Critical Assessment of Global Crisis - Essay Example

Critical Assessment of Global Crisis Introduction In past years, the whole world has experienced a wide range of crisis from the financial crisis, banking crisis to the economy recession. Since 2007, the world has experienced and might continue to experience in next few years a virulent financial crisis to ever been recorded since the Great Depression of 1929. There have been growing literature from many scholars on the nature and the major causes of the financial crisis. Most of researchers and economists have argued that misjudged underpricing risk has caused the emergence of global financial crisis. Investors and other market players have been overconfident with forecasted results obtained from mathematical and other scientific models used to measure and manage risks. These results in most case have turned out to be wrong with the dynamism in the finance sector. Most investors have been investing their funds in the risky environment has the result of following model results. Additionally, it has been argued that the major basis of the financial crisis was the loose of monetary policy in the early 2000s also known as the “Greenspan put.” Fed and central bank lowered short-run interest rates to rescue financial markets. Timeline of the Financial Crisis There are several key dates indicating the phases of the global financial crisis. Originating from the US, initial signs of financial crisis originated from escalating defaults in the subprime market. The subprime market refers to the marketplace for borrowers who have excessive debt experience, high default rates and the borrowers with recorded bankruptcies and who have a history of missed payments. On the summer of May 2007, Moody’s a credit agency reported that it had planned to reduce creditworthiness assessment of 62 tranches of mortgaged-based securities (MBS), that is, the debt obligations representing a claim on income obtained from mortgage loans. Between June and July of the same year, more tranches were downgraded. In August 2007, French Bank BNP halted three of its funds on a temporary basis because it was unable to assess the value of subprime mortgage securitizations. In short, financial institutions across the world begin to the reassessing the value of the mortgage recognized against their lending. This led to loss of trust and the confidence in these mortgages to tremble. Most institution cast doubts on securitized assets evaluation has they begin to hoard huge amounts of cash assets so as to cover any arising losses originating from their portfolios. The securitization market went under stress leading to a sharp increase in interest rates. Figure 1: spread between 3-month expected fed fund rates and 3-month LIBOR The figure (1) above indicates the spread between 3-month expected fed fund rates and 3-month LIBOR from Jan 2007 to May 2008. LIBOR is a benchmark rate used for interbank lending. In other words, it is a rate used to determined interest rates in a given economy including business and the consumer loans rates. Usually, in norm basis, the difference between 3-month fed funds rate and LIBOR spread is always ten fewer basis points. In 9th August 2007, the spread sharply increased to forty (40) basis points. The LIBOR spread then fluctuated between 25BP and 106 basis points. After the increase in the LIBOR spread of the highest basis points to ever been recorded interbank lending market started to dry. A financial institution such as banks started to realize that they had no idea on the value of their financial positions as they were unable to assess the lending risk. It is worthy to note that banks do not necessary require money reserves to make loans. Financial firms such as banks usually, first create loans and later they search for reserves to finance their operations. In the balance sheets, loans normally represent risky assets. Therefore, before making loans banks first have to assess the effects these loans have on their balance sheets. However, in the last quarter of 2007 these banks realized they could not be able to assess the effects of lending operations in their statement of financial position. Therefore, these banks had to keep a tight rein on the lending. As a result, the most financial institution started to face serious liquidity problems. However, liquidity implications were intensified by the increase on relying on cash assets via marketability method which means that financial institutions hold long term maturity-based assets which are financed by short-term liabilities in the hoping they could definitely and readily sell these assets in markets once conditions require them to do so. However, this notion was valid until mid-2007 when many financial institutions faced liquidation problems. One of the notable casualties of liquidity problems was British Bank of Northern Rock. Also, United States’ commercial bank credit increased by $575 billion dollars during the last quarter of 2007, afore falling sharply in the first quarter of 2008. This led to rising in commercial bank credit in the same year when interbank lending market had parched up. Many financial firms were unable to raise liquidity from the lending market; this meant they had to rely on their liquidity on credit lines with other banks. However, credit rating agencies such as Moody’s, and S&P progressively downgraded securitized assets value ratings as the crisis progresses. Notably, on the last day of Jan 2008, Standard and Poor’s, a credit-rating agency, downgraded over 8000 securitized assets. As results of increased downgrading of securitized assets led to more doubts to the value of the statement of firm’s financial position of financial firms. However, financial institution responded by re-evaluating the composition and size of their financial position. In short, they removed of risky assets and replaced them with safer assets as well as contracting their balance sheet. To deal with liquidity problems and the downgrade of assets value, financial firms had to dispose of some of their assets to comply with capital requirements and accounting problems. To dispose the assets, these firms had to value assets as per mark-to-market principles. Unluckily, some of these principles are naturally pro-cyclical. This means that, they increase the reserves and profits as the asset prices increase. However, a decrease in these prices implies substantial writing down of an asset resulting to a vicious cycle. As a result, sales reduce forcing these firms to “fire sales” so as to comply with capital requirements. Consequently, the action is taken impacts mark-to-market value of assets of the firm leading to more actions to “fire sales” and so on. In mid-2008 liquidity implications, financial industry worsened resulting to solvency problems for many financial firms across the world. Housing markets problems (Subprime mortgage crisis) emerged in the US and later spread in the other countries across the global hence causing global crisis. In the next section, we are going to focus on Subprime lending fiasco discussing the causes, effects and how we could have avoided the crisis. Subprime Lending Crisis The subprime lending crisis also famously referred to as mortgage crisis or mortgage mess came to people attention due to increase in the year 2006 home foreclosures, which went ahead to increase rapidly in 2007 causing national financial fiasco that spread across the global within a year. There was a decline in consumer spending causing the housing market to tremble. As a result, home foreclosures number continued to increase resulting in falling of the stock market. The mortgage meltdown leading to foreclosures fallout lead to dissension among lenders, legislators, and consumers causing furious debate of how we would have avoided the crisis and possible ways to fix the meltdown. By mid-2007 the United States subprime mortgage sector had collapsed. Most lenders had in the industry had declared bankruptcy, reporting substantial losses which led some of them to put their business up for sale. In addition to the financial crisis in the US, mortgage meltdown spread across the global resulting to plummeting of stock markets. Stock prices went down in many countries around the world as a result of this mess. For example, stocks price in India and Germany fell by 7%, 5.5% in Britain, and 3.9% in Japan while in China Stock prices fell by 5.1%. Stock markets analysts said that stock prices fell as result of fears of losses on loans made on securities in the United States. It is fair to say that mortgage crisis significantly affected economies across the global. It is due to this reason that subprime lending crisis is popularly referred to as “Global disaster.” International Monetary Fund released a report in 2008 indicating that the mortgage meltdown leads to losses amounting $565 billion. If we combine the losses caused by mortgage crisis with other factors such as loans and securities related to commercial real estate, IMF will indicate that these losses could result in about $945 billion or more across the global. In the report, IMF mentioned that banks and other financial institutions suffered half of the total losses. The reported figures were just estimated not the actual losses meaning these losses could be even higher than initially indicated. In the same year, credit rating agency Standard and Poor’s indicated that global financial institutions could write off more than $285 billion dollars in subprime real estate and securities linked to the United States. The Cause of the Subprime Lending Crisis Several theories have been developed to explain the cause of the mortgage crisis. Many economists claim that the crisis was caused by a combination of many factors and that subprime lending played a significant role in creating the crisis. Housing Bubble The mortgage breakdown began with the housing bubble that affected a half of the United States, home prices reached their peak in late 2005 and started to decline from 2006 and 2007, and the prices reached their new low in 2012. A housing bubble is a condition that is characterized by rapid increase in the real property valuations up to a point where unsustainable levels were arrived at about the income level and some other economic indicators of affordability. Following the rapid increase in the valuation of the property was a decrease in the property price and mortgage loan that were significantly higher than the property value. The housing bubble was identified after a market correction of the United States' housing that began in the year 2005, by Alan Greenspan the former Federal Reserve Committee chairman. The identification of the bubble was late because it had already grown and led to the rise of the subprime mortgage crisis in the year 2007. The CEO of Freddie Mac Richard Syron also confirmed the presence of the bubble and warned that the home prices were overvalued, correction of this condition would take years and significant cash in the value of mortgage would be lost. The Decline in the Interest Rates Many experts claim that the United States housing bubble was created in part by historically low interest rates. As a result of the crash in the dot-com bubble in the year 2000 as well as the Great Recession that followed afterward in 2001, the Fed Reserve decided to reduce the short-term interest rates to 1 percent from initial 6.5 percent. In the year 2007 Greenspan put admitted that lowering of the real long-term rate of interest engendered the housing bubble. Mortgage costs were set according to 10-year Treasury bond yields, which were subsequently impacted by the Fed interest rates. The Fed Reserve Board stated that a connection arising from the low-interest rates, the higher cost of homes, and the increase in liquidity was caused by the increase in the value of homes in the economy at large. During the year 2005, the Fed Reserve Board stated in its report on international finance that housing values, like other asset values, are affected by the interest rate, and in some nations, the mortgage market is an important channel for transmitting monetary policies. Bursting of the Housing Bubble The Fed Reserve Board increased the interest rates 17 times between years 2004 - 2006, raising interest rates from 1 percent to 5 percent. The Fed Reserve Board then delayed increasing the interest rates due to fears of accelerating a downturn in the mortgage market that would undermine the entire economy. Some economist, like Nouriel Robinin a New York University economist, felt that the Fed Reserve Board should not have raised the interest rates as they did, as this would have avoided the worsening of the housing bubble later. Robinin too warned that as a result of the declining sales and prices in the year 2006, the mortgage sector was in freefall and it would disturb the whole economy in the United States, causing a recession in the year 2007. Still, in the year 2006 Barron Magazine also warned that a crisis in the housing sector was nearing, the magazine also indicated that the mean price of new mortgage homes had decreased by 3% from the start of January 2006. It also forecasted that the United States mean price of mortgages would drop by 30% in the following three years. Housing Bubble Correction Predictions by different business writers and economists in the year 2006 and 2007 of the possibility of having a correction in the housing market due to the over-valuations in the mortgages during the time of the bubble accelerated the crisis. The estimates made suggested a correction of a few points by about fifty percent from peak values. Mark Zandi, an economist at the commercial firm of Moody, predicted a crash of at least double digit in depreciation within the year 2007 and 2009. Still, in the year 2007, a paper was presented during the economic symposium hosted by the Federal Reserve Board. By a Yale University economist by the name Robert Shiller, the article warned that past trends show that significant declines in the real mortgage prices will occur, in some regions the decrease will even be fifty percent beginning from the year 2007. The Rise of Subprime Lending Subprime market borrowing was one of the significant factors that led to the rise in mortgage interest rates as well as the demand for housing facilities in the period of the bubble. The United States tenure rates rose from 64% from the year 1994 to 69.2% in the year 2004, which was indicated as the highest level the rates have ever reached. This demand aided the increase of housing rates as well as the consumer spending which resulted in increasing like never before in home values of 124% between the year 1997 to the year 2006. The majority of the homeowners took advantage of the rising valuation of property to get funds to refinance their household with reduced interest rate, while others took second mortgages against their overvalued property for the purpose of consumer spending. The United States’ debt proportion to income increased to 130 percent in the year 2007, which was 30 percent more than what was recorded in the earlier decades. With the trembling housing bubble, the following events occurred; high default rates on the subprime market, Alt-A, and other housing loans were classified as risky borrowers with a little credit standing and lower income than the prime borrowers. Alt-A is a mortgage classification in which the risk profile drops between the prime and subprime. The borrowers of the Alt-A mortgages usually have a good credit standing, but the mortgage contains some aspects that raise its risk profile, like higher debt –to-income ratios or poor documentation of the income of the borrower. The number of subprime mortgages increased from nine percent in the year 1996 to twenty percent in the year 2006. The cost of these mortgages amounted to $600 billion in 2006, and this accounted for a fifth of the United States loan market. The number of subprime loans increased because of the increasing value of real property this made borrowers to take more risks. Some economists believe the Wall Street-fueled this behavior through packaging the loans into security instruments and sold them to investors who were seeking higher returns Impacts of Subprime Lending Crisis After discussing the major causes of the crisis, we now turn our focus on the impacts of the meltdown in the US and the globe at large. As mentioned before, the subprime lending fiasco leads to huge losses to financial firms. These losses significantly affected the ability of banks and other financial firms to lend leading to slow economic growth. Subprime lending fiasco also led to dramatic fall in global stock markets. It was reported that stock owners in the US-based companies suffered losses amounting to more than $8 trillion. This was as a result of fall of their holdings value from $20 trillion dollars to $ 12 trillion dollars. These losses were only from US-based companies meaning across the global there were significant losses in stock markets. At the start of 2007, the crisis began to impact the financial industry. In the February 2007, HSBC one of the world largest bank reported having written down it's holding of mortgage-backed security by $10.5 billion loss related to the crisis. In the same year, over 100 mortgage firms were sold, another shutdown while others suspended their operations. As the crisis worsened and deepened during the year, most financial institutions merged while others were looking for partners to merge. As a result, losses incurred caused by the fiasco. However, most financial institutions reported huge losses across the global. The table 1 below show financial institutions against losses reported as a result of the subprime lending crisis. Table 1: List of some of the financial institutions to have reported losses as result of the crisis Table 2 shows the financial institution that was reported to have filed bankruptcy as a result of subprime lending fiasco Table 2: Business reported to have filed bankruptcy At the end of the year 2011, more than a million homes had been a foreclosure in the US. This led to a reduction in sales of new homes resulting in huge losses to investors who had invested in the MBS. S&P housing price index reported that housing prices in the United States had fallen by 8 percent from the peak in the year 2006. The US Real Estate markets experience substantial price variations with some prices appreciating while others were depreciating. Unsold houses amounted to 9.8 million by the end of 2007 total sales. Combating the Crisis Many analysts and economists argue that mortgage crisis could have been avoided. I agree with them that it was possible to avoid this mess. However, to support my argument, I have discussed ways in which subprime lending crisis could have been avoided. Being caused by human action and inaction, I believe that this crisis could have been prevented. First, regulation of financial sector could have prevented mortgage meltdown. The federal government failed act of 2004 on the regulation of mortgage lending standards would have prevented penetration of toxic mortgages in the finance sector. Secondly, reports showed that regulators had the idea and tools of the eventual crisis but failed to act. Also, consistent response to the signs of the crisis could have prevented the crisis. Thirdly, regulators could have been given the authority to impose and manage prudent limits on leverage and risk. These limits and regulations could have supervised and protected the customers from the mortgage crisis. The Fed could have regulated mortgage brokers making bad loans and who invested too much money on leverage. Regulating these brokers could have prevented consumers from borrowing bad loans and hedge funds hence curbing the meltdown. Regulations on lenders of could have reduced the downturn by lowering most of the leverage. Transparency and honesty of credit rating agencies could have prevented a lending crisis. These agencies indicated investment grading ratings of the financial institution and people had too much trust in them. Biases in credit rating contributed to the financial crisis. Proper implementation of financial regulation policies could have curbed the lending crisis. Tight controls could have been imposed on loan underwriting; this could have to be done through restricting loan amounts given to borrowers. Lenders should have evaluated borrower’s net assets, annual income as well as the value of the collateral before issuing any loans. Additionally, to reduce the moral hazards, Fed could have introduced policies to prevent underwriters from selling 100% risk loans. To decelerate credit boom, the Fed Reserve could have timely reduced the lending rates. Also, Fed could have lowered the outsized fiscal deficits that had contributed to foreign borrowing. On the other hand, regulators and other real estate players could have been stricter when applying prudential principles on financial operations where financial firms were operating. Improved mortgage origination could have helped in preventing the subprime mortgage crisis. One of the causes of mortgage meltdown was underwriting problem, where homebuyers were given higher quality than they deserved. If we had improved underwriting standards, we could not have witnessed subprime lending crisis. Poor risk management in most of the financial firms that had bought mortgage-related assets led to the subprime lending crisis. If we had improved regulations and better risk management practices, we could have prevented mortgage mess. Read More