Financial Markets and Institutions - Assignment Example

?S&P 500: Market Analysis I have chosen the S&P 500 index, and the period under consideration is March 14, to March 18, During this week, the US stock indices witnessed erratic movements, with the S&P 500 falling to its lowest levels in 3 months. The fall began on March 15th as worries over Japan’s earthquake and subsequent tsunami wreaked havoc on world stock indices. S&P 500 was no different, registering a decline of 1.1% as the market panicked over the Japanese calamity. This was further exacerbated by the situation prevalent in the Middle East, Libya in particular. The fear of supply shocks in the oil production triggered panic selling of oil stocks, which saw the benchmark index fall. March 16 saw an even worse situation in which economic data of the US painted a dismal outlook for the economy. Whole sales prices were seen increasing more than expected, while a lower than expected demand in the housing sector pushed the investors over the edge and panic selling took place. Investors sought sanctuary in US Treasuries instead of the stocks. Another key factor that lowered the stock index was the fact that option prices jumped up by 21% given the situation in Japan. However, the index saved grace and climbed up by almost 2.2% in the following two days, owing to the fact that G& offered their assistance in helping to control the Japanese fiasco. At the same time, the US manufacturing sector registered steady growth figures which boosted the S&P index. Another key factor was that investors displayed a slightly higher risk appetite and this saw Treasuries going down as yields rose to 3.26% from 3.19%. The most primary determinant of any index is the economic outlook of the region. S&P was highly influenced by the economic data that was coming forth. The disaster in Japan nudged the fact that US imports from the region would suffer. This could cause production issues in the US, which depended on machinery and raw material from Japan. Furthermore, the economic indicators such as inflationary pressure and weak demand elucidated the fact that the GDP growth would slow down. These assumptions triggered the rise in US treasuries which were seen as a safe haven. Oil prices not only raised the energy costs in US, but also created a sense of dread in OMCs’ who were at risk of supply shocks. Investors offloaded these stocks, judging that the P/E measures would drop due to lower earning concerns. Present valuation of future cash flows, or rather the ability to generate future cash flows was the major determinant in the decline and the rise in the market during this week. As mentioned above, the rise in manufacturing growth suggested that the sector would show positive returns, hence the market jumped up. International support for the Japanese boosted sentiments that their production capacity would soon normalize. Investors took this as a positive sign and the S&P 500 gained ground on this. The economic theory apart from present value of cash flows which applies to the S&P’s fluctuation is the inflation development. If inflation persists, then monetary tightening could occur. Any hike in interest rates would hurt economic growth, and such sentiments can cause a decline in the indices. As mentioned earlier, the biggest determinant of price movements of stock indices are the economic indicators and expectations of these indicators. If expectations lead to believe that there will be a positive change, then the prices of these indices will jump up. The flip side of the coin is that if sentiments perceive the market factors to be unfavorable, then a downward spiral can ensue. Financial Crisis 2008-11 Introduction The global financial crisis which started in early 2007 has proven to be perhaps the great financial catastrophe in history. Although it traces its roots back to the starting of the millennia, the subsequent meltdown was most gruesome over the past 3 years. What began as a crisis of the sub-prime mortgage market in the United States quickly transcended national borders and developed into an upheaval of epic proportions. What ensued was a systematic debacle of stock exchanges, investment banking, derivatives etc. all financial markets ranging from equity, currency, real estate, futures etc. In order to fully understand the devastation caused by this dilemma, we have to take focus on the core issues and identify the stream of events as they occurred and how they subsequently collapsed global financial markets. Key Factors The factors involved in the financial debacle of the 2007 can be summarized as mortgage underwriting, mortgage fraud, predatory lending, housing speculation, excessive leveraging, financial innovation, regulatory avoidance, inaccurate credit ratings etc. the amalgamation of this factors is the global meltdown we see crippling the economics of the world. If we look at these issues closely, we’ll see the sequence of events made the following scenario predictable. The global financial crisis began through the US sub-prime mortgage market. The past two decades leading up to the year 2005 had experienced phenomenal growth in terms of increases in housing prices. There was an abundance of capital flowing into the country and this translated into excess liquidity available for banks to lend out. The housing bubble experienced its pinnacle in 2005-06, which was the main indicator that the bubble would collapse in a similar manner to the Dot Com era. Default rates on sub prime and adjustable rate mortgages (ARM) began to increase quickly as the market witnessed growth of consumers. This was augmented by the rise in prices of the housing sector due to demand pressures. The banks that were lending in the sub prime market were also busy in another set of transactions, one of which was passing on the risk of these assets to other institutional investors. These included investors from the US, the EU and some parts of Asia. Extremely complex derivatives were employed to mask the risk profiles of the assets, such as credit default swaps. Off-balance sheet items were increasing, known as SPVs’ or Special Purpose Vehicles where bad loans and defaulting assets were parked as a separate entity so that the parent company seemed to be doing prosperously. When the interest rates in the US were raised in 2007, the consumers using the ARM mechanism started to default on payments. As the delinquency ratio increased for the market, the banks that had given the loans started charging more risk premium. This in turn increased the defaults. At the same time, the housing bubble came crashing down and prices of real estate fell drastically. Customers who planned to use the house they had loaned to repay the debt in case of defaults now realized that their houses had lost a significant proportion of its value. With the asset now worthless and the debt obligation constantly rising, the housing bubble became a nightmare for the consumers. On the other hand, the institutional investors who had purchased the CDOs’ and MBSs’ now realized that they’re money had eroded over night. Due to this revaluation of the asset value, Bear Stearns, a Financial Powerhouse, lost approximately $5 billion through the erosion of the existing value of its assets. This is just one of the many firms which took the brunt of this collapse. As the losses began to sink in and liquidity became short, these institutions starting pulling their money out from various other investments they had made around the world. This triggered a freefall of indices on a global scale including in Japan, UK, EU etc. and not to mention on its own turf like the Dow Jones. Impact The Financial Crisis had an imposing presence on financial institutions around the world, but the initial shocks were absorbed by banks of the USA and a couple of UK banks. The IMF has estimated that the losses of the crisis are nearing the $3 Trillion mark. These toxic loans affected many banks who had directly or indirectly involved themselves with the sub-prime mortgage securities. Investment banks like Bear Stearns realized the shortfall in liquidity, and accordingly opted to arrange funds through the divestiture of their other investments. This led to the spreading of the financial crisis on a global scale. It also triggered panic sell-outs at dirt cheap prices to other relatively more stable institutions. The deposit base of Commercial banks were not spared from this fate either, with depositors withdrawing their money rapidly for the fear that banks were becoming insolvent. This bank run sucked up even more liquidity from the market and all lines of credit were being closed. Depository institutions such as these banks were left without any liquidity with which to alleviate their position, and this quickly lead to their apparent downfall. Flipping the coin, money markets also began to experience withdrawal. Mutual Funds regularly invest in commercial paper issued by the different corporations who use the funds to continue operations. These funds are also used to meet short term debt obligations. When liquidity started becoming scarce, the mutual funds opted to withdraw their money from this market, resulting in a liquidity crisis for corporations which had nothing to do with the sub-prime market. Without the ability to generate funds, these companies found it difficult to maintain their interest payment cycle. Without being able to roll over their obligations, they were slowly beginning to dwindle. The Federal Reserve took immediate action by extending insurance for money market accounts via temporary guarantees. They also initiated programs by which the FED would buy commercial paper from these corporations. The shadow banking industry was perhaps the one hit the hardest. Shadow Banking refers to financial institutions which do not have a depository base, but engage in investment transactions. They had grown to a substantial size up till 2007, almost equal to the conventional banking sector in terms of importance. Without the ability to obtain investor funds in exchange for most types of mortgage-backed securities or asset-backed commercial paper, investment banks and other entities in the shadow banking system could not provide funds to mortgage firms and other corporations. The liquidity crunch crippled the shadow banking sector, and many reputable firms suffered dire consequences. Several major institutions which failed, were acquired under duress, or were subject to government takeover included Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac, Washington Mutual, Wachovia, and AIG. Market Dynamics Financial markets the world over are always interconnected. The most evident example of this fact was seen in the financial crisis, when a housing bubble bursting in the USA crippled the major economies of the world. Institutions opt to mitigate their portfolio risk by diversifying the investments in various asset pools the world over. Similarly, banks trade in currency markets and complex derivatives. The bond and capital market are also deployment tools to ease of excess liquidity concerns. In line with this, commodities are also a secure asset pool to invest in, if other markets are not as appealing. Then there’s the real estate market, the prime market etc. The issue is that since all these markets are linked, a domino effect occurs and a collapse of one can lead to disaster for the others. Defaults in the investments can trigger liquidity concerns, and this will be addressed by withdrawal from stock indices. The impending doom of bank defaults can lead to deposit runs. Misinterpretations in interest rate climate can tumble bonds and currencies alike. The point is that since each market is somehow affected by the other due to the lack of a buffer, the spill over effect can take place very quickly. Recent Implications Although the crisis is gradually passing, there are still signs of a lackluster economic cycle evident throughout the world. The USA is still in a recovery stage, and although growth seems to be picking up, the inflation factor has crept in and now the Federal Reserve is finding itself between the proverbial rock and a hard place. If they increase interest rates, its hampers growth as investments reduce and cost of capital goes up. If they keep the rates constant, the inflation levels spiral. On the European front, there is a lot of strain on the single currency union as its member nations are buckling under the debt pressure. Greece, Spain, Portugal etc. have all been recipients of rescue packages by their well-to-do counterparts. The debt woes have kept policymakers in Europe reluctant to trigger the GDP, and they’ve opted on less callous interest rate policies in an attempt to curb inflation. Stock indices the world over have recovered from the debacle, yet investment banks seem to have mellowed down a bit. Health tests of a number of banks have been conducted to measure the robustness of the financial system, and safeguards are now being placed to avoid the same incident from reoccurring. References Nabar, Malhar, December 16 2008, Rewriting the rule rook: The US policy response to the financial crisis 2007-08, Retrieved from: http://www.wellesley.edu/Economics/Nabar/__files/response_121608.pdf Butler, Willem H., December 2007, Lessons from the financial crisis 2007, retrieved from: http://www.cepr.org/pubs/policyinsights/PolicyInsight18.pdf Allayannis, Yiorgos, July 07 2009, The financial crisis of 2007-2009: The road to systemic risk, Retrieved from http://hbr.org/product/the-financial-crisis-of-2007-2009-the-road-to-syst/an/UV2551-PDF-ENG Conklin, David W., June 09 2008, The 2007-2008 Financial Crisis: Causes, impacts and the need for new regulations, Retrieved from: http://hbr.org/product/the-2007-2008-financial-crisis-causes-impacts-and-/an/908N14-PDF-ENG Rampell, Catherine, January 03 2010, Lax Oversight Caused Crisis, Bernanke Says, Retrieved from : http://www.nytimes.com/2010/01/04/business/economy/04fed.html Lazzaro, Joseph, November 4 2010, Bernanke on the Financial Crisis: Interventions Prevented Cataclysm, Retrieved from: http://www.dailyfinance.com/story/bernanke-on-the-financial-crisis-interventions-prevented-catacl/19433654/ Bloomberg Data Terminal, 2011. 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