The Global Crisis in Finance - Essay Example

?Introduction There are many reasons underlying the recent global financial crisis and it is difficult to evaluate any major one as the "main" cause.Verick and Islam (2010), in a report written for Institute for the Study of Labor, outline the reasons as the play of "interest rates, global imbalances, perceptions of risks and regulation of the financial system (2010). This view is a good one which will more or less be developed in this report. As far as establishing blame for the crisis, it may be perhaps be better to view the crisis as a business cycle because it is bound to occur again in spite of the current concern and efforts to set up corrective measures. There are presently many analyses of the crisis, perhaps the best one appearing as a recent report from the United States Congress. It agrees with most analyses that, at least mark the origins of the crisis as occurring in the United States. and most of these analyses seem to reflect the two points of views that divide the US political system. In general one view would say that the crisis was precipitated by the greed of Wall Street speculators and subprime lenders. The other side would point to the victims of the crisis in the US, the ones who didn't have credit but agreed to take upon mortgages for housing they couldn't afford. The main effort of this report will be to describe how the crisis happened and rapidly spread to the UK, England, and other parts of the world. It will try to understand the corrective policies and measures that have been made. Finally it will address the question of who has responsibility for the crises occurring. Discussion The Setting On the eve of the of the 2007-2008 global economic crisis it is significant that all but a handful of the world's learned economists, despite the gradually accumulating data, could not see the disaster coming (Verick and Islam, 2010). Most of advisors were still under the influence of the 2001-2007 boom. Apparently this boom stood upon a shaky economic foundation that forced even the World Bank and the International Monetary Fund to revise their forecasts. To understand the economics feeding this "straw boom", one must review world macroeconomics leading to it. There were two oil crises during the 1970s (Verick and Islam, 2010). The latest one occurred in 1979. This one produced a economic slowdown through the 1980s that especially characterized the developing countries. These countries had their economies more or less influenced by structural adjustment programs (SAPs) controlled by Western developed countries (Verick and Islam). SAPs were rendered by reduced macroeconomic volatility under the wisdom of government directed monetary policy in most of the developed countries. The 1990s can be experienced as low growth among these countries, with the Asian 1998 financial crisis all the more keeping that growth in low wings. The technology dot-com collapse occurred in 2001 and after it settled, the developed countries begin to collect themselves in a period of so-called sustained boom. Economist Robert Shiller is noted for reporting that the US housing boom started in the late 1990s (Verick and Islam, p. 15). This is notable as many commentators have placed blame for the current crises on the US monetary policy which lowered policy interest rates to 1 percent in 2003. The claim is that this effort in effect freed liquidity in US markets, heightening borrowing while creating debt-financed consumption (of housing). The point is that housing prices was on the rise in the US market before 2003. But even by that time, it only became more substantial as an open field for (housing) speculators. The period from 2002 through 2007 became filled with "robust optimism". Bernard Beneche, a widely respected economist later to be Chair of the US Federal Reserved, termed the period as one of "Great Moderation". Global economic balances were fed by surplus capital from China and other Asian and Middle East countries, primarily into the US housing market, that is, the mortgage debt market. At this time, perhaps one of the main reasons for the economic crisis was affirmed. This was the underestimation of risk. This feature probably exemplifies the outline of all business cycles as liquidity is somehow, but especially by monetary policy, loosened at the first stage. There was, however, a contrasting situation occurring with wage growth in emerging economies. Wage growth remained flat in Indonesia, South Africa, and Turkey during this period. In fact real and sustained wage growth was sluggish in developing countries and there was also rising inequality (Verick and Islam). The new wealth was not being shared. There were food riots in 2007 and the first part of 2008 affecting the economies of some of the developing nations. Up to 100 million people were forced into poverty (Verick and Islama). The recession would push 64 million into poverty (World Bank 2010). These riots occurring at that time were actually the cause of speculators such as Goldman Sachs, who had already heightened and exhausted, by that, the housing market. US Deregulation During the Great Moderation period, with liquidity loosened in the US, the next ingenious step was to create an instrument that, while investing, could efficiently transfer, or secularize risk. To understand the creation of derivation, it is best to get a good understanding of the background leading creating the US investment bank. Many researchers outline a number of laws, passed in the US Congress that occurred after the 1920s and 1930s Great Depression gave present shape to US investment banks. The 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. Regan appointed Alan Greenspan as chairman of the Federal Reserve Bank. Greenspan had been Charles Keating's lawyer and Keating had went to jail as one of the main savings and loans executive cheating speculators. Greenspan had argued that his client had 'a sound business plan' and that there had been 'no foreseeable risk' (xxx). In 1999, under President George Clinton, Congress passed the Gramm-Leach-Bliley Act which overturned the Glass-Steagall Act of 1933 and allowed mergers of banks with investment houses (McClendon, 2010). Not only did the banks become larger, but the executive compensation of bankers and brokers increased astronomically. Credit Comes to a Halt The investment houses, with the aid of new computer technology, were able to create the derivative as a new banking instrument that would allow transfer of debt and risk. Some US federal regulators saw the writing on the wall and sought to regulate the secularized versions of derivatives, the collateralized debt obligations (CDOs). But in 1999, at the urging of President Clinton's economic advisors, Allan Greenspan and Larry Summers (who would become President Obama's chief economic advisor),Congress passed a law that specifically banded regulation of the derivatives market. The races were on. They heightened in the United States in 2006 and early 2007 when reports of rising defaults in the sub-prime mortgage market begin to come in. Banks in Europe were racing with secularized instruments, transferred mountains of debts, too. In July, 2007, Gold Sachs indicated to IKB Deutsche Industriebank AG, that it would no longer sell its CDO securities to its customers, effectively cutting out credit lines to the bank (FICI, p. 247). The global credit market suddenly squeezed to a collapse. The credit crunch in 2007 has often been pointed to as a main reason offsetting the global economic crisis. As discussed later it certainly caused the default of Northern Bank, UK's first bank victim to the crisis. But there is a larger picture behind the credit crunch. As housing prices began to rise in 2006 and 2007 the United States Federal Reserve Bank used monetary policy, in 2007, to raise interest rates to control inflation. These new costs were spread to mortgages and especially to the new accumulation of subprime mortgages. Secondly many of the subprime mortgages were sold as adjusted rate mortgages. This meant that for the first or second year the mortgage costs were low, then the cost were readjustment a percentage point or more. The result was that the low-credit subprime buyer was suddenly faced with an astronomically high mortgage bill and was forced to eventually default. Mortgage defaults rapidly increased and housing prices began to fall. Further complicating the issue was that falling housing prices caused negative equity. For the low credit subprime buyer, mortgage payments because higher than the value of the house. The housing market busted. The year 2007 was marked as a year of financial panic. Shin (2009) explains that the global crisis erupted when the short-term funding market and lending among banks froze on August 9, 2007. This was the day when French bank BNP Paribas shut down its investment houses that bought U.S. subprime mortgage assets (2007). Paribas had around €400mn exposure in Lehman Brothers assets. Their decision effectively led to Lehman Brothers bankruptcy in 2008. A major reason for the global crisis is drawn out at this point. The credit market froze up, effectively stopping interbank liquidity. Northern Rock and the Banking Industry On September 2007, Northern Rock, a small but well respected bank in northeastern England, was shown on TV experiencing an "old-fashioned bank run" (Shin, p. 102). Northern Bank was not directly involved in the United States subprime market, but however its intermediary broker, Granite Finance Trustees Ltd, was involved. Many European banks had purchased short-term assets from United States investment houses such as Bear Stearns, Lehman Brothers, Merrill Lynch, and Goldman Sachs. The agents responsible for representing Northern Rock had done the same. Milne and Wood (2008) explained that Northern Rock's finances, the structures of its liabilities were tied up in cross border wholesale market for inter bank financing (518). The wholesale market allowed banks to obtain short-term loans in money markets and securitize debt in CDO instruments. When this credit market froze up, Northern Rock did not have the required funding shortfall to protect its retail deposits. The Bank of England did not accept securitized mortgages for collateral (p. 525). Northern Rock had a long term history with an auspicious beginning as a merger of two building societies in the late 19th century. The bank became public in 1997 and immediately went into the hopeful client of building assets through the secularized market. The amount of nonretail funding the bank had, that made it U.K.'s fifth largest bank by 2007, had almost doubled to 47.8 percent of its liabilities by December 2007, from 27.8 percent in 2000 (Shin, 2009, p. 104). The run on Northern Bank was not because of defaulting assets based on CDOs. Northern was not directly involved in the CDO market. But as Shin elaborated, its debt was secularized and the bank's defaults were based on the "nonrenewal of Northern rock's short- and medium-term paper" (p. 109). The banks creditors represented "sophisticated institutional investors" who were suddenly constrained from risk-taking, they were stopped, more or less, from "collateralized borrowing transactions" (p. 112). Needless to say, Northern second tier financiers were caught and could no longer sustain the rollover of Northern short-term debt. After injection of emergency funding from the Bank of England, which had initially hesitated, Northern Rock was nationalized by Act of Parliament in February 2008. The fortunes of Northern Rock were followed by Bradford & Bingley, a primary mortgage lender, which had to be nationalized in September, 2008. U.K.'s banking industry was brought to the verge of collapse. The Financial Services Authority had to provide emergency funding to Lloyds RSB, Halifax Bank of Scotland, and Royal Bank of Scotland. The global crisis recession was in full force. Conclusion There are many reasons that can be seen behind the global financial crisis. It had many sources of fuel. Speculation was indeed one, but also the desires of people to own their own homes. Perhaps it can be said that the theatre of the crisis had many actors and actresses. China served as a major one pouring the fuel of capital into a rising and speculative capital market that only asked for more. But aside from institutions there were more crushing real results. These were the lost of homes and the sudden burden with unheard-of debt carried by the working class. The most important figures was yet the lost of employment. Worldwide job losses were pegged by the UN International Labor Organization at 50 million at the end of 2009. In the United States unemployment rose from 5.0 percent in 2005 to 10.0 percent by October 2008. Unemployment in the U.K. was 4.7 in 2000. It was 7.9 by December 2010. Can blame be placed? Perhaps it can. But as economies move to change their structures, to rebuild from sudden loss, this report ends with support for a rebuilding process that would reaffirm hopes and make proper choices so that the next business cycle may not be as fatal as this last one was. "We had to go through a lengthy process to get a mortgage that was barely more than we earned, and now my son's girlfriend can get double that with hardly any income," said one [North Rock] customer, who declined to give his name but said he planned to withdraw his entire savings of more than ?100,000. "That's just not right" (Werdigier, 2007). Works Cited Financial crisis Inquiry Commission, January 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: U.S. Government Printing Office. 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: pp. 131-179. Milne, A. and Wood, G. 2008. Banking crisis solutions old and new. Federal Reserve Bank of St. Louis Review, September/October 2008, 90(5), pp. 517-30. Shin, H.S. 2009. Reflections on Northern Rock: The Bank Run that Heralded the Global Financial Crisis. Journal of Economic Perspectives, 23(1), pp. 101-119. Verick, S. and Iyanatul, I., 2010. The Great Recession of 2008-2009: Causes, Consequences and Policy Responses, IZA DP no. 4934. International Labour Office. Bonn Germany Institute for the Study of Labor. Werdigier, J. 2007. A rush to cash out of Northern Rock. The New York Times, 17 Sep. Accessed at http://www.nytimes.com/2007/09/17/business/worldbusiness/17iht-northern.4.7538205.html?_r=1&pagewanted=all Read More