The Nature of Sub-Prime Crisis - Assignment Example

Before the sub-prime crisis, investors were engaged in large scale borrowing of money, for purposes of building their homes. This borrowing was unsustainable, mainly because the housing industry was experiencing some unsustainable wages, and there was a high level of consumer debts. However, as the prices of houses rose, investors felt that they were getting richer (Read, 2009). The financial industry was encouraged into issuing out mortgages, mainly because they believed that housing prices normally appreciate in value. However, on a historical note, interest rates on mortgages could also go up. Majority of the subprime borrowers were caught unawares, and they were unable to pay off their monthly payments (Bliss, 2010). Furthermore, a rise in foreclosures initiated by financial institutions was able to increase the number of houses within the market. This led to a decline in the housing prices, leading to an increase in thee defaults of mortgages. This default had an adverse effect on financial and depository institutions such as banking organizations. Because subprime borrowers were unable to pay off their loans, banking institutions were forced to write off their debts. Furthermore, because of the defaults of sub-prime borrowers, depository financial institutions were forced to issue a margin call (Read, 2009). This led to an increase in the sale of mortgage backed securities, because of panic. Financial institutions increased their rates of margin calls, resulting to a series of defaults, eventually leading to catastrophic losses by banking organizations. It is estimated that financial institutions in the United States were able to loss approximately 1 trillion dollars, because of the effects of this financial crisis. A company such as AIG insurance was nearly collapsing, and it required a bail out from the US government, in order to sustain its businesses (Read, 2009). AIG insurance was able to receive approximately 85 billion dollars from the federal government, in exchange of 80% of its equity (Bliss, 2010). Jones (2010) explains that one of the factors that led to the near collapse of AIG was an aspect referred to as financial innovation. This is specifically at its London offices. This division encouraged for the use of a financial tool referred to as collateralized debt obligation (CDOs). This was an example of a financial innovation, and it was very popular amongst large financial institutions. This included banking organizations that issue out mortgages, investment banks, and other financial organizations. Under CDOs, a financial institution would lump up various types of debts, into one bundle (Read, 2009). That is, the risky and the less risky debts. A variety of debts were known as tranches. Majority of large scale investors were able to hold mortgage backed securities, which were created through the use of the principles of CDOs. These mortgage backed securities were filled with subprime loans (Bliss, 2010). The London branch of AIG advocated for the use of this option, in the issuance of insurance services. AIG decided to insure the CDOs debts against default through a financial tool referred to as credit default swap. The company believed that the chances of paying insurance for these products were unlikely; hence it was a good policy. Initially, this policy was very successful to the company, but with the emergence of the financial crisis, many people were able to default on their mortgages, hence forcing AIG to pay off those debts (Bliss, 2010). This nearly led to the collapse of AIG, because the losses incurred by its operations in the United Kingdom were very great. It is important to explain that mortgage backed securities were seen as a very good type of investment. Furthermore, financial institutions believed that it was difficult for the holders of this type of security to default from paying their loans (Bliss, 2010). However, this was not the case, because holders of mortgage backed securities were able to default on their payments, leading to the near collapse or fall of thee financial institutions. This concept of financial innovation is therefore seen in the creation of CDOs, and mortgage backed securities. Furthermore, the securitization of the mortgage market also played a role in the emergence of the financial crisis. Securitization was able to remove loans from the banking records, and this enabled these banking institutions to be compliant with laws that touch on their capitals (Bliss, 2010). It was also possible for these financial institutions to issue out other loans, through the proceeds emanating from their sale of mortgage backed securities. Furthermore, the liquidity of the international and national mortgage market was able to allow the inflow of capital where there was a shortage. Bliss (2010) therefore explains that the securitization of the mortgage market was able to create a moral hazard. This is a situation where banking and financial institutions issued out mortgages, without worrying on how these mortgages would be paid. This gave an incentive to these banking organizations to process more mortgage transactions, without a worry on how these transactions would be paid off. Therefore, the credit quality of their borrowers was poor. Therefore, Gwinner and Sanders (2008) explains that the securitization of the mortgage market played an influential role in relaxing the standards that financial institutions could use, for purposes of issuing out mortgages. For instance, the mortgage fee fell by about 5% during the periods of 2002, to the year 2007. Banking and financial institutions were willing to lower their standards, for purposes of gaining a market share of the mortgage market. This led to the issuance of mortgages to people who were not credit worthy, leading to a high rate of defaults during the periods of 2007, to 2008. These high rates of defaults nearly caused the collapse of the economic systems of the world, which includes United States, United Kingdom, and majority of European States. One of the reasons why this crisis was almost destroying national economies is because it led to a decline in home constructions. This in turn reduced the GDP of a country. Secondly, a reduction in property prices would lead to a reduction in household consumption, mainly because of a concept referred to as wealth effect. The government was therefore forced to intervene, for purposes of reducing the impact of this crisis. For instance, in United States, the Federal Government was able to lend to several banks, and even bail out some financial institutions, to the tune of billions of dollars. For instance, the US government was able to purchase 600 billion worth of mortgage backed securities. Furthermore, central banks were able to engage in a concept referred to open market operations. This was an issuance of short term loans to banking organizations, so that they would remain liquid. These measures helped to stabilize the effects of economic down turn, and they could not contribute to the emergence of the moral hazards in future. This is because there were a series of regulatory measures put in place that could guide the manner which financial institutions were carrying out their affairs. An example is the Volcker rule, initiated in 2010, which was able to make a limit to financial institutions engaging in proprietary trading. In conclusion, the long term effect of the intervention by the national government is an increase in its national debts. This is due to the borrowing of money from international and local lenders for purposes of financing the recovery of their economies. Bibliography: Bliss, R. (2010). Financial institutions and markets: The financial crisis--an early retrospective. New York: Palgrave Macmillan. Top of Form Bottom of Form Gwinner, W., & Sanders, A. (2008). The sub prime crisis implications for emerging markets. Washington, D.C.: World Bank. Top of Form Bottom of Form Jones, S. (2010). Time for a visible hand: Lessons from the 2008 world financial crisis. Oxford: Oxford University Press. Top of Form Bottom of Form Read, C. (2009). Global financial meltdown: How we can avoid the next economic crisis. Basingstoke [England: Palgrave Macmillan. Top of Form Bottom of Form Shiller, R. (2008). The subprime solution: How todays global financial crisis happened and what to do about it. 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