The Financial Crisis - Essay Example

Econ 331 Final Essay: The History and Effect of the Credit Default Swap Market and Sub Prime Mortgages on the Financial Crisis The purpose of this essay is to provide insight as to how; historically speaking the current financial crisis had been partially created and exacerbated by the credit default swap market and the sub prime mortgage crisis. This paper will first provide an overview the current state of the financial crisis followed by arguments describing how the two factors listed above have helped mould the financial situation as it is today. Next the paper will look at some of the solutions as utilized by governing parties to help remedy the situation and finally provide an outlook for the future of the global economy. There is little question that the global economy has been in the depths of one of the greatest financial crisis’s since the great depression. In an article published by Reuters (2009) the forecast for the year 2009 predicted an overall decline in gross domestic product for the US of 2.5%-3% and global markets of 1%-1.5% While there are a number of different theories that have been proposed as to why the world has been plunged into the current economic climate the there is no one simple answer. As was argued by Walison (2009) writing for the American Spector, neither political parties or the administration are entirely to blame rather it is a convalescence of a number of different factors that have brought the current situation about. One major contributing factor to the current economic crisis as argued by Bailey et al. (2008) is that much of the current situation can be traced back to sub-prime mortgages that have emerged in the last decade. The authors had highlighted that home prices had been increasing year over year in the U.S. from about the mid nineties until about 2006 which was a trend that had continued despite a lack of change in other input factors such as income levels. It was upon this foundation that a so called ‘bubble’ was formed in which increased levels of investors and potential home buyers sought to purchase homes based on future expected returns. Where the complication arose out of this matter was the establishment of sub-prime mortgages. In a 2009 speech given by Chairman of the United States Federal Reserve; Ben Bernanke when asked about the role of regulation in the sub prime mortgage crisis the primary indicator mentioned was that it was simply the case that the majority of the worst possible loans made by lenders were subject to very little if not any federal regulation. The majority of sub-prime mortgages offered were adjustable rate mortgages which lock in a favorable rate or the first few years and generally did not require a significant down payment. The result of this is that when housing prices began to fall lenders quickly raised the lending rate used and as such the more and more people began defaulting on their loans, and ultimately cased a reluctance of lenders to issue more credit even to qualified buyers. With fewer and fewer buyers ably to repay their loans it was also the case that many lending institutions would face liquidity issues, which ultimately would affect their bottom line as well. It was argued by Phillips (2008) that another major contributor to the current economic climate was the credit default swaps market. Whilst credit default swaps have been around since about the mid 90’s, According to Teather (2008) it was JPMorgan Chase that helped create the modern instrument as we know it today, and they were designed to help transfer risk to a third party. The way that this function was achieved involved a simple swap contract where the purchaser would make payments to the retailer and in exchange for these payments receives dividends if the instrument were to default. It was again argued by Phillips (2008) that credit default swaps played an influential role in the financial crisis simply by nature of the amount of capital they controlled without strong regulation, as well as the lack of transparency owing to the fact that the financial instruments are privately negotiated. The way that the credit default swap market has exacerbated the financial crisis is that the instruments were in effect encouraging investors in put their money into more risky investments. An example provided by Phillips (2008) links the CDS market to the housing crisis. Several years ago when American investors started buying more houses because of new lower interest rates as regulated by the Federal Reserve. As mortgages became a better investment it was the case that CDS were issued to protect against payment default. As a final result major institutions were such as AIG and Lehman Brothers had invested heavily in credit default swaps and as mortgages started do default it was the case that major investors began to take their money out of credit default swaps and ultimately lenders have to reduce the amount of credit on offer. As more and more mortgage backed securities started to fail major companies had to pay out their credit default swaps so much so that they could not cover their losses. As these major companies started to loose share value and are linked to many other major companies this created an investor panic that hurt the major markets. In order to combat the steep decline in the American and Global economies a number of different steps have been taken to help remedy the overall situation as well address sub-prime mortgages as well as credit default swaps. Firstly in the United States Congress the Economic Stimulus Act of 2008 was signed, which ultimately gave tax rebates, tax incentives, and gave increased regulation on mortgages, to help boost consumer confidence and stimulate growth in the economy. Hakim (2008) stated that the Governor of New York David Paterson initiated a program to better regulate credit default swaps by making it illegal for anybody other than licensed insurers to issue the instruments as well as setting limits on minimum capital requirements and reserves in order to provide a financial buffer should the instruments default. In regards to sub-prime mortgages Secor (2008) listed several regulatory changes that have been made in order to alleviate the situation such as requiring income verification through documentation in order to guarantee a mortgage, as well as guaranteeing that borrowers can make payments after initial rates have expired and giving borrowers 60 days to refinance a loan before an interest rate can go up. Whilst these changes should logically have a significant effect on improving the regulatory climate the world still remains in an economic depression an it remains to be seen what effect these changes will have in the long run. References Bailey, M.N.; Litan, R.E.; Johnson, M.S. (November 2008) The Origins of the Financial Crisis. The Brookings Institute. Available online at http://www.brookings.edu/papers/2008/11_orgins_crisis_baily_litan.aspx Accessed on December 13th 2009. Bernanke, B.S. (April, 2009) Speech: Four Questions About the Financial Crisis. Moorehouse College, Atlanta, Georgia. Available online at http://www.federalreserve.gov/newsevents/speech/bernanke20090414a.htm Accessed on December 13th, 2009. Hakim, D. (2008) New York to Regulate Credit Default Swaps. The New York Times. Available online at http://www.nytimes.com/2008/09/23/business/23swap.html Accessed on December 13th 2009. Phillips, M. (October, 2008) The Monster That Ate Wall Street. Newsweek. Available online at http://www.newsweek.com/id/161199/output/. Accessed on December 13th 2009 Reuters (2009) Three Top Economists Agree 2009 Worst Financial Crisis Since Great Depression,; Risks Increase if Right Steps are Not Taken. Business Wire News Database Available online at http://www.reuters.com/article/pressRelease/idUS193520+27-Feb-2009+BW20090227 Accessed on December 13th 2009. Secor, S. (2008). The New Sub-Prime Lending Regulations Have Arrived. LendersMark.com. Available online at http://www.lendersmark.org/sub-prime-mortgage-regulations.htm Accessed on December 13th 2009. Teather, D. (September, 2008) The Woman Who Built Financial ‘Weapons of Mass Destruction’. The Guardian Available online at http://www.guardian.co.uk/business/2008/sep/20/wallstreet.banking Accessed on December 13th 2009. Wallison, P.J. (Febrary, 2009) The True Origins of the Financial Crisis. American Spectator. Available online at http://spectator.org/archives/2009/02/06/the-true-origins-of-this-finan Accessed on December 13th 2009. Read More