2008 Financial Crisis - Term Paper Example

2008 Financial Crisis Until the start of the financial crisis in August 2007, the world was experiencing strong economic growth (Obstfeld & Rogoff). Investors and consumers were optimistic in their expectations, which reflected itself in high consumption and investment rates. In 2007, the US entered a financial crisis, consequences of which are still suffered by the entire country. Until the crisis began and unraveled in 2008, most economists were optimistic. The US economy was growing, markets were considered to be liquid and employment levels were high. However, within one year, everything changed. According to Reavis, “the collapse of the U.S. housing market triggered the financial crisis” (3). Weak financial regulatory structure, lack of understanding the innovations in the financial sector, over borrowing and securitization of mortgages are seen as main causes of the crisis. Though already in 2006 the Treasury recognized the need for a stronger financial regulatory structure, the crisis was unexpected. Short run potential financial market challenges together with the long run challenges were discussed by the Treasury staff (Swagel 6). The result was March 2008 Treasury Blue print for a Modernized Financial Regulatory Structure in case of policy changes in the long run (Swagel 6). Possible near term scenarios were considered, with some of them being: market driven events such as the failure of a major financial institution, a large sovereign default, or huge losses at hedge funds; as well as slower-moving macroeconomic developments such as … a prolonged economic downturn (Swagel 6). However, the crisis unraveling in 2008 was unexpected, as the Treasury did not expect any of the possible near term scenarios to occur (Swagel 6). Thus, the crisis caught everyone unprepared. Before the crisis, the Treasury focused on “risk mitigation beforehand and on preparing broad outlines of appropriate responses in the event that a crisis did develop” (Swagel 6). However, the Treasury viewed the developments in the financial sector with favor, sometimes also not understanding the adverse effects they could have on the US economy (Swagel 8). Swagel argued that the Treasury favored the innovations, such as mortgage – backed securities, because “they added to the liquidity and efficiency of capital markets and made it easier for firms and investors to lay off risk” (8). The policymakers did not have a solid plan to save the economy. Moreover, the US politicians, financial regulators, and monetary authorities did not view any of the risks to be plausible threats (Obstfeld & Rogoff 6). This paper will focus on causes and solutions to the 2008 crisis. Previously mentioned causes of the crisis will be discussed in more detail. It will also be shown how causes interacted and thus also deepened and prolonged the scope and length of the crisis. As also mentioned previously, policymakers were not prepared for the 2008 crisis. Thus, solutions will be discussed as well. Prior to the crisis, the economy was over performing. According to Reavis, the US real estate markets were blooming: From the late 1990s into the mid-2000s, housing prices around the country rose at a compound annual growth rate of 8%. By 2006, the average home cost nearly four times what the average family made. (Historically, it had been between two to three times.) Demand was outstripping supply (Reavis 3). Despite flat incomes, families bought houses whose prices were rising. The Clinton administration enabled them to do so by easing the eligibility requirements (Reavis 3). Risky homeowners and the housing boom from the late 1990’s till the mid 2000’s drove the US economy’s growth through additional jobs in construction, remodeling, and real estate services ( Reavis 3). Families borrowed $2 trillion (Reavis 3). Mortgage-backed securities and credit default swaps (CDSs) became popular. A mortgage-backed security is a pool of mortgages that were bundled together and sold as securities (Reavis 7). They became popular because they were low – risk since the housing prices kept on increasing. Thus, even if a borrower defaulted on a mortgage, the house could be resold at a much higher price to an eager buyer. An average mortgage had an average return of 5% to 9% in interest per year (Reavis 7). CDCs also became popular. CDSs are insurance-like contracts. They are used for municipal bonds, corporate debt, and mortgage securities. In an event of a default they would cover losses (Reavis 7). The buyer of the CDC pays a premium over a period of time and is in return covered in case of a loss. CDSs were before the crisis sold by banks, insurance agencies, hedge funds, pension funds, and other investment outlets to decrease their credit risk (Reavis 7). Since the CDC market was not regulated after 2000, investors traded contracts “without any oversight to determine their value and ensure that the buyer had the resources to cover losses in case of default” (Reavis 7 - 8). As a result, the financial sector became more profitable than the corporate. In the 1973 – 1985 period, profits in the financial sector amounted to 16% of domestic corporate profits (Johnson). However, by the 2000s, they amounted to 41% (Johnson). Compensation in the 1948 – 1982 period was between 99% and 108% of the average for domestic private industries (Johnson). In 2007, it amounted to 181% (Johnson). Credit default swaps market, unregulated by the 2000 regulation, “grew astronomically from $900 billion at the turn of the millennium to over $50 trillion in 2008” (Murphy 2). Growth was deceitful. Until 2006, the US economy was growing. Though GDP growth had slowed in the second half of 2006, it increased again in 2007 (Swagel 9). The labor market was flourishing since 2003 (Swagel 9). However, the debt to GDP ratio “doubled from 50% in the 1980s to 100% of GDP by the mid-2000’s” (Reavis 3 – 4). According to Reavis, this ratio was comparable to the ratio in 1929 (Reavis 4). Having started in 2005, foreclosure rates for subprime borrowers in 2007 increased and “subprime mortgage originators such as New Century went out of business” (Swagel 9). In turn, housing prices decreased. The Fed and the Treasury came with an analysis in May 2007 stating that 2007 would be a year of foreclosures, but that the problem would subside after 2008 (Swagel 9). The crisis started unraveling in August 2007. Investors became skeptical about the off – balance structured investment vehicles (SIVs) through which banks financed long – terms assets by using short – term funds (Swagel 10 – 11). Wall Street firms stopped buying riskier mortgages as families started defaulting on their loans and prices of houses started decreasing (Reavis 5). The downward spiral began. Unlike what was expected, many banks became illiquid; with too small assets, they failed to cover their liabilities (Reavis 5). Credit markets froze and neither consumers nor firms could obtain funding (Reavis 5). Two types of housing problems occurred. One was in the Midwest and along the Gulf Coast, where high default and foreclosure rates were caused by weak economies, largely caused by the 2005 hurricanes (Swagel 13). Here the cause of the housing crisis originated in the economy. The other type is characterized by states located on “the downside of housing bubbles,” such as Arizona, California, Florida, and Nevada (Swagel 13). Housing prices steeply declined, which led to foreclosures and lack of funding to marginal buyers (Swagel 13). Subprime lenders were not able to obtain funding needed for refinancing their prime adjustable-rate mortgages (ARMs) as the value of their houses declined (Swagel 13). The housing bubble, where houses were overpriced, started correcting itself. Besides the subprime mortgage securitization, loosening of the financial regulation system is seen as another cause of the crisis. The repeal of the Glass-Steagall Act in 1999 is seen by some as one of the important factors that led to the crisis (Reavis 6). This act prohibited any institution to engage in investment banking while conducting a function of a commercial bank (Reavis 7). Also, no institution was allowed to act as a bank and an insurer (Reavis 7). Commercial lenders such as Citigroup could from then on underwrite and trade instruments such as mortgage-backed securities. The 2000 Commodity Futures Modernization Act left the derivatives market unregulated (Reavis 7). Derivatives increased liquidity and mitigated risk by protecting banks that loaned out large sums of money, yet expected that some defaulting might occur (Reavis 7). Sources of support to institutions failed as well. Government-sponsored enterprises Fannie Mae and Freddie Mac had a charter from Congress with a mission of supporting the housing market. They were in charge of purchasing and securitizing mortgages “in order to ensure that funds were consistently available to the institutions that lent money to home buyers” (Reavis 11). As the Clinton administration became supportive of loans to high risk families, these companies were pressured by Congress to increase lending to lower-income borrowers. However, a result was lower credit standards and purchased or guaranteed “dubious” home loans (Reavis 11). In absence of regulation, investment was unchecked. Not only were CDCs sold and resold without any concern for quality, but foreign investment made American financial institutions even more reckless (Reavis 9). The middle classes in emerging markets, such as China and India, became rich at increasing rates with nowhere to invest that money in their home countries. The US, a traditionally safe country to invest in, became even more attractive. Global investments increased from $36 trillion in 2000 to over $70 trillion in 2008 (Reavis 9). However, US Treasury bonds were no longer attractive as the federal funds rate, which stood at 6.5% in 2000, dropped to less than 2% by 2003 (Reavis 9). Thus, these investors bought CDCs and mortgage – backed securities. Not only did they help increase the American financial sector’s dependence on these new, yet largely unexplored and untested derivatives, they also encouraged reckless behavior. As demand increased but quality was not guaranteed, highly risky mortgages could be included as well (Reavis 9). Regulators also supported reckless balance sheets of the financial institutions. The leverage rules for investment banks were loosened by Securities and Exchange Commission (SEC) in 2004 (Reavis 10). From ratios of 10 to 15, by 2008 the ratios increased from 30 to 40 times (Reavis 10). Once defaults on mortgages started, these institutions lost liquidity. Clientelism deepened the crisis. In October 2008, the government approved the Troubled Asset Relief Program (TARP), which gave cheap loans to financial institutions. Recipients were too – large – to – fail institutions: “Citigroup, for example, received $45 billion; Bank of America, $25 billion; and AIG, $180 billion” (Reavis 12). Conditions were attached to the loans which tried to limit salaries of executives. The popular belief was that these loans would flood the economy with liquidity and that loans would again be given out to consumers. However, banks refused to lend the money (Reavis 12). The effect was healthier banks and an unhealthier economy, with governmental resources gone to an unproductive investment. Programs initiated by the Treasury Secretary Timothy Geithner proved to be equally unproductive (Reavise 12 – 14). Reinhart and Rogoff argued the 2008 crisis was nothing unusual (“This Time is Different”). They looked at a dataset for different countries over a time period of eight hundred years (Reinhart & Rogoff “This Time is Different”). What they discovered is that increased capital inflows increase the risk of a debt crisis: “historically, significant waves of increased capital mobility are often followed by a string of domestic banking crises” (Reinhart & Rogoff “This Time is Different”). Moreover, they discovered that domestic banking crises predict debt crises (Reinhart & Rogoff “From Financial Crash to Debt Crisis” 1701). As mentioned previously, strong economic growth in countries like China significantly increased capital flows to the US. The US debt to GDP ratio also increased significantly. The result was the worst crisis since the Great Depression. Romer argued that though not as destructive as the Great Depression, this crisis has been the worst in terms of unemployment, home foreclosures and financial sector breakdown since the Great Depression (1). In 2009, unemployment amounted to 8.1% (Romer 1). However, during the Great Depression unemployment reached 25% (Romer 1). Moreover, real GDP declined 2% from its peak in 2009 (Romer 1). The Great Depression was worse, as between the peak in “1929 and the trough of the great Depression in 1933, real GDP fell over 25%” (Romer 1). Consumer confidence decreased. As real estate prices decreased, consumer confidence decreased. Consumer confidence is based on wealth available to consumers. More valuable houses imply more money available to consumers as they can obtain larger loans from banks. The crash in 2008 led to an increase in savings in response to uncertain real estate markets (Romer 2). However, unlike in the 1930’s, the current crisis has spread worldwide. US securities were sold globally. As the crisis set in America, so it spread across the world as well. Coupled with local problems, the crisis became international. Moreover, a decrease in US demand decreased exports for many countries exporting to the US, such as China, Taiwan and South Korea (Romer 3). Effects of the crisis follow the general trend. Reinhart and Rogoff argued that the aftermath of severe crises can be characterized by three developments (“Aftermath”). They argued that asset market collapses are “deep and prolonged” (Reinhart & Rogoff “Aftermath” 2). They found in their dataset that real housing price declines are on average 35 percent and are stretched out over six years, “while equity price collapses average 55 percent over a downturn of about three and a half years” (Reinhart & Rogoff “Aftermath” 2). Moreover, they argued that the aftermath of banking crises is “associated with profound declines in output and employment” (Reinhart & Rogoff “Aftermath” 2). Usually the unemployment rate rises on average by 7 percentage points over the down phase of the cycle and it persists for four years (Reinhart & Rogoff “Aftermath” 2). Output falls by over 9 percent, but the duration of the downturn in production is shorter than in case of employment. Lastly, they argued that the real value of government debt explodes. They found that debt increased to 86 percent in the large post – World War II crises (Reinhart & Rogoff “Aftermath” 2). However bailout costs are not the main causes of these explosions. Instead, they found that debt increased because of a crash in tax revenues resulting from output contractions and countercyclical fiscal policies that were ambitious (Reinhart & Rogoff “Aftermath” 2). The US economy responded similarly. The housing prices declined by almost 28 percent by 2009 (Reinhart & Rogoff “Aftermath” 3). This decrease was even larger than during the Great Depression (Reinhart & Rogoff “Aftermath” 3). Similarly, unemployment kept on increasing into 2011. Debt also exploded. US GDP decreased too by 6.7 percent from the end of 2008 till the start of 2009, but then increased by the end of 2009 (Bureau of Economic Analysis). However, I do not completely agree with the dominant views on the causes of the crisis. Whereas I agree that securitization and lack of supervision have led to the crisis, I would not blame so much the private sector for it. Objective of every company is to maximize profits. This implies that every company will innovate and through innovations try to be the first on the market. Being first on the market implies highest profits as there are no competitors to steal a market share. Thus, it is not a surprise that CDC and mortgage – backed securities were developed. Moreover, foreign investors should not be blamed either. Obstfeld and Rogoff cited Former U.S. Treasury Secretary Henry Paulson, who argued that: the high savings of China, oil exporters, and other surplus countries depressed global real interest rates, leading investors to scramble for yield and underprice risk (Obstfel & Rogoff 2). However, Obstfeld and Rogoff disagreed with the above statement. They argued instead that foreign investment in the USA only postponed reforms that were needed. They blamed the inadequate reform progress, which resulted in low savings rates in the US, as well as a rising level of debt (Obstfeld & Rogoff 5). I would blame the government. The repeal of the Glass-Steagall Act in 1999 and the 2000 Commodity Futures Modernization Act enabled the private sector to go about their business unregulated. Moreover, activities by Fannie Mae and Freddie Mac set the standards. However, these standards were too low. Thus, it is no wonder the private sector acted irresponsibly. It is usually argued that the markets will regulate themselves, but I disagree. Of course I do not agree with the fact that markets should be nationalized. I am not a proponent of nationalization, as many claimed the government attempted to do to the institutions (Reavis 13). However, history has shown that unbridled markets produce externalities, and they are borne by the consumers and the wider economy. On the other hand, the too – big – to – fail companies are provided with billions of tax money to then store it and guard it from the hands of the rest of the economy. I believe solutions are in the hands of the government and the market. High levels of unemployment cannot be solved through an increase in employment at Citigroup and companies alike only. The entire economy needs to recover. Consumption needs to rise, real estate markets needs to be revitalized and through that investment should increase. Solutions focused on financial institutions. Swagel called for a strong support to banks and elimination of toxic assets such as mortgage – backed securities. Romer too agreed that the financial sector needed to be secured before anything else was done (9). However, Romer believed that the financial sector would not recover without the prior recovery in the real sector (9). Fiscal and monetary stimuli would too prevent a rise in unemployment and a further decrease in investment (Romer 4, 7). Fiscal stimulus in form of the American Recovery and Reinvestment Act allocated $800 billion to the tax cuts, direct government spending, help to the individuals directly hurt by the recession and states (Romer 4). Moreover, some believed that monetary policy would adjust expectations, even though interest rates were near zero (Romer 7). However, unemployment rose. Though growth picked up again in 2010, I would not argue that the US has exited the crisis. In February of 2012, unemployment rate stood at 8.3 percent (Bureau of Labor Statistics). Though there was a rise in employment in 2012 from 2011, the US economy still has many unemployed that need to become absorbed. Romer argued that the US economy would eventually recover, and improvements are indeed present, but unemployment must be combated. Another fiscal stimulus should address unemployment levels. The US government should promote entrepreneurship, which in turn, should increase employment levels. Since businesses depend on consumer confidence in their decisions to invest and expand operations, consumption needs to be increased. But this can only be done through tax breaks and an increase in wealth and income. We still have seven years of the fiscal stimulus left, but most of that money was already spent by 2011. Thus, an additional investment in the economy is needed. Moreover, good risk management practices must spread. Jorion analyzed risk management practices of several banks after the 2008 shock. Good practices were discovered: in house expertise on risk valuations; shared information across firm; they charged business lines for liquidity risk; avoided CDC, CDO’s; used quantitative and qualitative analysis; tested for different assumptions; and tested for correlations (15). Moreover, winners were not hierarchical firms, where top managers passed on commands and others followed without any feedback to the manager (Jorion 15). United States Government Accountability Office (GAO), argued similarly about bad risk management practices that led to the fragility of financial institutions. So far, the legislation has provided a good framework for good risk management practices. The Dodd–Frank Wall Street Reform and Consumer Protection Act from 2010 and Basel III introduced new regulation of hedge funds and private equity funds (Anderson et al. 2). The definition of eligible capital narrowed, liquidity requirements increased, contingent capital was required and new management practices for annual stress tests were required so that managers would no longer ignore a possibility of a shock (Anderson at al. 2). The government also increased regulatory activities over the financial sector. New oversight authorities over banks and nonbanks were created (Anderson et al. 3). I believe this was necessary, as previous practices were inefficient and inadequate. Murphy argued that the credit default swaps were largely mispriced (4). Analyses focused on predicting the future movements based on the past performance (Murphy 3). Thus, a likelihood of a sudden and significant shock was overlooked (Murphy 3). They did not consider inter – related risks, and made assumptions that markets are always in equilibrium (Murphy 3). Such analysis then misguided the financial institutions, as they failed to see the interaction between the financial sector and other parts of the economy. The most recent legislation attempts to address these shortcomings and promote good practices described by Jorion. This paper has described the factors that led to the US crisis. The causes are both, regulatory and financial. However, I believe the main fault lies with the regulators. Financial companies innovated but were not aware of the potential risks these instruments brought along. Moreover, their risk management practices were in majority cases inadequate for dealing with such instruments, especially as the use of American mortgage – backed securities spread across the globe. Without a strict regulatory system, profit seekers, both internationally and domestically, engaged in reckless behavior. They traded without concern for quality of the derivatives. The government and the private sector became indebted. The debt to GDP ratio increased, and as the crisis started unraveling, most companies saw their liquidity disappear with mortgage defaults. Solutions have produced positive outcomes, but more work is needed. GDP growth has resumed, and financial sector has been largely stabilized. The money injections in the economy have prevented the economy from escalating into the 1929 crisis. However, unemployment is still high. Thus, solutions must focus on high unemployment levels in the short run. In the long run, the regulatory changes made so far will produce better oversight and more prudent decision making by the financial institutions. This in turn should make such crises even more seldom. Though this is the largest crisis since 1929, improvements in regulations and governmental policies have ensured we did not have more of them. Works Cited Anderson et al. “Assessing and Addressing the implications of new financial regulations for the US banking Industry.” McKinsey & Company, March 2011. Web. 2 April 2012. Bureau of Economic Analysis. National Income and Product Accounts Tables. U.S. Department of Commerce. Web. 29 March 2012. Bureau of Labor Statistics. Labor Force Statistics from the Current Population Survey. United States Department of Labor, 2012. Web. 1 April 2012. Jorion, Philippe. “Risk Management Lessons from the credit Crisis.” European Financial Management (2009): 1 – 19. Murphy, Osten. “An Analysis of the Financial Crisis of 2008: Causes and Solutions.” Social Science Research Network, 2008. Web. 29 March 2012. Romer, Christina. “Lessons from the Great Depression for Economic Recovery in 2009.” Brookings Institution, 2009. Web. 28 March 2012. Obstfeld, Maurice and Rogoff, Kenneth S. “Global Imbalances and the Financial Crisis: Products of Common Causes.” The Federal Reserve Bank of San Francisco Asia Economic Policy Conference, 2009. Web. 30 March 2012. Reinhart, Carmen M. and Rogoff, Kenneth S. “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises.” NBER Working Paper No. 13882 (March 2008): 1 - 123. Reinhart, Carmen M. and Rogoff, Kenneth S. “The Aftermath of Financial Crises.” NBER Working Paper No. 14656 (January 2009): 1 – 13. Reinhart, Carmen M. and Rogoff, Kenneth S. “From Financial Crash to Debt Crisis.” American Economic Review 101 (August 2011): 1676–1706. Reavis, Cate. “The Global Financial Crisis of 2008: The Role of Greed, Fear, and Oligarch.” Massachusetts Institute of technology, 2012. Web. 2 April 2012. Simon, Johnson. “The Quiet Coup.” The Atlantic, May 2009. Web. 2 April 2012. Swagel, Phillip. “The Financial Crisis: An Inside View.” Brookings Papers on Economic Activity, Vol. 2009 (SPRING 2009): 1 – 63. Williams, Orice M. Review of Regulators’ Oversight of Risk Management Systems at a Limited Number of Large, Complex Financial Institutions. United States Government Accountability Office, 18 March 2009. Web. 3 April 2012. Plagiarism Declaration I declare that, to the best of my knowledge this assignment is my own work, all sources have been referenced, and the assignment contains no plagiarism. I further declare that I have not previously submitted this work or any version of it for assessment in any other subject. Student's Signature: Date of Signing: Read More