Causes of the 2008 Global Financial Crisis - Research Paper Example

The Causes of the 2008 Global Financial Crisis 0 Introduction The causes of the recent global financial crisis haveattracted a significant attention among financial analysts and investors. It is arguable that the evaluation of the causes of the Global Financial Crisis is more important than the assessment of its impact on the financial markets, and the entire economy. An examination of the causes of the recent economic crisis can help policy makers in the financial markets to make prudent decisions that would protect the banking and other sectors from facing similar crisis in the future. It is notable that players in the financial markets have diverse views regarding the causes of the Global Financial Crisis of 2008. The opinions of these individuals range from over-leveraging of the financial products and excessive risk-taking by banks to unjustifiable executives bonuses and salaries and the lack of sufficient regulation of the money and capital markets. It is important to provide an overview of the causes of the economic hardships that prevailed following the Great Recession which began in 2007. This paper is focused on analyzing the causes of the 2008 financial crises with a view of avoiding decisions that associated with negative economic impacts, such as the collapse of the largest financial institution prior to 2008 (Lehman Brothers); the collapse of the Lehman Brothers on September 2008 resulted in the loss of significant investments, jobs and substantial effects on the general performance of the economy (Quirk 31). 2.0 The Subprime Lending The subprime mortgages are classified as risky mortgages due to the high probability of defaulting on the loan payment by mortgage borrowers; on the other hand, the prime mortgage is considered less risky mortgage since the borrowers are unlikely to default on the loan payment. The subprime mortgages are considered by a majority of lenders as profitable given the fact that they are associated with high levels of high-interest rates; however, the borrower is likely to fail to meet the periodical payments and the total sum of the loan. The period prior to the financial crisis of 2008, there was an increased competition among the mortgage lenders that saw a number of these players relaxed the underwriting standards to experience increased profits and significant market share (Weber 159). In this respect, there was a tendency by a majority of the mortgage lenders to lend subprime mortgages (risky mortgages) among borrowers with low level of creditworthiness. The lending of the risky mortgages was notable among mortgage lenders between 2004 and 2007; this period was associated with an increased competition among scrutinizers, an aspect that is attributable to the entry of the private scrutinizers (Weber 171);the stiff competition among the scrutinizers undermined the traditional function of policing the origination of mortgages. The financial analysts argue that the subprime mortgages were less than 10% in the mortgage market prior to 2004; however, in 2004, the subprime mortgage was reported above 20% for the next three years (2004 to 2006) (Anabtawi and Schwarcz 118). There was a high level of defaulted loans with respect to the financial crisis; as of 2011, the Federal Deposit Insurance Corporation had to provide one-hundred and sixty-five financial firms a total of $9,000 million to cover the losses that were associated with bad loans (Anabtawi and Schwarcz 119). It is arguable that the greed among the loan lenders to generate significant profits that are associated with the high interest-rates subprime-mortgages contributed to the financial crises of 2007 and 2008. A Table Showing the Increasing Levels of the Subprime Mortgage 2000-2006 Source: Thomas, 2010. 3.0 The Rising US Current Account Deficit and the Relaxed Credit Requirements The loan consumer market was enticed to borrow substantially due to the availability of loans with low-interest rates; notably, the US Federal Reserve reduced the target of the federal funds rate to 1% from above 6% (Armingeon 543). This step was taken with a view of reducing the negative financial effects that resulted from the collapse of the dot-com bubble; additionally, the reduction of the federal funds rate was carried with a view of protecting the economy from facing deflation. As opposed to boosting investment in business, the credit lending was majorly stimulating the real estate market. Financial analysts argue the decline of the interest rates saw the credit market expand excessively; this factor resulted in the financial crisis. The US was coerced to borrow foreign funds; the borrowing of the foreign funds resulted in high prices of bonds and decreased levels of interest rates. It is evident that the prices of bonds and coupon rates are inversely correlated; typically, when the yield rate (the bond price) rises, the coupon rate normally declines. Due to the increase of the US current account deficit by $650,000 million from 1996 to 2004, there was a need for the US government to finance the deficit with a substantial amount of the foreign funds (Hetzel 386). The foreign funds were finally experienced in the US financial market; the overseas governments provided funds via the buying of the government bonds; the US residents took the advantage of the foreign borrowed money to finance homes and other financial assets; this resulted in the increase of prices of such assets. Conversely, the financial firms used the foreign funds to make substantial investments in the mortgage-backed securities. In response, the US government raised the Federal interest rate substantially between mid-2004 and 2006; the mortgage with adjustable interest levels saw their rates increase significantly (Hetzel 381). A large number of mortgage borrowers faced exorbitant charges as a result of the high-interest rate; the prices of houses declined-the prices of assets normally decline when the interest rates increase. The increase in the interest rates and the general decrease in the prices of houses resulted in difficulty among financial players in predicting the future trend of the market; in this regard, it was deemed that the mortgage market is increasingly risky- the properties of the real estate sector, as well as the associated financial assets, experienced a sharp decline in value. It is arguable that the increasing US current account deficit coerced the government to borrow foreign funds to finance the deficit, an aspect that resulted in an increase of the financial asset prices and, consequently, a decline in the interest rates; with a view of reducing deflation, the target interest rate was increased. The increase in the interest resulted in the housing bubble (the housing market experienced a decline in prices); in this respect, the increasing US current account deficit and the associated relaxed credit condition contributed to the housing bubble and resultant economic hardships. A Graph Showing the Increasing Level of the Trading Account Deficit between 1970 and 2005 SF FED, 2007 4.0 The Housing Bubble Statistics indicates that the prices of the common US house increased by one-hundred and twenty-four percent between 1998 and 2006 (Holtzman 95). Statistically, the standard house price was established at an average of three times that of the income of a household (Holtzman 95);as of 2004, the price of homes rose to four times that of a household income. The property bubble led to various owners of homes refinancing their houses at a relatively low interest rate; a number of homeowners were witnessed securing second mortgages (Holtzman 96). The increasing houseprices wereelicited by collateralized debt obligations;the mortgage lenders were enabled to continue providing the subprime mortgages due to the availability of investors who invested in CDOs (Collateralized Debt Obligations) and other mortgage -backed securities. The selling of the mortgage-backed securities reduces the need of a lending institution of acquiring additional capital; due to the availability of cash that is generated via selling the mortgage-backed security the lending institution can invest in additional new loans. The prevailing CDOs in the mortgage market resulted in an increase in the real estate bubble; as of September 2008, the housing prices had dropped by an average of 20% relative to the high prices that were experienced in 2006 (Taub 36). While the housing prices decreased, the homeowners (borrowers with mortgages of adjustable interest rates) failed to refinance with a view of avoiding the high payments relating increasing interest rates; the failure to finance led to a number of borrowers defaulting on their loans. As of 2007, the lending institutions began filing for foreclosure of 1,300 thousand properties; this is nearly 80% of the foreclosure filings made since 2006. The filing for the foreclosure increased to 2,300 properties as of 2008 (Scanlon, Lunde, and Christine 24). The scenario discussed above with respect to the real estate market indicates that the housing bubble is attributable to the cause of the 2008 economic hardships. A Table Showing the Increase and Decrease of the Houses Prices between 1974 and 2008 Source: Lambert, 2014. 5.0 The Innovation of Financial Products The innovation of the financial instruments is a process via which financial firm designs a certain financial instrument with a view of meeting the objectives that are set by an investor. The aim of tailoring a given financial instrument is to assist a person to obtain funds; however, the designer of a certain financial instrument ensures that an investor is protected against a certain level of financial risk. The financial market is typically associated with a number of innovative financial instruments; among the innovative financial instruments include the mortgage products with adjustable interest rate and the collateralized debt obligations, as well as the binary options and the credit default. It is evident that the financial market was characterized by a number of the innovative financial instrument prior to the financial crisis which occurred in 2008. Among the innovative financial products that were popular in the financial markets prior to the global financial crisis is the credit default swaps; this financial instrument was popular in the beginning of 1990s and early 2000s (Stuenkel 611). At the beginning of 2007, the value of the credit default swaps was reported at 62,200 million; the value of these instruments declined to 25,500 million following the financial crisis as of 2010 (Stuenkel 611). The financial analysts attribute the economic crisis of the 2008 to the innovation of the financial products, such as the credit financial swaps due to a number of reasons, including the fail to respect the regulations and rules of the money and capital markets. In the case of a loan default, the seller of a credit default swap undertakes to compensate the purchaser;in this respect, the seller of the credit default swap emerges the owner of the default loan. With its popularity dating back to its development by JP Morgan in early 1990s, was meant to ensure persons are compensated in the event of a loan default: the credit default swap became a risky financial instrument in the financial markets. Stuenkel (622)indicates that the financial markets regulators concerns regarding the transparency of the credit default swap show the innovative financial instruments contributed to the financial crisis; this is because every instrument trading in the financial markets was required to be associated with a high level of transparency in the light of the financial regulations. Due to the promise of compensation of default loan, a significant number of individuals were inclined to borrow substantial loans for diverse investments. The availability of the credit default swap saw various financial firms (banks) obtain funds that were used to finance the subprime loans. Unlike the prime mortgages which are associated with a low level of return, the subprime mortgages are associated with a high level of risk and return. Due to the high level of risk of the subprime mortgage with respect to defaulting, the relation between the credit default swap and the risky mortgage explains the contribution of the CDS to the 2008 subprime crisis. The AIG is one of the financial institutions that experienced a significant loan default with respect to its clients; the AIG attempted to insure consumers against the loan default through the use of the credit default swaps. AIG agreed to compensate the lending firms the face value of the loans in case a borrower defaulted on a loan. However, during the financial crisis, a significant number of the financial firms experienced financial distress; in this respect, many firms were unable to meet their financial obligations. Considering the scores of defaulting firms, AIG did not manage to pay face value of loans for the defaulting firms. This scenario explains the contribution of the innovative financial instruments, such as a credit default swap, to the 2008 financial crisis. The preceding explains why CDS, one of the innovative financial products, led to the crisis that was experienced in 2008 (Quirk 36). The collateralized debt obligation is another innovative financial product in the financial market; this instrument enables banks to obtain money from diverse investors to finance new loans. This instrument contributed to the increase in the housing bubble. The assets of the collateralized debt obligations witnessed a percentage increase with respect to the subprime and related risky mortgages. In particular, the percentage of the subprime and risky mortgages in relation to the assets of the collateralized obligations was estimated at 37% as of 2007; this demonstrates that the risky mortgage formed a large percentage of the underlying assets that are associated with the debt collateralized obligations. Whilst the collateralized debt obligations enabled diverse investment banks to trade mortgage-backed securities among different investors and, accordingly, free up the capital, there was less concern concerning the upshot of the new financial instruments in the light of the financial stabilities. 6.0 The Incorrect Pricing of Risk and Investment in Risky Assets by Investment Managers The financial analysts argue that the financial instruments were not correctly priced since the exposure of banks to risks was not transparent among the investors. Normally, the risk of a financial instrument is measured by the interest rate; however, the level of risk is also represented by fees. The pricing of risk denotes the additional compensation that investors seek for assuming an incremental risk; White (45) believes that the failure of the financial consumers to assess the risk of mortgage instruments in a transparent manner led to a significant expansion of the credit market beyond the reasonable level. As a result, the impact of the economic meltdown was more than they would have been in the event that the risks were evaluated in a transparent fashion. In particular, the majority of individuals failed to relate the risks via the consideration of accuracy that were associated with the new financial instruments, such as the mortgage-backed securities and the collateralized debt obligations. Additionally, the consumers in the financial markets did to understand the effect of not relating the risk to the new financial instruments on the instability of the market. For instance, collateralized debt obligations of 102,000 million which were liquidated between 2005 and 2007 exhibited a recovery rate of thirty-two percent as far as the high-quality collateralized debt obligations are concerned (Roe 1642). On the other hand, AIG did not have the financial capacity to compensate lenders following the default by borrowers via the use of credit default swaps; the government compensated the lenders via the bailout program. Additionally, there was a wide use of the financial model that was not clearly among the users; with respect to the financial model, the financial players supposed that the price of credit default swaps would accurately predict the price of the mortgage-backed securities. Since the price of the credit default swaps was easily traced, the financial model became popular among investors, issuing firms and credit rating agencies that are associated with the credit default swaps and collateralized debt obligations. It is in the view of the financial instruments which were deemed complicated among consumers that confidence was built in the financial markets when the international debt rating agencies and bank supervisors began to use the financial models that indicated less risk than the actual value. Moreover, there was a conflict that emerged between the asset managers and institutional customers; the investment managers invested the clients funds in highly-priced credit assets with the objective of optimizing their income. Typically, the compensation of the asset managers relies on the amount of assets that are managed. The high level of investment in the global capital made the prices of the credit assets to decrease; as a result, the investment managers were to invest assets whose risks and returns did not match or refund the customers. A large number of investment managers resolve to invest in assets that were over-priced. The action of the managers was against the preference and wishes of clients; the action by managers endeavored to ensure the investments remain under their control. The asset managers were witnessed investing in assets that are associated with the mortgage market. The above scenario indicates the attempt by issuers of CDOs and CDS, as well as rating agencies to establish a financial model that did not predict the actual value of risk of other 7.0 Conclusion The financial analysts and investors believe that the financial crisis of 2008 was caused by a number of factors; a majority of economic evaluators believe that it is the combination of various factors that resulted in the significant economic hardships that were experienced worldwide. However, other financial players believe that the crisis was caused by a single factor; for instance, a number of them believe that the 2008 economic crisis was majorly caused by the innovation of the financial products. On the other hand, other believes that the financial meltdown was caused by a significant growth of the subprime mortgage market. Although there are diverse views regarding the cause of the 2008 global financial crisis, it is accepted the factors that led to the global recession are different. Among those factors include the considerable expansion of the subprime mortgage market, the housing bubble, the increasing US current account deficit and relaxed credit requirements, financial innovation and incorrect pricing of the financial instruments. The financial market consumers, investment banks and other financial firms, and the regulators in the financial system should be keen in the future to avoid practices that are likely to result in a similar global financial crisis. Works Cited Anabtawi, Iman, and Steven L. Schwarcz. "Regulating Ex Post: How Law Can Address The Inevitability Of Financial Failure." Texas Law Review 92.1 (2013): 75-131. Academic Search Premier. Web. 3 Aug. 2014. 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