the entire region and explicitly noted that that meant “the establishment of a US-Middle East free trade area within a decade.” [25]
Prior to the June 2004 G8 Summit on Sea Island, Georgia, Washington issued a working paper, “G8-Greater Middle East Partnership.” Under the section titled Economic Opportunities was Washington’s dramatic call for “an economic transformation similar in magnitude to that undertaken by the formerly communist countries of Central and Eastern Europe.”
The US paper said that the key to this would be the strengthening of the private sector as the way to prosperity and democracy. It misleadingly claimed it would be done via the miracle of microfinance where as the paper put it, “a mere $100 million a year for five years will lift 1.2 million entrepreneurs (750,000 of them women) out of poverty, through $400 loans to each.” [26]
The US plan envisioned takeover of regional banking and financial afairs by new institutions ostensibly international but, like World Bank and IMF, de facto controlled by Washington, including WTO. The goal of Washington’s long-term project is to completely control the oil, to completely control the oil revenue flows, to completely control the entire economies of the region, from Morocco to the borders of China and all in between. It is a project as bold as it is desperate.

Once the G8 US paper was leaked in 2004 in the Arabic Al-Hayat, opposition to it spread widely across the region, with a major protest to the US definition of the Greater Middle East. As an article in the French Le Monde Diplomatique in April 2004 noted, “besides the Arab countries, it covers Afghanistan, Iran, Pakistan, Turkey and Israel, whose only common denominator is that they lie in the zone where hostility to the US is strongest, in which Islamic fundamentalism in its anti-Western form is most rife.” [27] It should be noted that the NED is also active inside Israel with a number of programs.

Notably, in 2004 it was vehement opposition from two Middle East leaders—Hosni Mubarak of Egypt and the King of Saudi Arabia—that forced the ideological zealots of the Bush Administration to temporarily put the Project for the Greater Middle East on a back burner.

Will it work?
At this writing it is unclear what the ultimate upshot of the latest US-led destabilizations across the Islamic world will bring. It is not clear what will result for Washington and the advocates of a US-dominated New World Order. Their agenda is clearly one of creating a Greater Middle East under firm US grip as a major control of the capital flows and energy flows of a future China, Russia and a European Union that might one day entertain thoughts of drifting away from that American order.
It has huge potential implications for the future of Israel as well. As one US commentator put it, “The Israeli calculation today is that if ‘Mubarak goes’ (which is usually stated as ‘If America lets Mubarak go’), Egypt goes. If Tunisia goes (same elaboration), Morocco and Algeria go. Turkey has already gone (for which the Israelis have only themselves to blame). Syria is gone (in part because Israel wanted to cut it off from Sea of Galilee water access). Gaza has gone to Hamas, and the Palestine Authority might soon be gone too (to Hamas?). That leaves Israel amid the ruins of a policy of military domination of the region.” [28]
The Washington strategy of “creative destruction” is clearly causing sleepless nights not only in the Islamic world but also reportedly in Tel Aviv, and ultimately by now also in Beijing and Moscow and across Central Asia.

F. William Engdahl is author of Full Spectrum Dominance: Totalitarian Democracy in the New World Order. His book, A Century of War: Anglo-American Oil Politics and the New World Order has just been reissued in a new edition. He may be contacted via his website,http://www.engdahl.oilgeopolitics.net.

Notes
[1] DEBKA, Mubarak believes a US-backed Egyptian military faction plotted his ouster, February 4, 2011, accessed in http://www.debka.com/weekly/480/. DEBKA is open about its good ties to Israeli intelligence and security agencies. While its writings must be read with that in mind, certain reports they publish often contain interesting leads for further investigation.
[2] Ibid.
[3] The Center for Grassroots Oversight, 1954-1970: CIA and the Muslim Brotherhood ally to oppose Egyptian President Nasser,http://www.historycommons.org/context.jsp?item=western_support_for_islamic_militancy_202700&scale=0. According to the late Miles Copeland, a CIA official stationed in Egypt during the Nasser era, the CIA allied with the Muslim Brotherhood which was opposed to Nasser’s secular regime as well as his nationalist opposition to brotherhood pan-Islamic ideology.
[4] Jijo Jacob, What is Egypt’s April 6 Movement?, February 1, 2011, accessed in http://www.ibtimes.com/articles/107387/20110201/what-is-egypt-s-april-6-movement.htm
[5] Ibid.
[6] Janine Zacharia, Opposition groups rally around Mohamed ElBaradei, Washington Post, January 31, 2011, accessed in http://www.washingtonpost.com/wp-dyn/content/article/2011/01/31/AR2011013103470_2.html?sid=ST2011013003319.
[7] National Endowment for Democracy, Middle East and North Africa Program Highlights 2009, accessed in http://www.ned.org/where-we-work/middle-east-and-northern-africa/middle-east-and-north-africa-highlights.
[8] Amitabh Pal, Gene Sharp: The Progressive Interview, The Progressive, March 1, 2007.
[9] Emmanuel Sivan, Why Radical Muslims Aren’t Taking over Governments, Middle East Quarterly, December 1997, pp. 3-9
[10] Carnegie Endowment, The Egyptian Movement for Change (Kifaya), accessed in http://egyptelections.carnegieendowment.org/2010/09/22/the-egyptian-movement-for-change-kifaya
[11] Nadia Oweidat, et al, The Kefaya Movement: A Case Study of a Grassroots Reform Initiative, Prepared for the Office of the Secretary of Defense, Santa Monica, Ca., RAND_778.pdf, 2008, p. iv.
[12] Ibid.
[13] For a more detailed discussion of the RAND “swarming” techniques see F. William Engdahl, Full Spectrum Dominance: Totalitarian Democracy in the New World Order, edition.engdahl, 2009, pp. 34-41.
[14] Nadia Oweidat et al, op. cit., p. 48.
[15] Ibid., p. 50.
[16] Ibid., p. iii.
[17] Michel Chossudovsky, The Protest Movement in Egypt: “Dictators” do not Dictate, They Obey Orders, January 29, 2011, accessed inhttp://www.globalresearch.ca/index.php?context=va&aid=22993
[18] George Herbert Walker Bush, State of the Union Address to Congress, 29 January 1991. In the speech Bush at one point declared in a triumphant air of celebration of the collapse of the Sovoiet Union, “What is at stake is more than one small country, it is a big idea—a new world order…”
[19] Allen Weinstein, quoted in David Ignatius, Openness is the Secret to Democracy, Washington Post National Weekly Edition, 30 September 1991, pp. 24-25.
[20] National Endowment for Democracy, Board of Directors, accessed in http://www.ned.org/about/board
[21] Barbara Conry, Loose Cannon: The National Endowment for Democracy, Cato Foreign Policy Briefing No. 27, November 8, 1993, accessed inhttp://www.cato.org/pubs/fpbriefs/fpb-027.html.
[22] National Endowment for Democracy, 2009 Annual Report, Middle East and North Africa, accessed in http://www.ned.org/publications/annual-reports/2009-annual-report.
[23] George W. Bush, Speech at the National Endowment for Democracy, Washington, DC, October 6, 2005, accessed inhttp://www.presidentialrhetoric.com/speeches/10.06.05.html.
[24] Richard Perle, Douglas Feith et al, A Clean Break: A New Strategy for Securing the Realm, 1996, Washington and Tel Aviv, The Institute for Advanced Strategic and Political Studies, accessed in http://www.iasps.org/strat1.htm
[25] George W. Bush, Remarks by the President in Commencement Address at the University of South Carolina, White House, 9 May 2003.
[26] Gilbert Achcar, Fantasy of a Region that Doesn’t Exist: Greater Middle East, the US plan, Le Monde Diplomatique, April 4, 2004, accessed inhttp://mondediplo.com/2004/04/04world
[27] Ibid.
[28] William Pfaff, American-Israel Policy Tested by Arab Uprisings, accessed in http://www.truthdig.com/report/item/american-israeli_policy_tested_by_arab_uprisings_20110201/

F. William Engdahl is a frequent contributor to Global Research. Global Research Articles by F. William Engdahl

“Tunis” is NOT the “Answer” for Egypt!

‎To those who think that “Tunis” is the “Answer” to Egypt’s problems….Do u really think that our government is the root of all problems? Do u think that the people are doing their best to change their very own lives? They all have conscience, are committed, strive to become better, and are proactive? Sure there are a lot of problems that should be taken care of by the government such as the poor quality of education, which might be the most major problem that faces Egypt, but we can not haphazardly blame the government for our own misfortunes that are most probably caused by our own bad decisions.
I always hear people complaining about unemployment, our slow and declining economy, increasing crime rates, higher prices, and even blaming the government because they CANT GET MARRIED.
Well unless the government hires a babysitter for every citizen to ensure that everyone is doing their jobs (or studying instead of smoking, drinking or watching tv) then we really can’t blame the government for our incompetence and ergo the unavailability of work that matches his qualifications.
Unless the government guarantees and “supplies” a bride, a house, and a good income for every groom, we can’t blame the government for rising number of bachelors (or the alarming rate of sexual harrasment cases).
We can’t keep blaming the government for our own misfortunes (especially if they resulted from our carelessness and our misjudgments).
Think of it this way: If you were a government official (subsidizing bread and fuel (which costs 1.5 euros/ litre in Europe and only 1.8 EGP in Egypt)), what would you do?

Securitization & the Financial Crisis

By: Mohamed Bahaa, Ahmad Hbous and Ahmed Hisham.

Executive Summary

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Securitization has been a primary means of transferring the credit risk from lenders, to investors.

In this paper, we will be discussing the securitization process, the credit enhancement techniques that were involved, as well as the role of the credit rating agencies regarding the current crisis.

What Is Securitization?

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Securitization is a structured financial process that packages different receivables and underwrites them to be sold in the form of “asset-backed” securities. These securities are relatively safe, because they are backed with an asset. The securitization is helping to shape the future of traditional commercial banking as it represents a shift in capital investments from portfolio lending models, towards “originate-to-sell” models. That’s to say, instead of waiting for the whole duration to get the loans and other receivable back, financial institutions are able to convert their illiquid assets into cash and generate transaction and underwriting fees. In other words, Securitization is mean of funding, generating fees, and managing balance sheet.

 

Background

Originally banks used to play the role of portfolio lenders, where they keep loans and mortgages until they mature. This was the case until the 1970’s when the Government National Mortgage Association (GNMA, or Ginnie Mae) introduced Asset Securitization. GNMA developed pass-through securities that aggregate individual home mortgages into homogenous pools. These pools are a backing for GNMA “pass-through” securities. Investors receive shares of the entire principal and interest payments made on the underlying mortgage pool. Securitizing mortgages helped in trading mortgages just like any other security. It expanded investors’ options for investing in mortgages directly.

Nowadays, most of home mortgages are pooled into mortgage-backed securities with a volume of $3.5 trillion. Other loans are also securitized into pass-through arrangements like car loans, credit cards loans, and student loans.

Parties Involved

There are several parties involved in the process of securitization starting from the homebuyers who get mortgage loans all the way to investors who buys the asset-backed securities. In the middle, we have the Originator who offers the mortgages loans or any other type of loans to customers. Originators are not necessarily financial institutions sometimes they are mortgages firm. If it is not a financial institution, it hires a sponsor who takes responsibility of underwriting, bookbuilding, etc. The following party involved is the Special Purpose entity (SPE) or Special Purpose Vehicles (SPV) that is an entity developed for a specific purpose which is securitization. In most cases, the originator creates the SPE. SPE is responsible for carrying the loans, and issue bonds on these receivables that is sold to Investors.

Process

Stage One: An Originator issues mortgages to Customers.

Stage Two: The Originator wants to convert the illiquid credit assets into cash. The originator creates a Special Purpose Entity (SPE) / Special Purpose Vehicle (SPV). The credit assets are transferred from the banks account to the SPE/SPV in a “true sale”[1]. Transferring these assets from the banks account makes it bankruptcy remote i.e. creates a legal and accounting distance between the originator and the SPE / SPV.

Stage Three: The SPE / SPV deposits the assets with trustee that acts as a custodian and advisor

Stage Four: SPE / SPV issues transferable and tradable securities to investors who pays to buy these securities backed by an underlying asset.

Stage Five: Cash received by SPE / SPV is transferred back to the originator after deducting its fees.

Finally: When homebuyers make repayments to the originators, it is passed on to SPE / SPV for payment to the investors of securities.

Benefits of Securitization

Securitization benefits the originator in many ways. First, it allows originators (banks) to pass the risks of lending to other parties and consequently freeing capital resources to back new loans that exceed their capacity.  Freeing capital occurs through converting illiquid assets to liquid assets available for additional loans. In other words, it’s considered a source of fund to originators. Second, it helps originators to expand their ability to lend; it gives them the opportunity to sell part of their loan portfolio to other party (SPE) and use the proceeds to lend more customers. Also it helps banks to match their assets with their liabilities and avoid the problem of maturity mismatch through securitizing the loans. Finally, going through the securitization process, banks are able to generate fee and interest income.

As well as benefiting the originators, securitization also benefits consumers and investors. For consumer, it offers liquidity to credit markets and gives borrowers the opportunity to get more loans with a great variety of payment structures at a lower cost. For investors, it presents a diverse range of investment options depending on the investor’s appetite for taking risks.

Tranching

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A very important process which became embedded with the securitization process lately in the financial world is Tranching. Now after the SPV combines all the subprime mortgage loans into one pool in order to sell mortgage backed securities in general or Collateralized Debt Obligations (CDOs) which is a very common form of asset backed securities (backed by assets or other securities). Now the SPV would seek to provide securities that will be suitable from different types of people, the risk takers who mainly care about getting as higher returns as possible, or the people who are unwilling to take risks and accept proper minimal returns, or even those fund managers who are restricted from investing in high risk securities. Therefore, The SPV will simply slice its pool into different tranches through the “Tranching Process”. The pool will now be divided into different tranches or classes each having a specific rating, hence forming a hierarchy of tranches. The highly rated tranches are mainly called “Senior” since they are the first ones to get their money back. The following tranche is called the “Mezzanine” or “Junior” tranche which has a lower seniority from payment than senior class. And the third tranche would be the “Equity” which represents the first people to lose their money in case mortgage loan borrowers default, and hence they have the higher risk and therefore it is only logical to have the highest return, while the senior and mezzanine will have lower returns. In this case, the securities will be appealing to all kinds of investors those who are unwilling to take risks and accept low returns (Senior) and risk lovers who want high returns (Equity). While losses will move from the most junior till the senior classes. According to J. Mitchell Fender, the author of “Structured Finance: Complexity, Risk, and the Use of Ratings”, “Tranching allows for the ability to create one or more classes of securities whose rating is higher than the average rating of the underlying collateral asset pool or to generate rated securities from a pool of unrated assets.” Therefore, it is clear how the tranching or slicing a loan pool is necessary in creating a better rating for the securities and creating a larger market for them. However, tranching is not a risk free operation. First of all tranching is a complex process and the SPV should account for all the possible scenarios of credit defaults and estimate an accurate loss distribution for the pool in order to maintain the required seniority of the tranches. Moreover, the resulting MBs performance is very hard to evaluate. During the recent financial crisis, most people used to evaluate the MBs or CDOs according to their past performance while underestimating the risks in the underlying assets.

As we can see from the figure below, the 3 main tranches (Senior, Mezzanine, and Equity) could be divided into more classes each with different rating. The figure below also shows how risk, losses, and returns are allocated among the classes due to the tranching process. Now let’s take a numerical example. If the SPV wants to sell mortgage backed securities for a loan pool with a worth of 1 Billion dollars, and the borrowers of the loans in the pool pay 100 million per year in interest. The SPV will need to collect the following:

$300 Million of Equity bonds, therefore selling 300,000 bond assuming each worth $1000

$300 Million of Mezzanine bonds, therefore selling 300,000 bonds assuming each worth $1000

$400 Million of Senior bonds, therefore selling 400,000 bonds assuming each worth $1000

Assuming that the Senior bonds get 6% coupon and hence they will get 6% x 400 M= 24 M

Assuming that the Mezzanine bond gets 7% coupon, hence they will get 7% x 300M= 21M

And the rest which will be 55 M will go to the equity class. Now assume that out of the 1 B of loans many borrowers defaulted and the interest payments decreased by 50%, therefore now we get 50 M each year. The senior classes will still get the 24 M, and the mezzanine class will also get the 21 M, but the equity class will not get 5 M instead of the 55 M they should be getting, and this clearly shows how they are facing more risk while getting high return, and how this tranche acts as a protection or a cushion for the upper classes, and therefore this can be considered as a form of a credit enhancement for the senior bonds (discussed in the next section).

What is Credit Enhancement?

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Credit enhancement is a key step in the securitization process in a structured financial system.  It is mainly a technique used to reduce risk and a form to protect against any potential losses. Therefore, it is considered as a financial cushion used in order to protect securitized pools of loans backed by collaterals (mainly mortgage) against losses that can result from cases of defaults, and hence credit enhancement helps absorb losses. Many believe that credit enhancement is important and helpful since it helps protect against potential defaults, but others see it as a form of an extreme makeover done in order to make pools of bad loans more appealing to investors and it is the same as “turning rotten grapes into wine”. And according to Scott Mason, a primary credit analyst in Standard and Poor’s, “Credit enhancement is used in project financings, public-private partnership transactions, and structured finance to help mitigate risk for the investors, and has been an accepted practice in bond financing for more than two decades.” In recent years the securitization market witnessed tremendous growth reaching trillions in value and hence using credit enhancement techniques in turn increased. Today the world is facing a severe financial crisis which was aggravated by the extreme use of the securitization process and the usage of credit enhancement techniques in order to reduce the risk and make the securitized pools of the mortgage loans more appealing for investors while in turn they are actually subprime loans. And hence many analysts believe that the credit enhancement process proved to be a weapon to deceive many investors and even credit rating agencies.

The Importance of Credit Enhancement

As mentioned above credit enhancement is used mainly to mitigate risk and reduce it regarding securitized assets, and it makes these assets more appealing from investors. Moreover, using credit enhancements is very important in order to get a good credit rating from most credit rating agencies, and this is a vital step for marketing and selling the securities. Many mutual fund managers and also pension funds managers are restricted from investing in securities with high risk and low ratings, and now using securitization and credit enhancement techniques, subprime mortgage loans can be appealing from the mutual and pension fund managers since they are highly rated and give high returns.

             There are many credit enhancements techniques and approaches, however, they are all classified within 2 main categories: Internal credit enhancement techniques and External credit enhancement techniques. First we will start by discussing the various major internal credit enhancement techniques:

1. Subordination: the concept behind the subordination credit enhancement technique is the same as that behind tranching. By default when the Special Purpose Vehicle slice the securitized assets into different tranches or classes, it is then applying subordination credit enhancement technique. Hence in this case the low rate classes mainly the equity then the mezzanine will absorb any losses that take place due to defaults. Therefore, the senior classes would be safe and protected against such losses. This specific method was conducted excessively in the recent financial crisis, and most of the financial institutions that have undergone the securitization process, usually depended on subordination credit enhancement in order to reduce the risk regarding the senior tranches or classes, while giving higher return for the lower rated classes (mezzanine and equity) in order to compensate for the higher risk they are faced with.
2. Overcollateralization: another important and commonly used form of credit enhancement. Overcollateralization is simply when the face value of the underlying loan portfolio is larger than the par value of the issued securities mainly bonds. Hence, for example, the SPV will buy the loan portfolio from the originator through a true sale process at a discount, let’s say the value of the portfolio is 100 million, and the discounted price that the SPV bought the portfolio with is 85 million, now the SPV can use the excess 15 million for credit enhancement. Therefore, the difference between the face value and the par value could be used as a protection against credit risk, and hence will act as a cushion for the investors, and it protect all the tranches from losing money.
3. Excess Spread: is the third major form of credit enhancement. It is the difference between the interest paid by the borrowers of the loans in the pool, and the coupon paid to the investors of the issued bonds, such difference can provide cash inflow that could be used as a protection or a cushion for the security tranches. For example, the borrowers of the mortgage loans could be paying 7% as interest, while the coupon of the mortgage backed securities is about 5%.  The difference of the 2% could be used for credit enhancement as a form of credit safety or overcollateralization.

These are the three main forms of internal credit enhancement techniques, other types are available, however overcollateralization, subordination, and excess spread are the major and most widely used forms of credit enhancement. The following figure shows how the different forms of internal credit enhancement can  be used in order to protect the investors and make the issued securities less risky, more appealing, and most importantly acquire high ratings (discussed in the following section).

If the pool starts suffering from credit losses, such losses will first affect and be allocated to the excess spread money used from the credit enhancement and therefore protecting all the above classes or tranches. Then if losses incurred are more than what is available in the excess spread then the losses will be allocated to the overcollateralization. However, if the credit default losses are more than both the excess spread and the overcollateralization, then the lower rated bonds will start losing some money, and so on. However, it is important to mention that the excess spread will build up every month and will then also be able to protect the investors again.

External Forms of Credit Enhancement

There are mainly five external forms of credit enhancement.  One major form of credit enhancement is surety bonds, which are insurance policies stipulating that the insurer guarantees payments of interest and principal to the ABS (Asset backed securities) investors, up to a specified amount. Another form of 3^rd party guarantee is when the parent company of the issuer guarantees payment. ABS paired with surety bonds have ratings that are the same as that of the surety bond’s issuer. By law, surety companies cannot provide a bond as a form of a credit enhancement guarantee.

The second form of external credit enhancement is a letter of credit.  With a letter of credit (LOC), a financial institution, in most cases of which is a bank, is paid a fee to provide a specified cash amount to reimburse the ABS-issuing trust for any cash shortfalls from the collateral, up to the required credit support amount. This is basically plays the purpose of a bank promising, for a fee, to pay the issuer when the issuer does not have enough to make the current payments. Letters of credit are now becoming less familiar forms of credit enhancement, as their appeal was “lost when the rating agencies downgraded the long-term debt of several LOC-provider banks in the early 1990s. Because securities enhanced with LOCs from these lenders faced possible downgrades as well, issuers began to utilize cash collateral accounts instead of LOCs in cases where external credit support was needed” (Wikipedia).

The third kind of external credit enhancement takes the form of Wrapped Securities. A wrapped security is also insured or guaranteed by a third party as with the surety bond and the letter of credit. A third party or, in some cases, the parent company of the Asset Backed Security issuer may provide a promise to reimburse the trust for losses up to a specified amount of money. The contract can also include agreements to advance principal and interest or to buy back any defaulted loans. The third-party guarantees are typically provided by AAA-rated financial guarantors or monoline insurance companies.

There are 2 other forms of external credit enhancements that are not subject to 3^rd party risk, since the issuer already possesses the cash collateral: cash collateral accounts and collateral invested amounts. The first of which is a Cash collateral account. 

In this case, the issuer borrows the required credit-enhancement amount, usually from a commercial bank, and then invests that amount in the highest-rated short-term (one-month) commercial paper. Since this is an actual deposit of cash unlike an LOC, which represents a pledge of cash, a downgrade of the CCA provider would not result in a downgrade of the transaction.

The second type is a Collateral Invested Amount (CIA).  This is similar to a subordinated tranche and either purchased on a negotiated basis by a single third-party credit enhancer or securitized as 144A private placement and sold to several investors. The tranche is often customized specifically for the investors. Like the cash collateral account, the CIA fund is reimbursed from future excess spreads.

 

 

 

 

 

 

 

 

 

The Credit Rating Agencies

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What are Credit Rating Agencies

Credit rating agencies are institutions responsible for assigning credit ratings[1] for debt issuers. Credit ratings are given according to the “independent assessment” of the creditworthiness of a client, through evaluating certain criteria such as the financial history, debt obligations outstanding, liquidity, other current assets and liabilities, etc.

Credit ratings are used to measure the “default risk” of an entity, and are used by investors, issuers, banks, brokers, and governments, either for investment purposes[2], or for assessing the credit standing[3]. In other words, it enables the individuals and institutions to relatively assess risk, according to a certain benchmark, in this case, the credit ratings.

Credit ratings could be assigned to short-term and long-term debt obligations, securities, loans, preferred stock and insurance companies.

Corporate Credit Rating Scales

Corporate credit ratings are constructed by many firms, the most prominent of them being Moody’s and Standard and Poor’.  Each credit rating corporation has its own “credit scale”.

Bond Rating		Grade	Risk
Moody’s	Standard & Poor’s
Aaa	AAA	Investment	Lowest Risk
Aa	AA	Investment	Low Risk
A	A	Investment	Low Risk
Baa	BBB	Investment	Medium Risk
Ba, B	BB, B	Junk	High Risk
Caa/Ca/C	CCC/CC/C	Junk	Highest Risk
C	D	Junk	In Default

Figure 1[4]

 

 

What Do the Credit Ratings Imply?

As mentioned above, a credit rating is a measurement of the “default risk” of a debt obligor/obligation. Entities with a AAA (Aaa) credit rating are considered “risk free” and thus, any debt issued, should theoretically be priced according to the risk free rate. In other words, the credit ratings implicitly measure the probability and the ability of an entity to repay the obligation.

Credit Rating Agencies’ Implications on the Current Financial Crisis

Credit rating agencies have always been reliable; being able to “objectively” quantify and measure the default risk of an entity. But as from the current financial crisis, their effectiveness, objectiveness and credibility have been questioned.

The credit rating agencies were able to open the doors of Wall Street to the “mortgage industry”, making it easier for mortgage lenders to issue new loans.[5] This seemed very attractive to mortgage issuers, and was beneficial to the mortgage industry, growing the industry to $2.5 trillion in 2006.[6]

Since mortgage lenders no longer have to wait until the mortgages mature to get their money back, they were now able to give out more loans (even to subprime borrowers), at virtually no added cost. Since they will be “selling” these mortgages “instantly”, they were now able to receive higher returns from “junk” mortgages, with almost “zero” incremental risk. Almost all of these subprime mortgages were pooled and sold as securities.

The securitized mortgages (Mortgage Backed Securities) had to be assessed by someone, in order to evaluate the default risk, thus, they were to be “rated” by the credit rating agencies. Eventually, the credit rating agencies were the entities responsible for setting the credit standards that determined which mortgages would be securitized and sold.

The junk MBS were to receive as high as AAA (Aaa) ratings by the credit rating agencies, who are now being scrutinized for assigning the “Junk” MBS investment grades (even though the underlying asset remains “Subprime”).

The credit rating agencies have justified these “over-ratings”, since these pools were “enhanced”, using numerous credit enhancement techniques, such as tranching and overcollateralization, which are discussed above. According to the article by Roger Lowenstein for the New York Times, the credit rating agencies argue that they are not “loan officers”, and they do not assess the credibility of the information given by the mortgages holders themselves, but they assess the bonds that are issued by the SPV to buy such mortgages, trying to forecast the possible default rate. In other words, the credit rating agencies study whether the cash inflow from the mortgages will cover the payments of the bondholders or not.

But how could an entity backed by subprime mortgages obtain a AAA credit borrowing rate? Basically, the special purpose vehicle would issue a number of bond classes with different “payback priorities”, i.e., different credit ratings (from as high as AAA to BB). The AAA rated tier would receive his payments first, then the next tier, and so on. Bonds issued with a lower credit rating, hence, would receive higher interest payments, but would face most of the losses if a default occurs[7].

This tranching technique protected the higher tier securities, which enabled the credit rating agencies to classify them as investment grade securities.

These securities are usually monitored by the credit rating agencies, in order to account for any changes in the ratings, if needed. As default rates increased and the credit rating agencies realized a higher default rate[8], they started downgrading these securities, as well as reforming their evaluation models. The credit rating agencies were pressured to downgrade Billions[9] worth of securities, to an extent that the AAA bonds were downgraded to BB, which caused a drastic decline in their market values, creating dramatic losses to security holders.

This downgrading caused many investors to lose faith in the credit rating agencies as well as other securities, since the credit ratings were considered “bogus”. Along with the credit crunch, this was one of the reasons stimulating the current economic downturn.

Thus, the credit ratings should be more regulated, and the standards of evaluating credit should be further studied and enhanced, in order to prevent such a happening to occur once more.

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[1] Credit ratings assess the credit worthiness of individuals, institutions and countries.

[2] To assess the risk involved; for better asset allocation.

[3] Usually used by banks; for pricing loans, etc.

[4] Source: Investopedia

[5] Since they will not be waiting until the mortgages mature to receive their earnings.

[6] Triple A failure, New York Times , http://www.nytimes.com/2008/04/27/magazine/27Credit-t.html

[7]  In this case, if a home owner defaults

[8] They found out that the mortgage holders bought houses on speculation of higher real estate prices, and since the prices of real estate declined, they lost interest and stopped paying back the mortgages.

[9] Approximately $1.9 trillion.

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[1] Sometimes, sold to other firms interested in creating MBS

The Banking System and the Financial Crisis

By: Mohamed Bahaa and Ahmad Hbous

The current financial turbulence, streaming on every single media stations around the clock is to be considered the worst of its time, unmatched by any other financial crisis to ever hit the world. It has undoubtedly left numerous individuals bankrupt with nowhere else to turn, and the situation will most likely be worse. Since Banks are considered as the “stimulators” of the economy, any halt in their operations could have drastic consequences that could be materialized internationally. In this paper we will be briefly discussing the main reasons that triggered and stimulated the current “financial apocalypse”, while analyzing the effects it has on the US and the Egyptian Banking systems.

The Financial Crisis

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Most analysts, officials and economists believe that the whole crisis was a result of the real estate market “bubble burst” along with the “Subprime Mortgage Crisis”.

Attached to the “Subprime mortgage crisis” is something known as the “United States Housing Bubble”; which was mainly concerning the real estate “bubble” within the states of California, Florida, New York and Michigan. These economic bubbles are characterized by rapid increase in the valuation of property, until unsustainable price levels are reached.

The previous graph shows the increasing trend in home sales and home prices in the U.S real estate market; however we can see that by the end of 2005 the demand started to decrease, and by 2006 and 2007 the demand for houses declined rapidly accompanied with a severe decrease in prices, and hence bursting the so called “Housing Bubble”.  The other major problem was the subprime mortgage loans (junk loans), where mortgage brokers and banks were attracted by the lure of big commissions; leading them to lend buyers with poor credit worthiness; where risk factors such as income level, credit history, employment status, and size of down payment were overlooked. The “securitization process” of these “junk” mortgages, which was primarily used to mitigate default risk, had magnified the effect to not only include the mortgage issuers, but the financial institutions responsible for the securitization of these mortgages (Such as Bear Sterns, which were to fall later). These “subprime” mortgage backed securities (MBS) were graded as AAA investment-grade securities considering that they were over collateralized by 150% of their value, which still does not change the fact that they are “Junk” mortgages. Hence, after the beginning of the crisis the mortgage lenders and many banks witnessed a dramatic increase in the number of foreclosures and defaults which led to huge e losses.

The severe losses faced by the major financial institutions were disastrous, and it was clear that the American financial system would be traumatized. By 2007 many investment banks and mortgage finance companies declared bankruptcy, including New Century Financial Corporation and American Home Mortgage. Others , such as Countrywide, which is considered as one of the major mortgage finance companies, decided to lay off more that 12,000 of its employees. In February 2007, HSBC issued the first major warning, bywriting down tens of billions in losses from their 2002 acquisition of the U.S. subprime lender Household International. But still many assumed that the crisis was still under control. However, when two of Bear Stearns’ hedge funds, with large investments in the US housing market, “blew up” in June 2007, people started to question the validity of their previous assumptions. It was in August 2007 when BNP Paribas, a major French bank, froze withdrawals in three investment funds that people began to panic. If a bank with no obvious exposure to the U.S. mortgage sector is facing that amount of trouble, then many US banks could be hiding their losses. And since then, many major American and international financial institutions are still suffering from major losses.

By May 2008 Bear Sterns has already lost more than 90% of its stock’s value; which forced JP Morgan to take over it for approximately $270 Million. The month after, Citigroup reported losses of more than $5.11 billion in the first quarter. Moreover, by mid-2008, all three major stock indices in the United States (the Dow Jones Industrial Average, NASDAQ, and the S&P 500) entered a bearish market. On September the 15th 2008, growing financial concerns caused the indices to decline by their sharpest amounts in the past few years. That day, the most noteworthy trigger was the bankruptcy of the investment banking giant Lehman Brothers, which was considered a dramatic turning point in the chain of events of this crisis. The following graph shows how the major events during the crisis, and its affect on the S&P500 index; which clearly shows how the Lehman collapse was indeed a turning point.

The Credit Crunch

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The crisis “claimed the lives” of about 22 American banks (investment and commercial banks). This was mainly due to the fact that the real reason behind the crisis originated from the United States’ financial system, which implies that the US firms would be the first to feel the consequences. Due to the financial crisis described above, The United States has incurred losses amounting to $7.5 Trillion which makes it the worst financial crisis since the Great Depression of the 1930.

With more major financial institutions reporting huge losses and increasing number of defaults anxiety in the market elevated, causing banks to require a higher premium on loans. This caused the “rattled” investors to seek “safe haven” in investing in T-bills. This initially caused a credit freeze; since banks are hesitant to issue loans, while depositors are afraid that the banks could lose their savings. This credit freeze could be clearly shown through the TED SPREAD, which is The Treasury-Eurodollar spread. The Ted Spread is the difference between the 3 month London Interbank Offered Rate (LIBOR) and the 3 month Treasury bill rate. This spread measures the “Premium” added to the Risk Free lending rate (T-Bill in this case) which primarily measures the amount of “perceived risk” in the market. It essentially measures this willingness and/or the ability of banks to lend each other; since by measuring the premium you would get on lending another bank (over the rate at which you would lend the US government) you are implicitly measuring the banks’ expected risk on this transaction (Considering that “the higher the risk, the higher the expected return” is always true). This implies that if the spread (premium) is wide, then banks are requiring higher yields to compensate for the higher expected risk (relative to the T-bills) of lending another bank. In simpler words, the TED spread measures the extent of trust (of repayment) evident in the interbank market, as a bank would demand a higher rate only in cases where there is a high probability of default. And using the figure below, we can clearly see that the Ted Spread have increased tremendously since the beginning of the crisis and hence it is clear that the US Banking sector is facing a tough credit freeze.

The credit crunch poses great threats regarding the operations of any healthy banking sector. When banks are reluctant to lend clients, and even each other, they will not be able to play their role as a financial intermediary and hence their profit cycle will be halted. And also as mentioned above the financial crisis had a very huge impact on the value of the stocks of most banks, and by losing stock value banks will suffer more losses and will not be able to raise enough equity or capital in order to sustain their operations. And in order to assist the banking system most governments decided to take certain measures to prevent further deterioration. Such measures were mainly bank recapitalizations, guarantee of deposits, bank loan guarantee, and even purchase of bad debt. Such plans aimed to reduce systematic risk, fears of bankruptcy, and reassure savers. However, it is very hard to judge whether such actions by world governments were successful or not since the results are yet to be determined.

Furthermore, another problem facing the American banking sector is the lack of confidence and trust in the system. People believe that this system has proved inefficient during this crisis and now they are unwilling to carry the bank’s risk, by depositing their money in a volatile and vulnerable banking sector. Such a problem is very hard to overcome; since restoring confidence is a long term process and doesn’t happen instantly, especially after the fall of certain major institution, that were once considered “invincible”. Moreover, as long as this problem prevails it is very difficult to “unfreeze” the current credit crunch.

What’s next?

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In order to know what could possibly happen in the future regarding the financial crisis, we need to examine and indentify our current position regarding the crisis.

• Stage one: house prices start to fall
• Stage two: delinquency rate in subprime mortgage rises
• Stage three: Investors suffer from losses and investments banks have to write down
• Stage four: Banks reduce balance sheets
• Stage five: forced deleveraging of hedge funds
• Stage six: credit freeze
• Stage seven: Impact on real economy

As we can see through the different stages, the banking sector in the United State was hit in its core, and till today it is still suffering from the effects of this prevailing financial storm. With the continuing credit crunch, loss of stock value and investments, and lack of confidence in the system as a whole, the banking sector will not easily overcome this challenge. Currently the U.S is in stage seven, where the crisis is starting to affect the real economy with lowest consumer confidence, decreasing profits in most industries, increasing unemployment rates, decreasing production, and hence overall expected economic slowdown. Such a slowdown will have a further devastating effect on the banking sector. However, since this crisis reached a global scale, it is now expected that we will witness a global economic slowdown. Therefore, for the few countries that were not directly affected by the financial crisis, and not highly interrelated with the American financial system, they will be indirectly affected by the global economic slowdown.

Egypt and the Financial Crisis

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The most straight forward description of the severity of the financial crisis came from the IMF; “The world economy is entering a major downturn thanks to the most dangerous shock in mature financial markets since the 1930’s”. It is unreasonable to believe that a country could not be affected by the global crisis, as it is also unreasonable to believe that all countries will be hit with the same degree of severity. Regarding the stock exchanges most countries witnessed a declining trend in the value of most stocks. However the Egyptian stock exchange was affected tremendously in the previous period prior to the financial crisis, and with the beginning of the crisis it even lost more of its value. The following table gives a clear overview of the performance of the Case 30 index from the beginning of 2008:

This graph illustrates the deteriorating and weak performance of the Egyptian stock exchange represented by the Case 30 index. The first phase of declining was due to the new government policies issued on May 2008 and also the decline was further stimulated by the rumours spread regarding a possible implementation of taxes on capital gains generated by exchanging stocks. And in September the Egyptian Stock Exchange lost about 31% due to the severity of the financial crisis. This tremendous decline was very surprising since the Egyptian financial system is still stable and was not widely affected, while the stock exchange performance was weaker than other countries whose financial systems were trembled. And even though many Egyptian companies announced that the crisis will negatively affect their performance, but the decline in value of their stock was much more severe and radical. Therefore, many people and companies suffered huge losses due to this decline in the stocks in Egypt.

The banking sector in Egypt witnessed many reforms in the last four to five years and the number of banks declined while mergers and acquisition processes increased in the last period, this movement made the present banks stronger and more efficient and this contributed significantly in enhancing the overall performance of the banking sector in Egypt. As banks all over the world suffer from liquidity crisis, credit crunch, and mistrust by the people, the banking sector in Egypt proved to be solid. As mentioned above the world Central Banks are intervening in order to stabilize the market and assist the liquidity stance of the banks but that doesn’t seem necessary in Egypt. The stability of the banking sector in Egypt is due to many reasons. First and the most important is the liquidity stance of the banks, most banks in Egypt have a surplus in liquidity due to the loans to deposits ratio which is about 50-53%, hence all banks maintain a high degree of liquidity. Moreover, as we can see due to the latest reforms all banks are obliged to announce their financial statements in order to encourage transparency in the financial system, therefore we were able to see that most banks are not suffering from losses due to the financial crisis. Moreover, none of the banks had substantial dealing with or deposits in any of the defaulting banks all over the world. Furthermore, the Egyptian financial sector was criticized due to not using new complex financial instruments especially not having a large derivative market. However, this proved to be another factor contributing to the current stability in the sector since many of these financial instruments proved to be somehow risky. Also, regarding the issue of trust, the CBE (Central Bank of Egypt) decided to guarantee all deposits in banks in order to assure people that they are not going to lose their money in case of any bank default. In addition, the main problem behind the crisis was the subprime mortgage loans in the United States, however in Egypt mortgage loans increased in the past few years but it is still considered relatively small-scale and even the loans given were not considered as junk and the financial institutions financed only about 80% of the value of the asset, and hence such loans have a very minimal effect on the overall financial situation in Egypt. In addition, the Egyptian banks are able to maintain a steady credit and lending cycle and hence preventing a credit crunch similar to that faced by many other countries. Due to all these reasons mentioned the Egyptian Banking sector will not be directly affected by the financial storm hitting the global financial systems, but on the other hand we have reached a stage in which the financial crisis is affecting the global economy as a whole, and even the world bank and the IMF have revisited their expectations for the global growth in the next few years. In 2006 the world growth was 5.1%. 2007 it was 5% growth. The projected growth rate for 2008 is 3.9%. Hence it is inevitable that most economies all over the world will be influenced by the economical crisis, and therefore the banking sectors will be affected indirectly by the crisis due to the economic factor.

When we look on the performance of the Egyptian economy in the past few years, we can see that economic growth reached 7% and the GDP is expected to be around LE 800 Billion by the end of the year. This high levels of growth were due to the increase in the rates of growth of total resources (final consumption, investments, and exports), and the increasing foreign direct investments, along with higher tax returns and many other encouraging factors. However, this growing trend is expected to slow down after the financial crisis which in turn leads to a global economical crisis. Rachid Mohammed Rachid, the Egyptian Minister of Trade and Industry, said “we as a government we know that if we do nothing and nothing means that we continue doing what we are doing and what we have been doing has been quite successful, what we have been doing has created in Egypt a momentum of growth of 6 to 7%, 7% last year. Fine, if we continue doing what we have been doing to deliver 7% growth, it is very clear that we will not get to the 7% growth in 2008 or 2009”. Therefore, we expect that the Egyptian economy will be affected by the worldwide crisis, but in order to know the degree in which the economy will be affected and how in turn this would impact the banking sector, we should know where exactly our economy is going to be hit. First we shall discuss the aspect of trade, it is expected that the 9.3% growth in world trade will decrease to about 4% in 2009. Such decrease will affect the Egyptian economy in various ways. The Egyptian exports will decline due to decrease in global demand, and also due to the economic slowdown in developed countries which could lead to a protectionist sentiment and adding barriers to trade, and hence disrupting the Egyptian balance of trade. The companies which depend heavily on global trade will have to decrease its production and thus decrease their contribution to the GNP (gross national product) of the whole country. Furthermore, the decline in trade will also lead to a decrease in the movement along the Suez Canal which constitutes a large source of revenue for the Egyptian government and the economy as a whole. Moreover, as mentioned above many companies that depend on exporting will be affected by the decreasing global trade, and hence their revenues will decline and the government will get lower taxes. Hence the overall effect of the declining trade would be lower income for the government and also a decline in the economic activity due to the decline in production of the companies that depend heavily on exporting.

Tourism is another important aspect which should be taken into consideration. Tourism is a vital sector for the Egyptian economy; it generates a lot of profits and attracts cash inflows of foreign currencies to the country. As people around the globe are losing many of their savings and capital due to the financial crisis, they will try to cut their spending to the minimum and hence traveling abroad for touristic purposes would be considered irrational, this is called the “Wealth effect”. And therefore the number of tourists coming to Egypt will decline and hence the tourism sector will suffer. Furthermore, the remittances reached about $ 1.9 billion during the third quarter of 2007/08 compared to nearly $ 1.6 billion during the corresponding quarter of previous year, with a growth rate of 19%. However, with ailing economies all over the world many of the Egyptians working abroad especially after the crisis is starting to overshadow the Gulf countries, it is expected that the remittances from Egyptians living abroad would also decline in the coming year or more.

On the other hand, it is expected that the inflation rates will drop due to the constantly decreasing oil prices. And as Minister Rachid also said “Every single commodity around the world is under pressure and there is obviously an opportunity, first of all, to all the countries that have been suffering from significant inflation, including Egypt, to see an ease and a drop, a significant drop in inflation and prices, and of course it will have to reflect on the cost of doing business and cost of living for all populations, mostly in emerging markets than in rich countries in that respect”. Other analysts believe that with this crisis the investments would be directed into emerging markets with higher risk but also higher return, while on the other hand others believe that Egypt will also witness a decline in the foreign direct investment especially after many foreign investors withdrew their investments from the Egyptian stock markets since they were in need of liquidity.

The financial system in the U.S has proved to be inefficient in certain aspects and the credit crunch is still a major catalyst for the crisis. Many banks failed in the U.S due to the interrelations between the banks and the lack of trust in the financial system especially after the collapse of Lehman Brothers which was considered as one of the few financial giants in the U.S. Moreover, the financial system was becoming more dependent on complex financial instruments that were more advanced than the capabilities of the regulators and hence such instruments were used excessively in an unregulated manner. Since the U.S was the source of the crisis it is logical that the severity of the crisis is much more than in any other place in the world. In Egypt the banking sector proved that it is based on solid grounds. With the lending cycle working efficiently and the liquidity stance is more than well and there is enough capital to absorb any potential shock, it seems that the Banking sector will not be affected by the financial storm. But with the financial crisis reaching a stage that is affecting the global economy, we can see that most economies including Egypt will have a portion of the slowdown. The Egyptian economy would suffer a decline in revenues generated by the tourism sector and Suez Canal, and also declining exports will all lead to a decrease in production and hence economic activity in general. This could ultimately lead to slow down in the economy, which will definitely disrupt the normal lending cycle of banks, since investments will tend to decrease, and also we will have lower tendency to save and therefore fewer deposits. Moreover, consumption would decrease and that would also lead to decrease in the demand for consumer loans. And as stated above the trade activities would decrease, and hence the banks will not be able to generate profits from the Letters of credit and letter of guarantee as before the crisis. Moreover, as the economic activity would decline and businesses and individuals might not be able to maintain stable revenues or cash flows, hence the percentages of defaults might tend to increase. All of this shows the potential effects of an economic slowdown on the banking sector in Egypt, and this proves that even though the banks would not be directly affected by the financial crisis, they will eventually be affected by the economic crisis caused by the financial crisis.

Interview with Mr. Lars Kalbreier

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In an interview conducted with Mr. Lars Kalbreier, CFA and Managing Director, Head of Global Equities and Alternatives Research in Credit Suisse, Mr. Lars stated that most countries will be affected by the crisis but with different degrees of severity. He believes that the current situation in the U.S is becoming more alarming as the credit freeze is not easing, especially that consumer spending will likely remain under pressure. He also states that the American banking sector proved to be inefficient in certain areas, and that most commercial and investment banks along with mortgage finance companies were driven mainly by greed and not by sound and rational decision that will give proper return with a proper amount of risk. When we asked Mr. Lars about when does he think the crisis will end, he stated that there are some indicators that should appear first in order to verify that the crisis is easing. Some of these indicators that he mentioned are; an increase in interbank lending (Ted Spread lower than 150 basis points), decline in CDS spreads, and volatility back to the range of 20-30%. Moreover, Mr. Lars argues that the effect on most emerging markets will differ than that of the developed countries and especially the United States where the crisis originated. The complexities of the financial instruments used in developed financial markets are far more advanced than the regulator’s capabilities which caused significant inefficiency driven by the desire of major financial institutions to make quick money. This problem is not present in most emerging markets, and till today many emergent markets have proved resilient. Regarding Egypt, Mr. Lars expect that the economic crisis will lead to some extent of economic slowdown that will in turn affect the banking system in Egypt, but as the loans to deposits ratio is quite assuring and the Central Bank of Egypt guaranteeing all deposits and no lack of confidence in the banking sector, it seems that Egypt will have a soft landing during this crisis. Furthermore, Mr. Lars believes that the weak performance of the Egyptian stock market is a “correction after years of outperformance” and now there are attractive valuations after the correction in equity prices, and today the prices represent the market in a more precise manner.

In conclusion, What Mr. Lars said is in line with our above analysis regarding the impact of the financial crisis on the American and Egyptian banking sectors. The American banking system is currently suffering from a severe shock, while the Egyptian banking sector is maintain it stability and performance. However, since the crisis reached the stage in which analysts are speaking of a global slowdown or even a recession since the world’s major markets are in a really bad shape (U.S, Europe, and some Asian countries) it is only logical to expect the emerging markets and especially Egypt to be affected economically. People may differ regarding the severity of the economical slowdown expected in Egypt but they all agree that whatever happens Egypt will still be in a safe position and this is clear in the Credit Suisse vulnerability indicators that prove that Egypt is insulated from the effects of the financial crisis.

Sources

http://economictimes.indiatimes.com/Indicators/Global_financial_crisis_The_Story_so_far/articleshow/3507868.cms

http://www.todayszaman.com/tz-web/detaylar.do?load=detay&link=156331&bolum=109

http://www.telegraph.co.uk/finance/financetopics/financialcrisis/3162206/Financial-crisis-500-billion-bail-out-plan-helps-stabilise-banks.html

http://news.xinhuanet.com/english/2008-10/04/content_10146313.htm

http://www.learningmarkets.com/index.php/20081002459/Stocks/Intermarket-Analysis/understanding-the-ted-spread.html

The TED Spread- Diagnosing the Health of the Economy

By: Mohamed Bahaa (Under the supervision of Dr. Stephen S. Everhart)

The banking sector is a major component of any economy, since its health is closely related to the strength of the Banking system. Banks act as intermediaries between surplus and deficit units, and help bring back the saved portions of the “household income” into circulation. As credit markets freeze, so does the whole economy; since the amount of money circulating decreases causing liquidity problems. But how is it possible to know whether banks are willing, or unwilling to lend?

I will be discussing one of the credit market proxies, the TED spread, while examining how is it affected by economic conditions, how it’s used in diagnosing the health of the economy, and how it can signal for favorable asset allocation structures and investment tips.

What is the TED spread?

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The Treasury-Eurodollar spread, also known as the TED spread, is the difference between the 3 month London Interbank Offered Rate (LIBOR) and the 3 month Treasury bill rate. This spread is known as the “Premium” added to the Risk Free lending rate (T-Bill in this case) which primarily measures the amount of “perceived risk” in the market. The LIBOR, used in calculating the TED spread, is the average of the interest rates offered in the London Interbank market on a 3-month dollar-denominated loan. The TED spread was initially set up as the difference between a 3 month T-Bill future contract and a 3-Month Eurodollar future contract, and hence the name Treasury Eurodollar spread. (Learning Markets)[1]

Components of the TED Spread Calculation

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The Treasury bill rate:

The 3-month T-Bill rate is considered as a risk-free lending rate; which theoretically implies that you would be willing to lend any person (or organization) with a zero default risk (Risk Free credit rating) at this RF rate. In this case, the T-Bill rate is considered as the benchmark on which risk premium is added to, of course, according to the risk involved.[2]

The LIBOR in US $ (Dollar denominated 3 month Eurodollar deposits):

The LIBOR is a reference rate based on the interest rates offered on unsecured interbank loans. This (theoretically) measures the expected risk when banks lend each other.[3] This rate as calculated in the TED spread, is the rate offered on interbank loans denominated in US $.

The Importance of the TED spread

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The intermediary role of the bank is what entitles it to being the “stimulator” of any economy. This is because of 2 main reasons. First of all, the money creation process in modern economies does not only rely on minting, or on the central bank, but it relies on the issuance of credit by banks. If for instance an investor wishes to deposit $10,000 for 1 year in exchange for the interest, the bank will receive this $10,000 and lend out a portion of it. If the bank issues a loan of $6,000 from the $10,000 deposit, now the borrower owns $6,000 and the depositor owns $10,000. Hence, the bank was able to “create” $6,000 from issuing a loan. Also By delivering the non-circulating portion of income back into the system, banks are able to “theoretically” increase investments, which will in return increase income, and receive more savings, etc.

When this cycle is obstructed, or a credit freeze takes place, the economy suffers drastically; the money creation process and the growth rate of the economy are both halted.  Credit freeze, is usually caused by evident fears in the market.. During such slowdowns, banks tend to refrain from lending, as a result of their inability, or unwillingness. The TED spread, essentially measures this willingness and/or the ability of banks to lend each other, since by measuring the premium you would get on lending another bank (over the rate at which you would lend the US government) you are implicitly measuring the banks’ expected risk on this transaction (Considering that the notion “the higher the risk, the higher the expected return” is always true). This implies that if the spread (premium) is wide, then banks are requiring higher yields to compensate for the higher expected risk (relative to the T-bills) of lending another bank. In simpler words, the TED spread measures the extent of trust (of repayment) evident in the interbank market, as a bank would demand a higher rate only in cases where there is a high probability of default.

The “extent of trust” mentioned above implicitly embodies the fear existing in the economy as a whole and within the interbank market. Credit spreads tend to widen as financial uneasiness is expected. This helps to pinpoint whether a financial turbulence is on the way, and how serious it is.

The 2007-2008 Financial Crisis, the TED and the Banking Sector

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Since the start of the Credit Crunch, August 2007, the United States has incurred losses amounting to $7.5 Trillion which makes it the worst financial crisis since the Great Depression of the 1930.[4] The crisis was initially a result of subprime lending, which was motivated by the eagerness of the “Undeserved Borrowers” or the non-creditworthy borrowers, to finance their homes through mortgages, accompanied by the gluttonous investors expecting higher yields promised on the mortgage securities[5]. The “securitization process” of these “junk” mortgages and loans, which was primarily used to mitigate default risk, had magnified the effect to not only include the mortgage issuers, but the financial institutions responsible for the securitization of the mortgages as well (Such as Bear Sterns, which were to fall later). These “subprime” mortgage backed securities were graded as AAA investment-grade securities considering that they were over collateralized by 150% of their value, which still does not change the fact that they are “Junk” mortgages. These credit enhancement techniques enabled the mortgage issuers to bypass the “default risk” by passing it on to the Investors[6]. Institutions now carrying less liability burdens, mortgage lenders are able once more to repeat the same process without waiting for the mortgage re-payments. Unfortunately, this instrument was misused, and was the major trigger to the unfortunate bankruptcy events of some of the giant financial institutions.

In mid September of this year, the world has witnessed the latest financial “Apocalypse”, starting with the fall of Lehman Brothers, one of the largest financial institutions internationally, as well as the “near death” experience lived by the American Insurance Group. This increased anxiety within the global financial world; if one of the largest and most stable financial institutions in the world collapsed, how would other smaller firms do? As problems and worries elevated, banks started to require a higher premium on loans, and rattled investors started to seek “safe haven” in T-bills. This initially caused a credit freeze, since banks are hesitant to issue loans, while depositors are afraid that the banks could lose their savings. As evident in figure 1, during September, as the uneasiness elevated, the TED spread has jumped to approximately 400 basis points, which is higher than the 300 basis points TED during the 1987 crisis showing in figure 2.

Figure 1[7]

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Figure2[8]

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Other Financial Turbulence Indicators in Brief

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Even though the TED spread is a comprehensive indicator for credit uneasiness, there are other indicators that can be used to diagnose the health of the economy. I will only be talking about 2 of these indicators; the Chicago Board Options Exchange Volatility Index, measuring the volatility of the equity market, and the LIBOR- Overnight Indexed Swap spread.

The LIBOR – Overnight Indexed Swap Spread

The LIBOR-OIS spread compares between the London Interbank Offered Rate (LIBOR) and the overnight index swap (OIS) rate[9]. This is calculated by subtracting the OIS rate from the 3 month LIBOR rate, and is calculated daily, by the average interest rate paid by institutions that day. [10]

The OIS allow financial institutions to “swap the interest rates they are paying without having to refinance or change the terms of the loans they have taken from other financial institutions”[11]

The LIBOR-OIS spread measures the amount of cash available within the interbank market, and is used by banks to determine interest rates. The larger the spread, the less cash there is available to lend out. This spread is beneficial in pointing out liquidity crisis, and is even more beneficial when used alongside with the TED spread.

Chicago Board Options Exchange Volatility Index (VIX)

The VIX is a leading indicator which shows the “market’s expectation of 30-day volatility”[12], also sometimes referred to as the “investor fear gauge”. The VIX is calculated using real-time option prices, hence reflecting the investors’ expected stock market volatility. It is calculated by the Chicago Board Options Exchange as a weighted “blend of options” on the Standard and Poor’s 500 index[13] .

When financial problems are evident in the market the option prices, and hence the VIX, tend to rise; the more the anxiety, the higher the VIX level.  The VIX is a good indicator for future market expectations, since it is derived from the Options market (which is based on instruments that are sold according to certain anticipations).  The VIX is quoted in percentage points of anticipated market movement throughout the next 30 days. Thus a VIX quote of 20, implies a 20% anticipated change in the market during the next 30 days. One complication is that a high VIX does not necessarily mean that the market will be bearish; the VIX implies a market movement, which could either be a negative or a positive movement. Thus, the VIX is a good utility to be used in order to forecast certain movements in the equity market, and hence, react accordingly.

The New VIX

The CBOE has recently adopted a “more precise” measure of expected market volatility, which is briefly described in the following brief description of the new amendments from the CBOE website:

Details from CBOE.com

Figure 3:The VIX (Blue) and S&P 500 (Red).

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[1]http://www.learningmarkets.com/index.php/20081002459/Stocks/Intermarket-Analysis/understanding-the-ted-spread.html

[2] “Risk adjusted” interest rates are calculated according to the risk involved, usually by calculating the Beta (sensitivity) of the asset. If there is a 0% default risk, then you lend at the T-Bill rate (if you consider this as your RF rate). If there is a 20% chance of default, then a market premium is added to the risk free rate as compensation for the amount of risk I would tolerate.

[3] Since the LIBOR usually entails a premium above the Risk Free rate, which implies a certain amount of “expected” risk.

[4] Reference: Commission on Growth and Development Working Paper on The U.S. Subprime Mortgage Crisis: Issues Raised and Lessons Learned, by Dwight M. Jaffe

[5] See Footnote 4

[6] Since it is graded as a AAA investment grade by the credit rating agencies, it was considered as a “good quality” asset.

[7] Figure from Wikipedia/TED Spread

[8] Figure courtesy of financialsight.blogspot.com

[9] Source: LearningMarkets.com

[10] Source: LearningMarkets.com

[11] Source: LearningMarkets.com

[12] Source: Investopedia

[13] Source: CBOE