Global Financial Crisis and Consequent Credit Crunch within an International Finance Perspective - Case Study Example

Discuss and analyze the recent global financial crisis and consequent credit crunch within an international finance perspective: include the events leading up to the crisis, economic and financial consequences, government responses and lessons to be learnt. Current Issue: The Subprime Mortgage Mess, the Housing Bubble and the Financial Crisis of 2008 A financial crisis is defined as a sudden decline in the value of financial assets or those financial institutions which are governing the financial assets. Financial crisis may result due to number of factors but the most common trigger observed is the negative sentiment of investors including panic and fear. Financial crisis most often have ripple effect in which bankruptcy of single financial institutions may result in laying down many other financial institutes (EconomyWatch, 2010). Events leading to Financial Crisis 2008 Financial crisis which occurred in 2008 were proved to be very adverse for the entire world. The consequences are now being faced by each and every country because nowadays economies are not isolated but in fact they are linked to each other. Recently, countries like Egypt, Greece and Italy faced serious issues related to bankruptcy. For this regard, it is essential for us to know the insights about the causes of such crisis as well as some backup plans so that we can avoid as well as survive from the financial crisis. For every individual, it is vital to understand the basic investment and spending criteria during the times of recession. In subsequent paragraphs, insight about the global financial crisis and the events which lead to these crises are mentioned. The global financial crisis of 2008 was mainly triggered by the crash of US housing markets. The situation was exacerbated by the subprime mortgage and subsequent defaults of U.S. At the beginning of the new millennium, global economy went through serious crisis which included recession,terrorist attacks of 9/11 and burst of dot com bubble.Chairman Alan Greenspan persuaded to lower down the interest rate to just 1% which gave rise to another economic trouble. Everyone took advantage of such lowered interest rate and mortgage brokers began to grant mortgages and loan to millions of buyers who did not have the required credit rating and income. Lowered interest rates means lowered amount of mortgage payments. This situation created a speculative frenzy of home buying which continued till 2006. In 2006, Ben Bernanke became the Chairman of FED. As long as this situation persists, the price of houses continued to rise in U.S as a result of lowered interest rates. Both Bernanke and Greenspan ignored the alarming sign that the bubble will burst very soon creating much greater trouble for the economy of U.S and ultimately the global economy. Mortgage brokers took ultimate advantage of this situation and lent mortgages to millions of buyers who otherwise would not qualify for home ownership. These borrowers were mostly poor people who could not afford to buy a high priced home when interest rates are higher. Previously, they did not qualify for loans because either of their poor credit history or low income. For about 60% of subprime loan, there was no income verification (Slavin, 2009). Investors lost confidence in their investments which worsen the condition of money market and financial institutions. Consequence of such situation would result in two most probable situations: Firstly, all the mortgage borrowers would default because of their incapability of paying off loans and thus, will lose their homes as well. Secondly, prices of real estate would start falling down. (Baker, 2008) The huge mortgages losses were primarily taken by giant banks including JP Morgan Chase and Citigroup but despite of this, hedge funds, investment banks, unregulated firms and brokerage houses also incurred significant losses. While the housing bubble ended rather quickly, but it caused serious financial turbulence. All over the world, banks had declared losses of around $200 billion as a result of collapse of housing bubble. The total figure is approximated as $1 trillion. The weakness of the financial institutions and housing market worsen the effects of recession. (Baker, 2008) Due to these financial crises, worldwide the investors switched from investments in equity markets to safe investments which tumbled the stock markets globally. Commercial papers and money market funds were no longer considered as low risk or safe assets. In general, financial institutions and markets failed because of lack of governance and incompatible remuneration structures. Inadequate transparency in the procedures of financial instruments and trading resulted in market failure. After all this turmoil, the question which arises in everybody’s mind is what actually caused the credit crisis? Many people guess that it happened just because of the mess of subprime mortgages, but in actual is just a small part of the entire situation. For the past several years, firms and investment banks were making bets that the prices of real estate, as compared to other investment, will continue to increase. In essence, the web of debt spread so vastly, that for instance if one large firm would default, then the ripple effect would overthrow the entire financial house. The firms were regulated through FDIC, Fed and other governmental authorities; no one could have any idea about how much was obligated to whom. In fact, we might never probably know that.(Baker, 2008) Government Data pertaining to Prices of Real Estate Government data showed that from 1953 to 1995, the real estate prices essentially remained unchanged. Robert Schiller constructed a series of data which showed that prior to 1995, the real estate prices nationwide have remained unchanged for the past 100 years. After 2002, the prices of real estate sharply upturned by 30%. Government’s response in dealing with Recession Government has a major part to play during the times of recession. The role of government is very prominent as it redesigns the fiscal and monetary policies so that it becomes appropriate as per the era of recession. In order to deal with recession, government redesigns the policies and takes other necessary actions. For the recession which is prevailing in Eurozone and U.S, the government has designed and crafted policies which mainly include: Reducing the level of taxes Reducing interest rated Increasing borrowings Spending on infrastructure and public works(Shah, 2010) At the time of recession, borrowing can be risky but the concept is that it would be recovered at the time of growth. The reason of reduced level of interest rates is that it will encourage the public to participate in economic activities and it will induce spending. Generally, tax rate is reduced because higher tax rates will result in further hardships for people. Finally, the attempt of investing in infrastructure will stimulate the economy as it will employ more people.(Shah, 2010) There is no hard and fast rule in dealing with recession. Every country takes action as per their requirements. However, in many other countries, governments take other measure to kick start the economy for instance in China, Japan and England, government prefer to borrow billions to bring stimulus in the economy. (Shah, 2010) Worldwide, the economy managed to preserve its momentum back. The fear of increased rate of inflation, food shortage and fuel has completely surpassed the greater fear of depression and recession surrounding the developed countries including economies of Latin America, Asia and Eastern Europe. Apart from these, some low income developing countries from Asia and Africa are also included in it because no country was in a position of bystander in the emerging financial crisis. Global consideration and coordination is vital since it can improve the effects of national policies. In order to cope up with financial crisis, government should avoid formulating and implementing policies that might have an impact of beggar-thy-neighbor. Many developing countries do not have adequate resources to approve policies to survive the financial crisis. For this reason, official assistance for the development of economy needs to get improved. (UNITED NATIONS INDUSTRIAL DEVELOPMENT ORGANIZATION, 2009) Concluding Remark The housing bubble began to loosen after the real estate prices reached their peak and the housing bubble melt down in the mid of 2006. This situation led to increase the default rise particularly in subprime market. The financial meltdown also affected the housing market.In order to resolve the rising financial turmoil that has been submerged all over the world, unprecedented policies and decisions have been made by policymakers and financial experts. Trillion of dollars have been injected in the economies worldwide to gain the confidence of investors and resolve the credit freeze. In U.S, nine banks have been made public and several deposit insurance and debt have been declared. Apart from the above mentioned serious problems, industries related to food and beverage sectors examined serious contractions all over the world. Finally, the results of financial crisis increased vulnerable employment and working poverty. Currently, the economies and financial markets are recovering slowly and gradually from the adverse effects of food and fuel crisis. The challenges are faced by not only developing countries but also developed countries. Many of the countries like Greece, Italy and Egyp are facing bankruptcy issues. Lessons which need to be learnt from this great depression are very necessary for everyone buttaking actions at governmental and economic level is out of an individual’s scope. For this reasons, individual investors need to study and learn about making individual investments and spendings. Financial experts recommend several strategies for individual investors by which they can survive in the times of recessions. These strategies can help the layman to make safe investments and making more spendingsduring recession. Works Cited Baker, D., 2008. The housing bubble and the financial crisis. [Online] Available at: http://paecon.net/PAEReview/issue46/Baker46.pdf[Accessed 6 April 2012]. Dullien, S., 2010. The Financial and Economic Crisis. New York: United Nations Publications . EconomyWatch, 2010. Financial Crisis, Credit Crisis, Credit Crunch. [Online] Available at: http://www.economywatch.com/finance/financial-crisis-credit-crisis-credit-crunch.html[Accessed 6 April 2012]. Faust, C. M., 2011. What Caused The Financial Crisis & Housing Bubble?. [Online] Available at: http://spfaust.wordpress.com/2011/11/17/what-caused-the-financial-crisis-housing-bubble-not-the-myth-about-fannie-mae-freddie-mac-2/[Accessed 6 April 2012]. Greenidge, K., n.d.. Financial Crisis 2008:What has been and should be the Nature of the Response by Countries?. [Online] Available at: http://www.caribank.org/titanweb/cdb/webcms.nsf/AllDoc/8D7C3F0365D32BAE042575210067ADD8/$File/FinancialCrisis2008PolicyResponse.pdf[Accessed 6 April 2012]. Rahn, R. W., 2010. What Caused the Financial Crisis. [Online] Available at: http://www.cato.org/publications/commentary/what-caused-financial-crisis [Accessed 6 April 2012]. Risk and Insurance Management Society Inc. , 2009. The 2008 Financial Crisis. [Online] Available at: http://www.ucop.edu/riskmgt/erm/documents/2008fincrisis_wakeupcall.pdf [Accessed 6 April 2012]. Shah, A., 2010. Global Financial Crisis. [Online] Available at: http://www.globalissues.org/article/768/global-financial-crisis[Accessed 6 April 2012]. Slavin, S. L., 2009. Macroeconomics. 9th ed. New York: McGraw Hill. UNITED NATIONS INDUSTRIAL DEVELOPMENT ORGANIZATION, 2009. The Global Financial Crisis and the Developing World: Transmission Channels and Fall-outs for Industrial Development. [Online] Available at: http://www.unido.org/fileadmin/user_media/Publications/RSF_DPR/WP062009_Ebook.pdf [Accessed 6 April 2012]. Read More