Financial Crisis 2007-2008 - Case Study Example

FINANCIAL CRISIS, HOME MORTGAGES, CREDIT MARKETS, FINANCIAL S, MORAL HAZARD, and ADVERSE SELECTIONS. Question Sincethe Great Depression of the 10930s, the 2008 financial crisis is considered to be the most despicable; it plunged the world economy and threatened the collapse of colossal financial institutions which were later bailed out by national governments. Nonetheless, the housing market suffered occasioning foreclosures, ejections, and persistent unemployment. The crisis is largely attributed to increased mortgage defaults that apparently mushroomed after securitization, an innovation that was envisioned to improve the performance and operations of the financial markets. Securitization can be considered as a disruptive innovation as it drove the world economy into an all-time debauched predicament whose shattering effects are still felt to-date in America and the world over (Driffill, 2013). Securitization is a financial engineering practice where financial institutions create a pool of assets, including mortgages and loans, and resell the repackaged assets to investors who takes responsibility of the assets thereafter (Bertaut & National Bureau of Economic Research, 2011). The mushrooming of securitization saw the emergence of asset-backed security (ABS) as a common type of mortgage-backed security (MBS) and a structured investment vehicle (SIVs) which become a driving force in the financial crisis by empowering banking institutions to possess superfluous capital which could be given out as loans to prospective homeowners without clear ascertainment of their credit worthiness (Glaeser, E. L., & Sinai, 2013; Farmer, 2010). Eric (2010) asserts that MBS was flavored by apportioning between agency MBS, and non-agency MBS. The agency MBS were insured by the government thus resulting to no real credit risk to the investors a factor that made it effective for many organizations to offer mortgage loans to mortgage loan seekers who later painfully defaulted the loans (Manoj, 2010). Apparently, securitization endorsed the disintegration of risks. Investors and mortgage seekers could gravitate towards investments or transactions that best met their reward or risk preferences. This was consequentially backed by securitization which transformed the mortgage market to a lascivious condition. It transferred possession of mortgages from lenders to investment banks and non-bank financial institutions (Batten & Szilagyi, 2011). Noteworthy, the mortgage owners were well acquainted with information pertaining to their borrowers default probability, but securitization bestowed the obligation of offering loans on investment banks and non-bank financial institutions that were not conversant with borrowers’ default possibility but rather used faulty Collateralized Debt Obligation (CDO) computations to predict default risks. The computed CDO default probability that were the basis of loans issuance morphed the mortgage market into a speculative bubble as it disregarded sub-prime mortgage improvements and the true state of the mortgage market in which prices related to real estate pricing were plummeting and the value of mortgages was starting no deteriorate Similarly, through CDO, risks affiliated with mortgages were manipulated and doctored and mortgages were ranked as a low risk speculation (Nwogugu, 2011). Banks, whose main technique of money creation is through interest charged on loans, were attracted to mortgages, and had to leverage and securitize loans so as to accumulate wealth during the available opportunities presented by economic boom. Apparently, as banks and homeowners strived to own consummate portfolios, borrowers found it hard to reimburse the mortgages later, and banks found themselves with no cash reserves. Consequently, banks experienced devastating monetary losses and started constructing negative sentiments towards the mortgage market. Considering the sheer fact that investor sentiments have the aptitude and capability to sway financial markets, as an innovation, securitization was a risky source of financial fluctuation. Securitization, therefore, encouraged financial institutions to transfer credit risks from their balance sheets to investors in capital markets and the institutions were left holding large amounts of MBS connected with nonprime mortgages when defaulted and losses become inexorable (Dwight et al., 2008). A bank should properly assess any innovation such as securitization that compromises underwriting standards. Securitization became a devastating force due to execution without apposite valuation (Krugman, 2009; Kolb, 2010). Question 2 Greenspan (2004) and Christensen (1997) assert that investment banks and non-bank financial institutions will circumvent risks since failure to be risk-averse will intrinsically lead to insolvency. However, the American government intervention in the financial market prior to the crisis created the notion that huge financial institutions of national importance could not be allowed to liquidate due to bankruptcy (Lounsbury & Hirsch, 2010). Evidently, the American government bailed out several financial institutions that were at the risk of failure and other financial institutions started acting without due diligence since they had already been assured of continuity through the Community Reinvestment Act. Consequently, they unsystematically issued mortgages as they had a higher certainty that the concomitant systematic and unsystematic risks will be squirmed by the government while they continue enjoying profits. This, coupled with securitization where credit risks and default risk were transferred to investors leaving mortgage originators unstressed, created morale hazard that transmuted in proliferated lending. Similarly, adverse selection which emerged due to existence of information asymmetry contributed to the crisis (Batten & Szilagyi, 2011). Financial institutions extended loans to lenders whose credit worthiness could not be ascertained and borrowers beguiled the market for best rates. This escalated loan default probabilities which ultimately prompted the crisis. Question 3 To combat the deflationary risk, the government was forced to intervene by increasing money supply (Bertaut & National Bureau of Economic Research, 2011). However, this intervention can only be perceived as a temporary solution since it increased wealth, investment, and consumption, but the morale hazard it created might trigger an even worse crisis in the near future. As a matter of fact, the government’s act of offering huge investment inducement packages only detriments the economy as the $1 trillion offered is used by investment banks to finance other extrinsic investments rather than fully channeling it into the economy. According to Friedman (2011) and Phillips (2008), the Federal’s intervention through lowering federal funds rate to 1% and 1.75% for discount rate might trigger inflation hence another crisis due to availability of excess cash. In 2008, while the government enacted the National Economic Stabilization Act that raised $700 billion to be used in buying MBS and other distressed assets, the money could escalate the Federal budget and another crisis could be bubbling. Question 4 Refinancing of budget deficits through debt became a common scenario after the 2007/8 financial crisis and the American government’s intervention in the financial led to growth of public debt. The government raised money through borrowing (selling of bonds) (Bernanke, 2009). The bonds attract an interest that must be paid on top of the principal amount. Due to the need to repay the loan, taxes will escalate thus discouraging investments (Shiller, 2008). Businesses will strive to optimize their returns so as to be guaranteed of existence and its cumulative effect will be increase in prices of goods and services and borrowing costs will escalate further draining income from the poor (Bertaut & National Bureau of Economic Research, 2011). In the long run, the projected economic growth and development will be difficult to attain as the welfare of the citizens will continue worsening unabated. Ultimately, the economy might collapse, and never to rise again; a rather despicable situation. Bibliography Batten, J., & Szilagyi, P. G. (2011). The impact of the global financial crisis on emerging financial markets. Bingley, U.K: Emerald. Bernanke, B. (2009), Financial innovation and consumer protection, Federal Reserve System’s sixth biennial community affairs research conference, Washington DC, 17 April. Bertaut, C. C., & National Bureau of Economic Research. (2011). Abs inflows to the united states and the global financial crisis. Cambridge, MA: National Bureau of Economic Research. Christensen, C. M. (1997). The innovator’s dilemma. Boston, Mass.: Harvard Business School Press. Driffill, J. (2013). Financial shocks, unemployment, and public policy. Wiley Blackwell. Dwight et al. (2008). NYU Stern White Papers - Mortgage Origination and Securitization in the Financial Crisis. Retrieved from http://whitepapers.stern.nyu.edu/summaries/ch01.html Eric, O. (2010). TheStreet. Retrieved from http://www.thestreet.com/story/10764075/3/securitizations-role-in-the-financial-crisis-part-1.html Farmer, R. E. (2010). How the economy works: Confidence, crashes and self-fulfilling prophecies. Oxford: Oxford University Press. Friedman, J. (2011). What caused the financial crisis. Philadelphia: University of Pennsylvania Press. Glaeser, E. L., & Sinai, T. M. (2013). Housing and the financial crisis. Greenspan, A. (2004), Risk and uncertainty in monetary policy, American Economic Review, 94, pp. 33-40. Kolb, R. W. (2010). Lessons from the financial crisis: Causes, consequences, and our economic future. Hoboken, NJ: Wiley. Krugman, P. R. (2009). The return of depression economics and the crisis of 2008. New York: W.W. Norton. Lounsbury, M., & Hirsch, P. M. (2010). Markets on trial: The economic sociology of the U.S. financial crisis. Bingley, UK: Emerald. Manoj, S. (2010). The 2007-08 Financial Crisis In Review. Retrieved from http://www.investopedia.com/articles/economics/09/financial-crisis-review.asp Nwogugu, M. C. (2011). Risk in the global real estate market: International risk regulation, mechanism design, foreclosures, title systems and REITs. Hoboken, NJ: Wiley. Phillips, K. (2008). Bad money: Reckless finance, failed politics, and the global crisis of American capitalism. New York: Viking. Shiller, R. J. (2008). The subprime solution: How todays global financial crisis happened and what to do about it. Princeton, NJ: Princeton University Press. Read More