The Causes of the 2008-2009 Financial Crisis - Essay Example

International Finance WHAT WERE THE CAUSES OF THE 2008-2009 FINANCIAL CRISES? WHAT HAVE CORPORATE FINANCIAL COMPANIES LEARNED FROM THE CRISES? The global financial crisis of 2008-2009 resulted in causing major problems to the economies of various nations. It was conceived that poor incentives within the US mortgage industry was one of the root causes of this financial crisis. This was evidently because the process of work undertaken within the US mortgage industry witnessed a huge change over the past few years, wherein usually, the banks were responsible for raising funds and accordingly, the bank lent these funds to the borrowers. Likewise, if in case the borrowers defaulted from paying back the borrowed funds, the banks were held liable for bearing the loss. This traditional system increased the necessity for the bankers to carefully evaluate the creditworthiness of debtors. However, as the years passed, a huge change was observed in the entire system of raising and borrowing funds. Under the new system it was observed that brokers started raising funds and lent it to the borrowers instead of the bankers. This particular process was termed as “originate and distribute model” wherein the brokers were paid depending upon the number of mortgages they sold to the borrowers. This in turn played a huge role in causing the financial crisis, as the brokers were not concerned whether the borrowers defaulted from the mortgage owing to limited liability in the transaction; instead they were only concerned about selling more number of mortgages. Consequently, the economies of numerous Asian and European nations were adversely affected by the US securitization system. For instance, there was a 4% fall in the GDP of Japan in the year 2009 wherein there was heavy decline in the overall industrial production of the nation due to which, its economy suffered largely. Thus, it was considered that one of the major causes for the financial crisis was due to the change in the U.S. mortgage industry (Allen and Carletti, 1-43). Global imbalances and the advent of the US housing bubble were also considered as a cause for the financial crisis being faced by the economy of various nations. It was believed that global imbalances resulted in bursting the US housing bubble, due to which, the global financial crisis occurred. Correspondingly, it is argued that the global imbalances was a result of economic policies framed in the East Asian regions, export-led development strategy, undervaluation of the exchange rate in China and accrual of global reserves that was driven by self-insurance purposes. Export-led development strategy was also considered as a cause due to the organized promotion of exports in the East Asian regions, which was done through various micro and macroeconomic policies along with dumping the same, causing global imbalances. Similarly, as the Chinese maintained relatively lower level of Renminbi (RMB) that increased its overall exports and resulted in rising trade surplus, which hence caused global imbalances (Lin and Treichel, 1-80). On the whole it can be asserted that the advent of housing bubble and the rise in global imbalances were the root causes for financial crisis among various nations in 2008-2009. Corporate financial companies, in order to tackle the risks related to financial crisis, have learnt several lessons wherein these companies consider that the nature of crisis requires being accurately forecasted within time, so as to apply correct prescriptions within the company for the crisis being faced. Financial companies have also learnt that liquidations are quite costly due to which, to resort is the best approach to managing the crisis under certain situations. It is also considered that maintaining patience is beneficial in avoiding severe disruptions, but it might turn out to be riskier and costlier if it is not used properly. It is conceived by the financial companies that guarantees are quite essential, but it requires to be structured appropriately and should be given a limited life in order to avoid huge costs and ethical hazards. In addition, it is quite important for the financial companies to understand the various dimensions of raising and lending funds so as to avoid the risks related to financial crisis situations. Likewise, financial institutions have also learnt that attrition in market liquidity occurs more frequently as compared to attrition in the bank deposits. Thus, the financial institutions have been able to gain adequate understanding that in order to develop resolutions for financial crisis, appropriately treating the non-performing assets is an important requirement (Lumpkin, 1-42). (2) WHY WAS THE EURO CREATED? HAS IT BEEN SUCCESSFUL? The EURO was created with the intention of obtaining more advantages from a single currency from the economical perspective. Previously, the member states in the European Union (EU) had their individual currencies, due to which, the risks related to inflation and rising interest rates increased substantially for individual member states. Moreover, earlier the costs related to exchange of goods and/or services from one member state to another was quite high as different member states had different currencies causing massive differences in the currency value. However, the creation of EURO has resulted in providing several benefits to all the member states within the EU. Contextually, it would be worth mentioning that the creation of EURO has resulted in eliminating the risks related to price fluctuation among different member states along with reducing the cost of exchange from one state to another. Moreover, EURO was created with the intention of increased extent of cooperation among the member states, which in turn would stabilize the currency and provide several economic benefits to these states. Strengthening a single market was also a core purpose of EURO creation as it helped in integrating the economic activities of all the member states (European Commission, “Why the euro?”). It would be noteworthy to state that the creation of EURO currency has been successful in providing several benefits on individual, business and economic levels for the entire EU. This is because it has provided more choices to the customers and induced price stability within the products that is marketed in the entire EU. Similarly, EURO currency has been successful in providing several benefits on the business level, as it has enhanced security for business transactions and resulted in providing greater opportunities to the businesses in the domestic and international market influencing their profit margin directly. EURO currency has also contributed towards enhancing economic stability within the entire EU and induced economic growth among the member states. Financial markets in the EU have been more integrated due to the creation of EURO currency in this regard. The currency of EURO has certainly been successful in creating a stronger presence of the European market in the global economy due to which, it has been witnessed that the export and import activities have significantly increased in the member states of the EU. In fact, the creation of EURO has resulted in providing several benefits worldwide, as it has instigated increased cooperation among international markets accelerating the flow of investments from one nation to another (European Commission, “Why the euro?”). (3) HOW IS VALUE CREATED IN AN LBO? Leveraged Buy-Out (LBO) is an activity that takes place when a company is purchased by another company with the combination of both equity and borrowed capital. LBO has been widely used in the present day context in which, companies decide upon undertaking mergers and acquisitions in their business process. It has been revealed that there are various sources of value creation in LBO’s wherein both direct and indirect drivers interplay for value creation of these strategic tools in an organization. It is believed that drivers that are operational in nature are called direct drivers while drivers that tend to be non-operational are called indirect drivers (Loos, 1-380). Direct Drivers: Direct drivers directly affect the cash flow of an organization, increasing the returns, cutting the overall expenses, effectively using the capital and using financial engineering in buyouts. It is considered that value is created in an LBO by attaining cost reductions in the operational activity of an organization that results in generating cash flow through better management and operational excellence. Utilizing the assets in an effective manner also results in value creation for LBO. Most of the LBO firms focus on improving their operational activities, which in turn, helps in increasing the overall revenue that is generated within the LBO firm. It is also considered that using a financing technique for purchasing a company results in creating value for LBO’s (Loos, 1-380). Indirect Drivers: Indirect drivers of LBO also contribute to value creation by amplifying the performance of an organization. Under indirect drivers, managers and employees are encouraged to buy equity shares for the organization, which in turn increases their involvement to leverage the operational efficiency of the organization; thus, creating value in an LBO. Likewise, upgradation in the structures of corporate governance results in enhancing the monitoring quality, which further creates value for the LBO firms. Likewise, companies engaging in LBO enhance their communication capability that further contributes towards creating value, as it provides a strategic direction and increases the overall knowledge of the LBO firms (Loos, 1-380). (4) HAS (QUANTITATIVE EASING) QE BEEN EFFECTIVE? WHAT WILL HAPPEN IN THE COMING MONTHS? Quantitative Easing (QE) is an eccentric monetary policy that has been used by centralized banking institutions to augment the economy wherein the standardized monetary policy being followed has turned out to be ineffective. While the US economy was going through a phase of financial crisis in the year 2008-2009, a large scale of private and government securities were undertaken by the Federal Open Market Committee (FOMC) so as to reduce the long-term yields. This process was called as QE wherein the FOMC made announcements regarding the decline in long term yields. However, it has been revealed that the core purpose of QE has been merely met, as it has not been effective in reducing the long term yields to a significant level. This was fundamentally because there has been no change in the behavior of Nominal 10-Year Yield spreads even after the FOMC started its QE policy. On the whole, it can be affirmed that the QE has not been effective in reducing the long term yields in the economy of various nations. Moreover, it has not been effective in increasing the overall output production and employment opportunities, due to which, it can be considered that WQE has been ineffective (Thornton, 1-2). In the coming months, the Federal Reserve will undertake a reduction of USD 10 billion in its QE policies, thereby reducing the procurements of bonds to USD 55 billion. Likewise, the Federal Reserve is quite likely to cut mortgage bond purchases from USD 30 billion to USD 25 billion along with reducing its treasury procurements from USD 35 billion to USD 30 billion in the coming months. Moreover, a slower growth is anticipated in the economic activities of the US, as per the announcement made by FOMC. Additionally, the Federal Reserve would increase its efforts to stimulate economic growth in the nation. Furthermore, the retail sales in the US market might decline in the coming months due to the increase in unemployment rate within the nation (Sharf, “Fed Cuts Monthly Asset Purchases To $55 Billion Maintaining Taper Pace, Market Awaits Yellen Remarks”). Works Cited Allen, Franklin and Elena Carletti. “The Global Financial Crisis: Causes and Consequences.” University of Pennsylvania (2009): 1-43. Lin, Justin Yifu and Volker Treichel. “The Unexpected Global Financial Crisis Researching Its Root Cause.” Policy Research Working Paper 5937 (2010): 1-80. Loos, Nicolaus. “Value Creation in Leveraged Buyouts.” University of St. Gallen (2005): 1-380. Lumpkin, Stephen. “Resolutions of Weak Institutions: Lessons Learned From Previous Crises.” OECD (2008): 1-42. “Why the euro?” European Commission. 2014. Web. 11 May. 2014. Sharf, Samantha. “Fed Cuts Monthly Asset Purchases To $55 Billion Maintaining Taper Pace, Market Awaits Yellen Remarks.” Forbes. 2014. Web. 11 May. 2014. Thornton, Daniel L. “Has QE Been Effective?” Federal Reserve Bank of St. Louis. (2014): 1-2. Read More