Global Financial Crisis - Essay Example

Introduction The global financial crisis began in 2007 in the United States mostly as a result of housing boom and bust and spread all over the world due to globalization. It has led to the collapse of major financial institutions such as Lehman brothers and Merrill lynch. It can be attributed to political factors as well as economic factors. These include; loose monetary policy, relaxation of regulation in financial markets, sub prime lending, and excessive risk taking by banks, overconfidence, complexity in rating by rating agencies due to complex securitization, and the housing boom among others. The way governments responded to the financial crisis also worsened the situation. For example, the rescue package by USA was not clear as some institutions like Bear Stearns was rescued while Lehman brothers was left to collapse leading to lack of confidence in credit market. The crisis had great impact as it led to slow growth which translated into unemployment further worsening the situation. The paper will discuss the origin or causes of the financial crisis and how it affects individuals and the economy as a whole. Loose monetary policy in USA has mostly been blamed for the crisis. According to Taylor (2009, p. 20), low interest rates led to depreciation of the dollar and consequently rise in oil prices from $70 a barrel in August 2007 to over $140 per barrel in July 2008. This consequently led to the increase in commodity prices especially housing prices. Davies (2010) argues that the crisis was precipitated by financial innovations and laxity in monetary policy which were used as measures to offset the impact of income inequalities on aggregate demand. Households were encouraged to borrow funds to finance consumption hence growth of leverage in American households. Credit expansion led to economic growth thereby pushing up the value of equities, commodities and real estate (Jackson, 2009). The increased housing prices were the beginning of the crisis. There was speculation in the market that the prices would continue rising in future creating an opportunity for banks to offer mortgage backed loans even to sub prime borrowers. Households were being encouraged to own homes and hence were given mortgages at low interest or waiver of interest for two years and no down payment (Kolb, 2010). The mortgage brokers then sold the mortgage to a bank at a commission hence transferring risk to the bank. The banks then bundled the mortgages into one complex product and got the services of credit rating agencies for valuation. Due to complexity of the product, the rating agencies gave a good rating to the product. The bank then securitized the loans and due to the high rating, the securities were worth much more than government securities thereby attracting investors. Banks could borrow funds to buy more mortgages so as to securitize and earn high returns. The easy money and overconfidence due to speculation of high housing prices in future led to excessive risk taking by banks and other financial institutions. Davies (2010) argues that the financial market regulators are to blame for allowing speculation and not offering adequate risk management controls. Due to speculation, there was decline in risk perceptions by banks as well as risk tolerance such that investors were accepting low returns for mortgage backed securities. The investors did not know the value of the securities or risks involved as they were relying on credit rating agencies who were giving wrong ratings due to complexity of the mortgages. Swan (2010) on the other hand, argues that the government programs aimed at promoting home ownership and increasing profits of real estate investments were to blame. The government enterprises and mortgage lenders Fannie Mae and Freddie Mac promoted the program by deducting interest for owner occupied home loans. They were buying mortgage backed securities including those that were formed with risky sub prime mortgages. Banks like Lehman brothers, northern rock and Merrill lynch were borrowing funds and lending to others for sub prime loans. Swan (2010, p.53) notes that securitized loans amounted to 15% of GDP in the US in 2006 and 4.4% in Europe. As a result of increasing prices and rising housing costs, consumer spending started to decline. When mortgage loans were recalled, the home owners could not afford to repay as most of them had no means of earning income and others were bad debtors. Mass repossession of houses coupled with high interest rates and declining economic activity led to the bursting of the housing bubble. There was lack of confidence in the credit markets due to rising defaults by sub prime mortgage holders and declining housing prices leading to a credit crunch. Financial institutions were not willing to give out loans to investors or small enterprises due to fear of default (Abbey, 2009). The value of shares fell and banks were unable to repay the loans they had borrowed to acquire mortgages and were also unable to resell the houses due to fall in price. Stock market investors began to panic as shares declined in value leading to fall of the stock markets. Large financial institutions like Bear Stearns which is the second largest underwriter of mortgage backed securities, Lehman brothers and northern rock in UK began to collapse as they had little in deposits and had no reserves all was tied in mortgage backed securities. Large insurance companies like American International Group (AIG) also began to collapse as they were offering credit default swaps. Hedge fund clients pulled out of the market and short term creditors cut their credit. The government efforts to save the financial sector could also have worsened the crisis. The Federal Reserve Bank and Bank of England offered to bail out the affected institutions. In the US, the Bush administration offered $700 billion for bail out. It bought out mortgage backed securities to remove some burden from the banks. In Europe, governments embarked on acquiring shares from the affected institutions so as to restore confidence (Shah, 2008). For example, it nationalised the housing lender Northern rock and mortgage lender Bradford and Bingley. The bank of England also began quantitative easing so as to increase money supply and encourage banks to start lending so as to end the credit crunch. Report by BBC (2011) indicates that the European central banked pumped 9.55 billion Euros into the banking sector to improve liquidity. The central banks also lowered interest rates in order to provide liquidity. The US began a rescue package known as the Troubled Asset Relief Program (TARP) (Taylor, 2009). However, it was not clear as to how much was involved and the financial institutions to be rescued. Taylor acknowledges that an interview held to ascertain the amount of the rescue package by the senate to the Federal Reserve board chairman Ben Bernanke and treasury secretary Henry Paulson worsened the crisis. They were intensely questioned and ascertained the amount involved was to be $700. However, it was not clear why the government had intervened to rescue Bear Stearns and AIG but let a large financial institution like Lehman brothers to collapse. This led to lack of confidence by banks as they were not aware of the criteria used to rescue banks. This further led to tightening of credit in the credit market. The impact of the financial crisis was felt all over the world. The credit crunch has brought the economy to its knees; without credit for investment there is less output leading to increase in prices. There is also unemployment due to slow pace of economic growth and closure of major financial institutions. This translates to loss of income for households and consequently decrease in spending and decline in aggregate demand or economic activity hence recession (Shah, 2008). Governments also responded by cut backs in spending and increasing taxes so as to get funds to finance the bail outs. This resulted in unemployment and heavy tax burden on households thereby reducing spending hence decline in economic growth. Remittances from abroad also declined thereby decline in economic growth. Governments incurred huge debts in bailing out the financial sector. According to Pettinger (2011), the UK’s official public national debt comprises of 68% of GDP while the budget deficit is 13% of GDP. Davies (2010, p.2) observes that the total debt for western economies may rise from 84.1% of GDP in 2007 to 109.9% in 2010. The developing countries rely on aid from developed countries. Due to the credit crunch and massive bail outs by the developed countries, the aid declined thereby affecting the economies of these countries leading to high food prices. The World Bank has been trying to improve those economies by offering loans. Since the crisis began, it has offered $138 billion to member countries (World Bank, 2010). These economies according to the World Bank can stimulate demand and support global recovery if only they could get enough finances. Conclusion The financial crisis has had great impact on world economies. It began in the credit markets and spread to the real economy and from developed to developing countries. Lack of regulation in credit markets coupled with loose monetary policy which culminated into the housing boom and sub prime mortgages and consequently growth in mortgage backed securities in the US was the major causes of the crisis. The complexity of the securities and underestimation of risk by rating agencies made the crisis more severe. The government actions in response to the crisis also prolonged and worsened the crisis. These led to lack of confidence in lending leading to a credit crunch and consequently reduced investments, job cuts, and consumption hence slow economic activity. The governments incurred huge debts in bailing out the credit market leading to high taxes which overburden the households. These could have been avoided if the government performed its regulatory role to curb greed from executives. References Abbey, John (2009) ‘Credit Crunch Explained-How Sub prime Mortgages and Securitization Has Led Us to Recession’. http://www.johnabbey.co.uk/wsb4919660101/creditcrunch. Accessed 11 April 2011. BBC (2011). ‘Timeline: Credit Crunch to Downturn’. Available at http://www.bbc.co.uk/1/hi/7521250.stm. Accessed 12 April 2011. Davies, Howard (2010). The Financial Crisis: Who is to Blame? UK: Polity press. Jackson, James (2009). The Financial Crisis: Impact on and Response by the European Union. Congressional Research Service. Kolb, Robert (ed.) (2010). Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future. New Jersey: John Wiley and Sons, Inc. Pettinger, Tejvan (2011) ‘Economy: UK National Debt’. Available at http://www.economicshelp.org/blog/uk-economy/uk-national-debt. Accessed 11 April 2011. Shah, Anup (October, 2008) Global Financial Crisis. Global Issues. Available at http://www.globalissues.org/article/768/global-financial-crisis. Accessed 10 April 2011. Swan, Peter (2010). The Global Crisis and Its Origins. In: Robert, Kolb (ed.). Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future. New Jersey: John Wiley and Sons, Inc. Taylor, John (2009). ‘The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong’. Working Paper 14631 National Bureau of Economic Research. World Bank Group (2011). ‘Financial Crisis: What the World Bank is Doing’. Available at http://www.worldbank.org/financialcrisis. Accessed 12 April 2011. Read More