The Recent and Current Global Financial Crisis - Essay Example

The Recent and Current Global Financial Crisis The recent and current global financial crisis was rooted by a collapse in the value of real estate under title to US mortgage companies and a variety of banks, including banking investment houses. This collapse led to immediate and deeply disparaging effects on the financial systems of the US and Europe and resulted in an international contraction of the employment market, increasing unemployment figures in most of the important global markets. Reasons have been analyzed for the failure of the financial markets. They have included faulting banks and investment houses for speculating under high leverage and low collateral, and homeowners defaulting on mortgages. Niinimäki (2007) noted a study that observed financial crises were usually preceded by periods of high defaults in the real estate market. This view has recently been confirmed by an IMF report (2011), that financial crises usually follow "credit or asset price bubbles" (IMF, p. 6). Moshirian (2010) has found that the inability of national regulatory bodies to respond adequately to a global market that has become increasingly interdependent has left these bodies unable to control regulatory arbitrage and the international movement of toxic assets (p. 504). In a way of confirming these last two perspectives Longstaff (2008) has found that lower movements in the ABX Index of credit-default swaps did cause financial contagion in other financial markets. This report will show how in the US, deregulation did serve to encourage market liquidity that could have advantaged banks and homeowners. The report will explain how the lack of appropriate regulation in the financial markets led to both a real estate bubble and the global financial crisis that reached the UK and world markets. Table of Contents Introduction 1 Deregulation 1 Risk-taking 3 Policy and Governance 4 Information Promoted 5 Findings 7 Conclusion 7 Recommendation 7 Bibliography 9 Introduction Since the Great Depression the American government has initiated programs that encouraged homeownership for the average citizen while at the same time promoting and insuring savings, as assets in banking institutions, that could be used to pay for mortgages. Following World War II there occured several rounds of deregulation policy expressed through passage of US federal acts that eventually, though not intentionally, allowed banks to collateralize the assets and to use them, as investment banks, to participate directly in the secondary financial markets. Deregulation was originally intended to finance supply with more liquidity of resources in order to meet an increasing demand in the real estate market. Eventually supply overtook demand while banks and financiers overtook market safeguards in favor of speculative profit. The US housing bubble that occurred in 1983 with the savings-and-loan debacle was amplified to multiple effects in 2008, producing the financial crisis that spread to the UK and the world. The 2011 US Congressional Financial Crisis Inquiry Commission Report identified "widespread failures in financial regulation and supervision" producing instability that undermined world markets (p. xviii). Deregulation McClendon (2010) explains how in 1980 the Depository Institutions Deregulation and Monetary Control act freed banks from usury ceilings held by US states, enabling them to charge conventional high interest rates to appropriate populations for home mortgage loans. This act also raised the deposit insurance limits up to $100,000. The ceiling had previously been $40,000. The Alternative Mortgage Transaction Parity Act of 1982 soon followed and allowed banks to make adjustable rate and interest-only mortgages outside of state restrictions. Both of these measures were intended to help banks and savings and loans institutions spread more liquidity into appropriate markets. The US Garn-St. Germain Depository Institutions Act of 1982 enabled savings and loans banks to enter the lending market with low loan-to-value ratios (McClendon, 2010). The result was that the savings and loans industry collapsed from speculation and little oversight. Thousands of Americans lost their life savings, and thousands of savings and loans executives went to jail. President Reagan appointed Alan Greenspan as chairman of the Federal Reserve Bank. Greenspan had been Charles Keating's lawyer and Keating had been prosecuted and had went to jail as one of the main savings and loans executive speculators. Greenspan had argued that his client had "a sound business plan" and that there had been "no foreseeable risk" (Dillon and Cannon, 2010). Risk-taking "The captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand and manage evolving risks within a system essential to the well-being of the American public" (FICI, p. xvii). But there had been plenty of risk. Niinimäki (2007) provides a discussion to demonstrate that banking crises "are connected with fluctuations in real estate markets". He analyzes how the fluctuation of collateral value may present moral hazards. Only when collateral value is known and certain may bank return volatility be alleviated. In such cases moral hazard may be reduced and banks may operate safety. Collateral in a sense introduces negative effects insofar as its value may not be known. Not knowing collateral value encourages bank non-monitoring and risk-taking or gambling. The value of a home may increase over the period of loan repayment. As well, it may also depreciate. As far as the bank is concerned Niinimäki attempted to demonstrate how these value changes represented certain or uncertain collateral as correlated with successful or unsuccessful loans. In a possible scenario monitoring borrowers by the bank may be eliminated because it indicated a "non-monetary cost". Niinimäki sketched his correlations over the factors of whether the bank monitors or does not monitor the collateral. Collateral and monitoring are seen as two tools to help eliminate moral hazard. Yet collateral may influence moral hazard since it may enable the bank to gamble with a "correlated risk". If the collateral value is high, this may signify a large and diversified portfolio, which Niinimäki says may lead to a belief in a certain return according to the law of large numbers (p. 16). However, collateral does not signify ability of the borrower to have income for which to repay the loan. Having collateral, fluctuating or not (certain or uncertain), may influence gauging the continued rise of real estate values instead of the direct application of cash flow evaluations. The result may be less monitoring of collaterals and more risk taking or gambling. These attitudes lied behind the housing bubbles of 1983 and the crisis of 2008. Policy and Governance At the end of the 1990s, computer technology emerged with the new banking instrument, the derivative. Investment bankers used derivatives to make innovative forays into the financial markets. President Clinton's economic advisors, Greenspan and Larry Summers, refused to allow the Commodity Future Trading Commission to regulate the derivatives market (Levine, 2010). Congress then passed a bill that specifically banded regulation of the derivatives market. Pools of loan mortgages were bunched into collateralized debt obligations (CDOs) and then sold to investors. CDOs were layered from AAA to A, then BBB and so on as various tranches. The first set received first payoffs of the principal and interest from the underlying mortgages. Underwritten by the large investment houses such as Merrill Lynch and Citigroup, CDOs were later insured by credit default swaps derivatives, written by such large concerns as AIG. CDOs were continually leveraged, bought and backed up with borrowed money (FCIC, p. 134). It is argued that the overall values of the CDOs became obscured, hidden by many layers of exchange, refinancing, and speculation. By 2004, CDOs were being exchanged in a market that had grown international to trillions of dollars (FCIC). Longstaff (2008) argues that CDO prices, as reflected on the unregulated ABX indexes which carried them, spread contagion effects onto the US Treasury bond and stock markets. In his study he demonstrates how ABX indexes could, within three weeks, demonstrate predictive effects on the returns of Treasury bonds and stock markets. However there were other , possibly, behavior effects that obscured clear correlations. Whether they were "deer-in-headlights" reactions, as Longstaff ends his study, the literature reports clear failures in ethics and corporate governance (Anwar, 2009). In late 2008, as banks and investment institutions began falling under CDO defaults, American Treasury Secretary Paulson and New York Federal Reserve Chairman Tim Geithner had, at the last moment, been persuaded that Lehman Brothers would be bailed out by a merger with UK Barclays Bank (Sorkin, p 354-355).The American Board member of Barclay’s, Bob Diamond, had pursued intense cross-country negotiations. However, Alistair Darling, Chancellor of the Exchequer, finally explained to the American officials that capital requirements were not forthcoming on the Lehman project. It was evident to all that the rapid depreciation of Lehman’s public stock was due to a huge share of toxic assets which Lehman had obscured. Darling informed the American officials that Barclays could not guarantee Lehman’s trade without a shareholder’s vote, which at that time was impossible. Information Promoted Moshirian (2011) discusses the international requirements by first summarizing several studies dealing with the failures of national regulation and corporate governance behind the global financial crisis. His major position is that there should be more international oversight and supervision to "provide more effective international coordination and expertise in mitigating financial risk" (p.503). A cause of the global failure was the inability of national leaders to operate together in a "global coordinated mechanism". Regulatory arbitrage could have received better control and information and data could have been access and exchanged in better ways. Historically, laws which the United States had passed to ease bank regulation, such as the Glass-Steagall Act (1933) and the Gramm-Leach-Bliley Act (1999) had actually worked against domestic industries in the larger foreign market (Bart et al, 2000). The laws may have had good relevance during their times, but the growth of world markets and liquidity overstrained their applications. Moshirian summarizes the history of the growth international institutions and their attempts to meet governance over a larger global market. The Breton Woods conference led to the International Monetary Fund, the World Bank, and the General Agreements on Tariffs and Trade (GATT). The European nations evolved to closer cooperation with the European Union and the establishment of the Euro as a common currency for 27 countries. The more recent October 2009 G20 Pittsburgh Summit would seem to set the stage for better cooperation but it has not yet none so, although there is a possible promise with the new Financial Stability Board (FSB), as a super national board. But control of regulatory arbitrage and allowing more data access and information across borders require better, larger, and firmer hands to control and coordinate. Along with the FSB, Moshirian underlines work that could be done by the rejuvenated Bank for International Settlements (BIS - Basel) and a focused International Monetary Fund (IMF) to help avoid global systemic financial risk. Findings The major causes of the current global crises can be drawn out as the failure of government to give proper and appropriate regulation and oversight to the financial markets and risk taking. Deregulation must also be properly governed with decisions made on, such as, how collateral is to be valued and how such value must be reflected in the company's accounts. Conclusion Niinimäki explains that if loans are not secured with (outside) collateral the monitoring bank risks failure. Under bank monitoring during a recession, bank failures are prevented. Longstaff reported how secularized risks spread contagion effects throughout national systems. These risks must be controlled , as Moshirian discusses, through mechanisms that are globally coordinated. To avoid global systemic risks, national policies today should incorporate global strategy insight into their national market oversight. At the same time, Global financial market cooperation should be pursued to avoid regulatory arbitrage and promotion better information sharing of financial data and allowing more data access. Recommendations A paper from the International monetary Fund (2009) addressed several flaws in the international structure, the "current global architecture", that this report accepts as its own recommendations to alleviate causes of global systemic risk. Surveillance should be clearer with practical application. Macro-prudential responses should receive international coordination by policy makers. Cross burden sharing to avoid regulatory arbitrage should be strengthened with ground rules. IMF funds should be augmented with better defined processes for short-term liquidity. Bibliography Anwar, G.M.J. (2009). The U.S. financial crisis from 2007: Are there regulatory and governance failure? Journal of Business and Policy Research, 4(1), 25-48. Barth, J.R., Brumbaugh, R.D., and Wilcox, J.A. (2000). The repeal of Glass-Steagall and the advent of broad banking, Journal of Economic Perspectives, 14(3), 191-204. Berlin, Mitchell. (2000). Why don't banks take stock? Business Review. Federal Reserve Bank of Philadelphia. Crotty, J. (2009). Structural causes of the global financial crisis: A critical assessment of the 'new financial architecture'. Cambridge Journal of Economics, 33(4), 563-580. Dillon, P. and Cannon, C.M. (2010). Circle of greed: The spectacular rise and fall of America's most feared and loathed lawyer. New York: Broadway Books. 291 Financial Crisis Inquiry Commission (FCIC). (2011). The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States. (Pursuant to Public Law 111-21). Washington, DC. International Monetary Fund (IMF). (2009). Initial Lessons of the Crisis for the Global Architecture and the IMF. IMF Research Department, Washington, DC. Levine, Ross. (2010). The governance of financial regulation: Reform lessons from the recent crisis. BIS Working Papers, No. 329. Accessed at http://ssrn.com/abstract=1717806 Longstaff, Francis A. (2008). The Subprime Credit Crisis and Contagion In Financial Markets. 2008. Journal of Financial Economics, In Press, Accepted Manuscript, Available online 25 January 2010 Norton, A.B. (2005). Reaching the glass usury ceiling: Why state ceilings and federal preemption force low-income bnorrowers into subprime mortgage loans. University of Baltimore Law Review. 35, 1-36. O'Brien, J. (2005). The politics of enforcement: Eliot Spitzer, state-federal relations, and the redesign of financial regulation, Publius, 35(3), 449-466. McClendon, J.K. (2010). The perfect storm: How mortgage-backed securities, federal deregulation, and corporate greed provide a wake-up call for reforming executive compensation. University of Pennsylvania Journal of Business Law, 12, 131-179. Moshirian, F. (2011). The global financial crisis and the evolution of markets, institutions and regulation, Journal of Banking & Finance, 5(3), 502-511 Niinimäki, J.-P. (2009). Does collateral fuel moral hazard in banking? Journal of Banking & Finance, 33(3), 514-521 Sorkin, A.R. (2010). Too big to fail. London: Penguin. Read More