What Happened in the 2007 Financial Crisis - Assignment Example

What happened in the 2007 financial crisis? Through asymmetric information hence adverse selection, the 2007 financial crisis was caused by the action and inaction by the government (Lounsbury 2010), which created a platform over which both banks, and bank-like institution taking excessive risks specifically in the mortgage backed security market (BBC News 2009). The risks kept building up and through the synergistic effect; they interconnected among the institutions, which in the end undermined the stability of the financial institutions. There were seven main causes that worked together to cause the 2007 financial crisis. Such included the securitization of the mortgages bringing forth to the rise in the shadow banking sector, regulatory arbitrage and conflict of interest, leverage and lower interest rates, outsourcing of mortgage broker function, the suits vs geeks’ problem and finally the bankruptcy law changes. The factors mentioned above worked as follows to cause the “perfect financial storm.” (Mishkin 2004) The securitization of mortgages was the first cause of the crisis given that throughout history it had been a trend that mortgages were issued and serviced by the same bank (Mishkin 2004). The government created Fannie Mae and Freddie Mac although both were eventually spun off as private companies to encourage home ownership by creating home loans, which were issued at quiet lower interest rates. These institutions along with other banks converted loans into securities called mortgage backed securities whereby the money paid by the borrower had to pass through the bank to the holder of the security (Mishkin and Eakins 2012). The banks were therefore able to get more funds to issues more loans by selling the loans. The selling of the loans also made them pass the risks associated by the loans to the buyers of the securities whose impacts both tended to reduce the rates of interest on the mortgages (Casti 2012). The two formally created institutions together with AIG and other financial institutions insured those securities against default through credit default swaps, which are just insurances on cars or houses. Securitization of mortgages itself wouldn’t necessarily be unsafe if only low risk mortgages were securitized but the successive administrations went on to encourage Fannie and Freddie to bundle mortgages so as to expand home ownership. Mortgage backed securities are much profitable when there is no default but with defaults insurance payouts grew and the government had to come in to bail out Fannie and Freddie plus AIG (Lounsbury 2010). Mortgage backed security market is part of the broader trend called the shadow banking where firms run from banks to direct finance due to the better rates they are likely to get (Lounsbury 2010). The participants in this sector take a greater risk as this sector is not regulated like the banking sector. These companies also lack the capital requirement that the banks have compounding the risks further so incase of anything these banks lose a lot. Through regulatory arbitrage, capital requirements reappear (Mishkin and Eakins 2012). This act occurs when financial institutions have a way of undermining the intent of regulation to increase profits like the bizarre risk rankings and the shopping for a regulator. Regulatory arbitrage combined together with the conflict of interest contributed to the growing instability of the financial sector. Poor lending practices caused by the changes within the mortgage market was a cause given that the lending authority was given to the independent contractor who were outsourced and being paid on a fee per loan. They therefore had the incentive for loaning people even without looking at their security, which banks could not do as they securitized the loans (The Guardian 2012). Recent government actions like allowing the investment banks to borrow at lower rates so that they could make profits by purchasing MBSs also contributed to the crisis. Previously, such high leverage rates were not allowed. “Suits vs. Geeks” problem where geeks as financial engineers who determined risks undertaken by banks with suits as the upper management warned suits that banks were taking great risks and hence suits should retrench (Lewis 2009). The suits though did not understand the risks or they did not care given they were making enormous profits hence the crisis. The changes in the bankruptcy law making the declaration of bankruptcy harder were another factor. This is because banks were now forced to make riskier loans since they could not declare individuals bankrupt hence unable to reorganize their debts (Reinhart and Rogoff 2008). 2. What problems of moral hazard and adverse selection were present in the 2007 crisis? The moral hazard and adverse selection presented in 2007 was created due to asymmetric information that existed between the lenders and the borrowers (Lounsbury 2010). This made it hard for the borrowers to be possessive of more information than the lenders hence inability of the lenders to determine which the less risky and more risky borrower is. As a result, the institutions in the contract ended up giving loans with high interests to good borrowers with the reverse happening to the bad borrowers. This trend also lead to credit rationing most so to the good borrowers who in turn opted to leave the market (Lewis 2009). The contract relations exist as banks selling to their clients what we call lemons due to their unobservable information about the borrower. In 2007, banks sold only the loans of borrower whom they had private information about, information, which is unobservable to the outside investors (Mishkin 2004). We find that borrowers with an active secondary market for their loans underperform their peers by about 9% per year in terms of annual, risk-adjusted abnormal returns, over a three-year period subsequent to the initial sale of their loans. Most of the banks together with the government created institutions deliberately formulated bad loans so as to enhance their fee income give the simple reason that there was created a secondary market where they could sell their loans. The creation of the financial institutions, which could not be regulated, made it quite hard for banks to even monitor their loans and regulate their borrowers. It was not easy to declare the borrowers bankrupt, which was harmful to the banks and to the borrowers as they were not able to know when they could pay back loaned amounts making the banks be at high risks (Mishkin and Eakins 2012). The problem of adverse selection resulted when the created institutions could commence operations without the minimum capital requirements and go ahead lending loans to borrowers without considering whether they had security for the loaned amounts (Lewis 2009). This placed the financial sector at cross roads since the long-term valuation of the borrowers was placed at a risk given that they could easily default the loans given and no penalty accorded on them. This is because borrowers may undertake suboptimal investment and operating decisions. Furthermore, they would even allow some stakeholders to appropriate cash flows at the expense of other stakeholders, which would destroy value in the end (BBC News 2009). 3. How did these problems lead to (and or worsen) the poor economic outlooks for countries involved? The asymmetric information through adverse selection of information would most likely lead to a disruption of the financial market and a general collapse of the economy due to the decline in lending which leads to the ultimate decline in investments (Casti 2012). The continued increase of the liquidity crisis could worsen the situation and even further it into the collapse of the global economy. The crisis would cause this by in the first instance paralysing the banking sector through a shakeout of the sector where it experienced a saving and loan meltdown (Reinhart and Rogoff 2008). As noted by the UBS and investment bank that a global recession would result that would last for more than two years before the same institution announces the end. Reports by the Brookings institution indicated that the consumption by the US was a third that of the whole world and that, this was because the economy of the US had been borrowing and spending too much for so many years making the rest of the world to depend on the US consumers as a source of the global demand. Therefore, if a recession occurred in the US while the rate of saving by the consumers in the US plummeted, there was an automatic decline of economic growth elsewhere across the world (Arnold 2012). This was witnessed in some developing countries who had recorded growth, which showed a significant decline, for example, Cambodia showed an economic decline from a percentage of 10% to a miserable 0% in the year 2009. This reduction in the economic growth of developing countries because of the economic crisis can be attributed to a reduction in trade and trade activities, fall in global commodity prices, reduction in remittances sent from migrant workers (MacNeil 2010) and this drastically lead to an increase in the number of people living below the poverty line. The production from the inputs in the machinery for goods and services decreased. This was by an annual rate of 6% in the fourth quarter of 2008 and first quarter of 2009 as compared to the same activities the previous year (Hahm and Mishkin 2000). The unemployment level of the US workforce dwindled by above 10% the highest rate ever recorded since the year 1983. The number of hours worked by the labour force per week reduced to the lowest ever to just 33 (Arnold 2012). Generally, the livelihood in America did not fare quite well and this went as far as affecting the wealthy and not the wealthiest. It was recorded that over 63% of the wealth of the entire American collapsed. The financial crisis of 2007 was a lesson that has taught us that once the confidence of the financial market is shattered, it cannot be quickly restored and it has vast impacts on the economy (MacNeil 2010). In an interconnected world, a seeming liquidity/financial crisis can very quickly turn into a solvency crisis for financial institutions. In addition, a balance of payment crisis for sovereign countries and a full-blown crisis of confidence for the entire world but the positive aspect is that, after every crisis in the past, markets have always come out strong to forge new beginnings (BBC News 2009). References Arnold, G, 2012, Modern Financial Markets and Institutions: A Practical Perspective, Pearson Education: Essex. BBC News, 2009, Timeline: Credit Crunch to Downturn. Available from http://news.bbc.co.uk/1/hi/business/7521250.stm Casti, JL, 2012, X-events: the collapse of everything, William Morrow: New York. Hahm, J, and Mishkin, FS, 2000, ‘The Korean financial crisis: An asymmetric information perspective,’ Emerging Markets Review, vol. 1, pp. 21-52. Lewis, M, 2009, Panic: the story of modern financial insanity, W.W. Norton & Co: New York. Lounsbury, M, 2010, Markets on trial: the economic sociology of the U.S. financial crisis, Emerald: Bingley. MacNeil, I, 2010, The future of financial regulation, Hart: Oxford. Mishkin, FS, 2004, ‘Asymmetric information and financial crises: A historical perspective,’ NBER Working Paper, no. 3400. Mishkin, FS, and Eakins, SG, 2012, Financial Markets and Institutions, 7th Global Edition, Pearson Education: Essex. Reinhart, CM, and Rogoff, KS, 2008, ‘Is the 2007 US sub-prime financial crisis so different? An international historical comparison,’ American Economic Review, vol. 98, no. 2, pp. 339-44. The Guardian, 2012, Financial Crisis Timeline. Available from http://www.guardian.co.uk/business/2012/aug/07/credit-crunch-boom-bust-timeline Read More