Cornell University Johnson at Cornell University


Bracing for Global Impact

The EU - A Brief History
Scenes from the Subprime Meltdown
One Union, Indivisible? Not Quite
The U.S. and the EU: How are we different?

Doug McInnis

The European Union focuses on insulating its economy from the severity of further reverberations following the initial shock created by America's mortgage debt crisis.

Bracing for Global Impact
The European Union was founded in the ashes of post-World War II Europe with the avowed aim of heading off another war. The EU's mechanism for this was primarily economic – to lift the financial well-being of its member nations, and, where possible, head off trouble. By and large, the EU has accomplished both goals over more than five decades. But when America's subprime mortgage-lending bubble burst, much of the debris rained down on Europe – evidence that even an entity as powerful as the EU couldn't protect its populace from the ill winds of the global economy. Now the organization wants to craft a strategy to prevent similar crises in the future, and that may lead to attempts by the EU to have a hand in the oversight of U.S. securities markets.

Europeans had no doubt where the trouble was originating from. Europe's economy had been hit "by disruptions in the form of American events," a top EU finance official remarked with understatement at a recent press conference. Johnson School Finance Professor Warren Bailey was more to the point. "Clearly you can see this as our financial engineering spilling over onto their shores," he says.

However the matter is stated, America's venture into subprime mortgage lending was rocking Europe's economy. And the long-term threat was substantial. The U.S. subprime real estate crisis quickly spawned new financial toxins that had more capacity to damage Europe's economy than the original problem of mortgage defaults by subprime mortgage borrowers in the Unites States. These new threats included a global credit squeeze, a severe erosion of corporate profits, and, ultimately, a recession.

"The subprime crisis has had two major impacts on European banking systems," observes Jean Dermine, MBA '78, professor of banking and finance at the INSEAD Center for International Financial Services in France. "The first is the fear that some European banks might be exposed directly to credit risk located in the USA, or that the end of the real estate boom will be observed as well in Europe. The second is a fear of a liquidity squeeze . . . [This is] globalization at work."

Source: Center for Responsible Lending

Soon after those remarks, the bloodletting began as third-quarter earnings statements trickled in. In the United States, Citi was among those suffering losses from subprime exposure. On the other side of the Atlantic, the victims included Deutsche Bank and UBS, Europe's biggest bank.

The downside of a global economy
Much has been made of the benefits of globalization in recent years. But as the subprime crisis in the United States spread damage from China to Europe, headlines like these in The New York Times began to appear: "Why a U.S. Subprime Mortgage Crisis is Felt Around the World" and "Calls Grow for Foreigners to Have a Say on U.S. Market Rules."

The first headline illustrated the obvious: Financial contagions don't respect international borders. The second portended something the U.S. financial industry wants no part of: Regulation from abroad by the European Union. But that may be the cost the United States has to pay to play in a global market.

"We have power with them and they have some say over us," says Bailey. "There are a lot of things they can do to regulate these instruments. If there's any business being done in Europe, they'll have a say about it. It's too early to say how it will play out."

Of course, there are less invasive options than an out-and-out move to regulate U.S. securities markets. For instance, the EU could try to regulate what European banks do in U.S. markets. "Europeans wouldn't dream of regulating the U.S. securities markets," maintains Dermine. "What they will do is regulate more tightly European banks active in those markets."

Another possibility is oversight by a third party. German Finance Minister Peer Steinbruck suggests the International Monetary Fund might play such a role. "I think surveillance might be one of the most important tasks – watching and observing and assessing the financial markets."

The European Union has already taken two actions. In August, the EU announced it would investigate U.S. credit-rating agencies, which are now being blamed in part for their role in the crisis. The agencies gave high investment ratings to securities backed by packages of subprime loans; that is, loans given to borrowers who are considered too risky for standard mortgages.

In early October, EU finance ministers followed with an announcement that they would prepare long-term guidelines to prevent a repeat of the subprime fiasco. Among other things, the guidelines would require more transparency regarding the risks inherent in complex financial products such as mortgage-backed securities.

Then, in mid-month, the EU unloaded a potential bombshell when it announced that its leaders had endorsed a treaty among member countries that would give the EU more clout in global issues. The treaty, if ratified by EU nations, would give the EU more power while reducing the sovereignty of its member states.

Precedent for regulation
In the past, the EU has successfully exercised substantial regulatory clout in dealing with U.S. corporations. For instance, in 2002, the European Commission nixed General Electric's plans to acquire Honeywell on antitrust grounds. The commission said a GE-Honeywell merger would have dominated the market for jet engines for large regional and corporate aircraft. And, in September, the EU's second-highest court sent a chill over America's high-tech sector when it affirmed a landmark antitrust order by the European Commission against Microsoft. The decision could herald trouble for other U.S. tech giants.?

These cases illustrate an ongoing fact of life as globalization continues to expand: Capitalism differs from place to place. EU countries have a long history of strong regulation, while in recent decades the U.S. has deregulated industries ranging from airlines to banking. The result has been two huge economic systems that sometimes clash. "These are competing models of capitalism," says Elena Iankova, lecturer in international business.

In the backlash over the current financial debacle, rank-and-file Europeans worry that the EU may face future damage from the flow of risky exotic financial products from the United States. "A lot of Europeans are averse to our high-octane finance, such as private equity," says Bailey. "Americans think it's healthy."

Why the dominoes fell
Europeans fear more damage because they read daily accounts of the carnage caused by their region's exposure to American subprime mortgage securities. "The problem in Europe is huge because they feasted on these mortgage-backed securities," Finance Professor Maureen O'Hara said in a recent Johnson School lecture on recent stock market volatility.

These securities fell dramatically in value when subprime borrowers began to default on their mortgages. Then, as things deteriorated in the subprime securities market, investors went on "a flight to quality," favoring safe bets like U.S. Treasury bonds. "Nobody wanted to hold anything that was remotely risky" O'Hara said.

The result was a credit crunch, not only in the United States but in Europe as well, that threatened substantial economic damages. Without credit, business can't thrive.

The problems were compounded by creative packaging of subprime securities. Once the original mortgage-backed securities were issued, they were sometimes repackaged into bigger financial instruments called collateralized debt obligations, or CDOs. Sometimes these CDOs were packaged together into still larger securities, called CDOs squared. The upshot was that "you had more and more bonds issued against the original mortgages," says Robert Jarrow, Professor of Investment Management.

The growing complexity of the financial system was apparently not well understood either by regulators or by those who bought mortgage-backed securities such as CDOs. "A lot of people really didn't understand what they had bought," said O'Hara.

"The basic financial system remains the same, but there are new gadgets added all the time and these gadgets can be very complex," says Jarrow. "So you may not have an expert at the Federal Reserve Board who understands it. Regulators are always playing catch-up."

One institution that got caught investing in the new gadgets was UBS, the Swiss-based banking giant. UBS was caught with positions in subprime mortgage back-securities worth $19 billion. UBS also held what it termed a "warehouse" of CDOs. The bank reported that it would take a $3.4 billion write-down of mortgaged-backed securities, which would push it into the red for the third quarter.

The Snowball Effect
As the subprime crisis snowballed, fissures cropped up throughout the U.S. economy. Home building slowed. Sales of durable goods fell. And the rate at which new jobs were added to the U.S. economy fell sharply. Soon it became apparent that the U.S. economy was in difficulty, and this had large implications for Europe.

Amidst this backdrop, the dollar fell to record lows against many foreign currencies. The cheap dollar made European products more expensive and thus harder to sell in the United States, and it made European vacations less affordable for Americans. By early fall, economists on both sides of the Atlantic began to lower earlier predictions for economic growth.

It's likely that the pain won't be fleeting. Typically, subprime loans came with two-year teaser provisions, such as low introductory interest rates. These teasers would help keep buyers in their new homes – at least until the teasers expired. Since subprime loans were issued through 2006 and into 2007, mortgage defaults will continue through 2008 and into 2009. For this reason, the subprime unraveling has been termed a "slow-motion train wreck."

So Europe is bracing for the long haul. News of the subprime debacle in the United States and its impact on Europe is now a staple of its financial press. On any given day, for instance, London's respected Financial Times will devote a half-dozen or more stories to subprime lending and related matters. A recent headline in the newspaper's online edition highlighted the gravity of the situation: "EU Plans Market Reforms To Avert A Crisis."

The EU understands all too well that trouble in the United States spreads. "All these economies are hooked together," said finance professor Bailey. "What happens on one side of the Atlantic affects the other."

This story contains information from The New York Times, The Wall Street Journal, The Financial Times, and Business Week

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The EU - A Brief History

1950s The European Coal and Steel Community, predecessor to the EU, is formed in 1950 in order to bring lasting peace to Europe. Its members are Belgium, France, Germany, Italy, Luxembourg, and the Netherlands.

1960s EU countries eliminate custom duties in trade with each other. EU nations agree to joint control over food production to assure all EU citizens have enough to eat.

1970s Denmark, Ireland, and the United Kingdom join the EU. The EU establishes a regional economic policy to create jobs in poor areas.

1980s The Single Europe Act becomes law. This treaty sets up the groundwork to resolve the free flow of trade across EU borders. Greece, Spain, and Portugal join the EU.

1990s The EU completes its plan to create a Single Market, which allows the movement of goods, services, people, and money across the EU. Austria, Finland, and Sweden join the EU.

2000-present Ten new nations join the EU.

Source: The European Union

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Scenes from the Subprime Meltdown

August 2007 - Foreign investors slashed their holdings of U.S. securities by record amounts, raising the possibility of flight from U.S. assets and the U.S. dollar. (Financial Times Online, Wall Street Journal Online)

August 17 - EU announces it will investigate whether U.S. ratings agencies adequately alerted investors to risks of subprime mortgage securities. (New York Times Online)

September 17 - Britons withdraw billions of dollars in a bank run on Northern Rock, the country's fifth-largest mortgage lender. (Associated Press Online)

September 21 - Europeans fear dollar's fall will hurt exports. (Financial Times Online)

September 28 - Merger and Acquisition activity in Europe fell 51 percent in the third quarter compared to the second quarter. (Dow Jones online)

October 5 - The European Central Bank reports a sharp slowdown in loan demand – an indication of an economic slowdown.

October 6 - European banks tighten credit standards as financial turmoil persists. (Wall Street Journal Online)

October 8 - EU plans financial reforms to prevent a recurrence of credit crunch. (Financial Times Online)

October 17 - The International Monetary Fund cut its projection for global economic growth in 2008 from 5.2 percent to 4.8 percent. The IMF blamed financial unrest resulting from problems in U.S. subprime mortgage sector.

(Agence France Presse Online)

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One Union, Indivisible? Not Quite

European Union economic and regulatory policies can affect the bottom line of U.S. businesses. But predicting where the EU may fall on policy questions is never easy.

While it is a union in name, the EU is far from united all of the time. Member nations squabble over economic policy, just as U.S. states scrap over economic matters in Washington, D.C. And it can become harder to reach consensus as the EU grows ever larger. A recent case in point: the EU has been unable to agree on a constitution.

The EU's member states are a diverse group marked by political, cultural, and language differences – and by different views over how capitalism should work. That's not surprising, given a roster that includes the United Kingdom, some very liberal Scandinavian countries, old European powers France and Germany, and former members of the Soviet block.

"There are several different models of capitalism across Europe," says Bulgarian native Elena Iankova, lecturer in international business. "For instance, there is the British model, which is more liberal toward business, like the United States. You have the Swedish model, which is very oriented toward social welfare. Then there is the continental model, which is somewhere in between."

The new members from central and eastern Europe are tilting toward American-style capitalism, with its emphasis on less regulation. Though there are many reasons for this, one of them stems from their pasts under the highly regulated Soviet system, Iankova said. "When you want to get away from the old system," she said, "you go in the other direction, toward the American model."

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The U.S. and the EU: How are we different?

  • The European Union has about one-half the land area of the United States but far more people. Just under 500 million people live in the EU, versus about 300 million in the United States.
  • Europeans, by and large, enjoy more economic safety nets than Americans, but they are also more likely to be unemployed. In 2006, EU unemployment ran 7.9 percent; in the United States, just 4.6 percent were jobless.
  • Both the United States and the EU are major exporters, but the United States imports far more than Europe because of Americans' appetite for foreign goods. As a result, the U.S. trade deficit in 2005 was nearly six times as large as the EU's.
  • The EU's GDP is about ten percent larger than the United States' GDP
  • The United States has 50 states. The EU has 27 member nations. Three additional countries – Croatia, Macedonia, and Turkey – are candidates for EU membership.

Source: The European Union

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