Financial Crisis, Home Mortgages, Financial Institutions and Adverse Selection - Case Study Example

 Financial crisis, home mortgages, financial institutions and adverse selection Financial crisis and financial innovation Financial crisis that have currently occur in different parts of the world has highlighted limitations of financial innovation. The cause of financial crisis is the financial instruments that are used in the economies. Some examples that have caused financial crisis are together with credit default swaps and collateralized debt obligation. When the instruments were applied in obtaining vehicles for credit expansion, it leads to financial crisis (Barger, 2008). The obvious association between the two comes from the fact that the mortgage market contraction, which in many countries evolved into a recession in 2008-2009, was led by intensive use of certain complicated financial instruments such as CDOs and CDSs in the United States and other countries. It should be recognized that virtually any financial product holds dangers and can be improperly used. Potential problems are likely to increase with the complexity of the instruments, the insufficiency of information conveyed by sellers, and the lack of due diligence on the part of investors (Carey, 2009). The huge mortgage securitization of current years seemingly had poor performance in the areas. Mortgage securitization in the successful years did not bring any help to reduce the problems that occurred in information that are characteristic of credit transactions. Appropriate risk assessment did not induce the same characteristics. Role of securitization in mortgage lending The role of securitization of the mortgage market. The roles of securitization in mortgage include barking up securities, collaterized debt obligation and structure invested vehicles (Barger, 2008). In today’s setting, one that gets a loan is likely to sell the loan to a third party which can be government agencies, an institution in the private sector or government sponsored entities. The mortgage is then sold with payment rights to the investors. The process can be long as the mortgage can be sold to several other people. The process is what is referred to as securitization. The main role that is played by the process is conversion of mortgages to mortgage backed up securities. In mortgage backed up securities, the payments that are made are based on collection from individual mortgages. Mortgage-backed securities were supposed to be sound investments as they were rated by genuine rating agencies. The securities however did not happen as planned and the hazard led to the crisis. Before the occurrence of the crisis, banks had wrongly believed that what comes due to innovation and securitization of their long-term assets were much able to eliminate their exposure to mortgage evasions and reduce the interest rate that they got, rate of risk and even make and bring more profit to them. Selection that was used when the mortgages started to go bad was not perfect and this lead to the crisis (Carey, 2009). When the mortgages started to go bad, many investment funds were not stable and couldn’t repay the loans they had taken from the banks. The banks had to clear the loans they had made to the investors. Government intervention in financial crisis The loaning standard was a vital factor to see if unequal information was an issue. From the analysis, a relaxed standard on mortgage lending was another contributing factors. In the context, the decision that was made led mortgage lenders who were willing to lower their standards gain market share (Berlatsky, 2010). Other mortgage lenders either had to lower their standards or lose market share. All were forced to lower their standards and this contributed much to the crisis. Unprecedented level of government intervention in the economy prevented an even more severe economic downturn than what actually occurred. In intervention by the government to reduce crisis, there is the application of two theories. The theories include public interest theory and private interest theory. In public theory, regulations that are made are done to protect the interest of everyone in the economy (Berlatsky, 2010). The regulation that is done through the theory is due to the response of market failure.in the case study, home construction is an important economic activity and the decline in home construction would reduce GDP. Regulation on construction by the government regulated the crisis. The decrease in home prices would also lead to the reduction of household consumption due to the wealth effect (Berlatsky, 2010). But the overflowing of this housing issue caused more severe and widespread harm than would be predicted from just these two reasons. The intervention of the government reduces all the factors that may lead to crisis when factors of intervention are well established. Government intervention will affect a moral hazard problem in the future. In the condition, there is establishment of factors in the competitive market allocation. When all the factors are put in a way the government wants them to work, there reaches a point when there will be no balance in the economy. There is a reach in the economy when the production and services that are provided do not respond to restrictions or become so much low. This can again trigger financial crisis in an economy. Effects of long term government intervention Fiscal policies that are put forward by the government were aimed to respond to the financial crisis. The policy is controversial to monetary policy. In debt crises, fiscal policy aimed in making tight natural remedies and is readily accepted. In a long run, debtor countries always suffer economic sanctions which are exposed to them by the creditors. The sovereign debt also imposes an extra burden on governments that are debtors. In development of the budget, the governments are not able to achieve the expansionary fiscal policy (Goldsmith, 2008). For debt crisis, there is no always acceptance of responses obtained from the fiscal policy. Debates have been developed on the constraints that are imposed by the political and institutional conditions. Politically, in the long run, the government is able to tighten monetary policies regardless of the actual economic effect. They do this through the central banks that have the ability to regulate the money supply and raise the interest rates(Goldsmith, 2008). It takes longer for the government to implement fiscal policy even when there is necessity. Effects that are brought by the policies of the government differ according to political determinations and cuts across all the countries that have the same financial crises. The responses that are given to financial crisis are always affected by three major factors the conditions include governmental ideological orientation, the electoral cycles and veto players. The changes that are to make by the government in the policies depends on the number of veto players. Government policy options also depend much on ideological orientations. These orientations take longer to be implemented and once they have been implemented they may affect again the financial status of the country (Özkan and Unsal, 2012). Right governments were seen to avoid inflation and tend to make the budgets balanced so that the small governments could be favored. Elections that are upcoming in a country are also able to have impact on the responses made by the government. This always is done mainly through fiscal policy. Political policy models and the cycle in political budget always influence re-election of leaders in upcoming elections. In dealing with sovereign debts, there is always association of the defaults that are made to high inflation (Özkan and Unsal, 2012). The increase in inflation in an economy makes the government to tighten the money that is supplied to the financial market. This will raise the interest rates of loans obtained from banks. Increase in the rate of interest affects those that had borrowed loans from banks and also risk failure of banks. References Barger, T. (2008). Financial institutions. Washington, D.C.: International Finance Corp. Berlatsky, N. (2010). The global financial crisis. Detroit, MI: Greenhaven Press/Gale Cengage Learning. Carey, A. (2009). Understanding mortgage meltdowns. New York: Nova Science Publishers. Goldsmith, R. (2008). Financial institutions. New York: Random House. Krugman, P. (2009). The return of depression economics and the crisis of 2008. New York: W.W. Norton. Özkan, G. and Unsal, D. (2012). Global financial crisis, financial contagion and emerging markets. [Washington, D.C.]: International Monetary Fund. Steinmetz, T. (2008). The mortgage kit. Chicago, Ill.: Real Estate Education. Zandi, M. (2009). Financial shock. Upper Saddle River, N.J.: FT Press. Read More