How did the recent financial crisis affect Financial Markets and institutions - Essay Example

Causes of recent crisis The most immediate cause of the credit crisis was the bursting of the US housing bubble (Almendarez , “The Financial Crisis and a Fragile Global Economy”). There was a sharp rise in the value of the real estates in several countries which included the advanced economies of the world. Various countries including the largest world economy were running high and growing “current account deficits” (Obstfeld & Rogoff, “Global Imbalances and the Financial Crisis: Products of Common Causes”).

Buoyed by the booming housing market there was an excessive rise in the leverage level especially in the consumer market of Britain and US and various global financial entities. Some noted economists like Greenspan argue that global imbalances led to the financial fiasco. Again there are others like Taylor who discards this view. The progressive deregulation of the financial markets coupled with an ineffective supervisory oversight is also said to be one of the reasons that aggravated the crisis.

There are contradictions regarding the link between the global financial turmoil and global imbalances. . balances with easily available foreign money facilitated deferral of crucial policy decisions (Obstfeld & Rogoff, “Global Imbalances and the Financial Crisis: Products of Common Causes”). To make gains from the boom in the housing markets the lenders extended adjustable rate mortgages (ARM) to borrowers with a wrong credit history. All this was well as long as the Fed kept the interest rates low but with the hike in the rate of interest the borrowers were unable to meet their rising instalments resulting in delinquencies and loan foreclosures.

The value of the mortgage backed securities fell sharply due to the sudden delinquencies. The investment in these securities were not limited to advanced economies rather to make gains from the housing boom the investors across the globe rushed to invest in these mortgage backed instruments. Therefore a fall in the value of these instruments sent ripples across the worldwide financial markets plummeting the global stock indices. Impact of crisis on money and capital markets The issue of asset backed commercial paper (ABCP) peaked in July 2007 with a sharp drop in the subsequent months.

The financial institutions like IKB Deutsche Industriebank AG were not able to roll over their ABCP investments. There was a sharp rise in the spread between the “ABCP rate and overnight interest swap rate” which is actually a measure of the liquidity and default risk of ABCP. The impact of the crisis was first seen in the global capital markets. In June & July 2007 there was a downgrade of the mortgage backed securities from AAA to A+. This downgrade was significantly large as the ratings downgrade normally happens in single notches.

OECD labelled these ratings downgrade to be unexpected and this exposed the credit rating agencies to