Ethics and Financial Crisis of 2008 - Essay Example

?Running Header: Financial Crises of 2008 “2008 Financial Crises’ Module The 2008 Financial crisis were one of the toughest economic crises faced by the big economy of United States of America. These crises were not natural and were not part of the economic cycle, but many experts state that these crises were a result of some of the most unethical financial practices that were common in the United States of America’s economy. The banks used new instruments which were not only risky, but were unethical also. These instruments were created to double the debt level in the US economy which was already indebted heavily. This created a bubble and when the debt levels went out of control, the bubble busted resulting in dire economic problems. The instruments used to create debt in the economy were subprime mortgages. These mortgages were given to people who do not have collateral for their borrowing and were given without banks assessing their sources of income. They were given on the basis of credit score. Hence, in case these people go bankrupt, banks had no avenue to recover their investments. Since, the Financial System in the USA is not independent this created a “domino effect” situation. When the largest investment bank in the universe Lehmann Brothers collapsed, many other institutions in the US started feeling the pressure. Many had to write off their investments in Lehmann Brothers and they started to crumble. In order to assess why this happened, a study of risky and unethical instruments that were prevalent in the US Financial System at that time is needed. (NY, 2009) Credit Default Swaps are one of the most risky instruments that were common in the United States of America’s financial system prior to the 2008 financial crises. This instrument was used by lending companies to hedge their investment against credit risk. If one party need loan, the lender usually asked an insurance company to hedge their loan in the case of credit event against a periodic fee. This looked really bright and it was considered that it was going to increase the level of investments in the economy. For example, if A needs a loan and have a credit rating of B+. B lends loans and lends only to companies with a credit rating of AAA. The third party C with a credit rating of AAA will tell B that it will insure A against a periodic payment. Suppose A agrees and lend $2 Billion to A. It is also important to assume that insurance companies have limited assets. Suppose C has assets worth $3 Billion. It can be assumed that in case of bankruptcy of A, B can recover his investment through C. This looked fine, but what started happening was that companies like started insuring the loans that were as big as 10 times of their assets. Now in case credit event occurs, then they were unable to repay the lender. That was only a speculation that borrowers won’t default on loans. However, if loans that were more than the assets held by C default, then there is no way C can pay A. This would lead to a collapse. Not only A and C will collapse, but A will also go down due to high level of non-performing loans. Similarly, all the debtors of A will also lose their money and domino effect will be created. This is what happened prior to the crises started. The instruments were so risky, that they lead to the fall of the whole Financial System of the United States of America. The reason of failure of these instruments was the high systematic risk that was present in this type of securities. Since, it is impossible to diversify this risk, there was no way that the insurance companies could predict which companies would do well and which would fall down. Since, these instruments could not be diversified it lead a collapse of the whole financial system of the United States of America. (Money Monitoring, 2011). MBS or Mortgage Backed Securities were another fancy term used in the era prior to the 2008 financial crises. Mortgages were given on the premise that the property prices have been rising in the economy. So even if the bank gives unsecured loans against mortgages they will make money out of their lending. This was nothing but a lie. The property prices in the USA were rising because not because of increase in purchasing power of the ordinary man in the United States of America, but they were rising due to unnatural demand being created by these loans. Now when people started to default on their mortgage payments, the banks took their properties and put them on the real estate market. This lead to the increase in supply and the inflated prices come down. As a result banks realized that they have much less in their pockets then what they lent. Many institutions found it very hard write off these losses and had to file for bankruptcy. Similarly, many institutions that were dependent on these banks also had to file for bankruptcy creating a vicious circle of bankruptcy.(EC Pulse, 2011) Collateralized Debt Obligations encourage banks to undertake risky investment. These were later sold to investors at an inflated price. The rate of these investments was usually more than the rate of safe investments like T Bill which were clubbed in Tier-1 investments. The rate increased with each Tier level. These people were the last one to get their return, after all the safe investments had been paid off. This created a difficult situation to banks when they started experiencing a situation where people started to default on their dues. Hence, many investors lost a lot of their money and as a result had to file for bankruptcy. (CFR, 2011) Too big to fail is a term that is used to describe the conditions of the US financial system prior to these crises. Many banks did not assume the moral hazards of their risky investments. In other words, they were too preoccupied with the materialistic side of their investment decision to look at what will happen in the economy if some goes bad. Many experts states that many large institutions take financial and monetary policies from government and are able to take high risk positions because even they fall down, the government and the Federal Reserve is there to help them out. However, “Too big to fail” discourages the financial institutions to make more safe and sound decisions. Many companies and institutions believe that in case something wrong happens, the government and Federal Reserve is there to help them out. In case nothing bad happens they can enjoy the high returns from their risky investment. All of this encouraged some of the most foolish economic and financial decisions that were ever witnessed by the world. The government of the United States of America could not save the institutions that were in the process of bankruptcy and many eventually did fall down resulting in heavy loss for the economy as a whole. (Chanda, 2011) Works Cited Council on Foreign Relations: A Timeline of Global Economic Crisis http://www.cfr.org/publication/18709/ Alfaro L, Chanda A, Kalemli-Ozcan S, and Sayek S,. ‘How Does Foreign Direct Investment Promote Economic Growth? Exploring the Effects of Financial Markets on Linkages’. Site last accessed on September 10, 2010 from http://www.hbs.edu/research/pdf/07-013.pdf EC Pulse. Credit Default Swaps: Is It the Coming Threat? Retrieved on 22 September 2010. http://www.ecpulse.com/en/studies/2010/10/12/credit-default-swaps/ Money Morning. Credit Default Swap Strikes Again. Retrieved on 20 September 2010. http://moneymorning.com/2010/02/26/credit-default-swaps-7 New York Times, Articles written on May 27 2009 http://www.nytimes.com/2009/05/28/business/economy/28econ.html?_r=1&emc=eta Read More