2007 Financial Market Crash - Essay Example

Financial Crisis Introduction This paper focuses on the 2007 Financial Market Crash with an aim of understanding in details the policy-making strategies that led to the crash of the economy. Further to that, this paper will explore in details the causes of the crash and the measures employed since then to solve the crash. The measures can be introduced along with the Government regulation policies to the current American mortgage in order to prevent another market crash. This paper considers the selling of bad debts to the world in the form of layered Mortgage Back Securities to explain books as the Main cause of the crash of the market among others. However, the paper explores the role the Government ought to have played in regulating the banks, the role of the banks in regulation of mortgages and how they would have accessed the housing bubble thoroughly. In this paper, we have put into consideration four areas to help in understanding the current issues and help us to come up with policy changes (Bates 2012, p234),. It also highlights the resolutions to avoid future market failures or limit the occurrence of the failure. There are several aspects that have been considered in this paper, and they are, mortgage defaults, sub-prime mortgages. In addition, mortgage-backed security and defaults, write off, a wealth effect, moral hazard, and adverse selection. Subprime mortgages that started in the year 1999 played a great role in the fall of the market (Cooper, 2010, p 56). They are mortgages that were offered to consumers who have little earnings or savings as compared to the amount of their savings. The initiative was carried out by Federal Mortgage Association with an aim of ensuring everybody owned a home. However, these mortgages were high-risk loans hence there were hefty terms and conditions attached to them. They accrued high interests and variable payments. The American Government In the year 2002 increased the credit they were giving to the Mortgages Company up to three trillion dollars. The company used to buy the mortgages from the lenders with an aim of making profits when the consumers pay. However, there was a rise in default cases which led to a threat of collapse of the companies. The type of mortgages they offered was referred to as Adjustable-rate mortgages as opposed to the standard Fixed-rate Mortgages. The terms for this type of Mortgage required the borrower to pay a lower amount initially, but the amount payable increased in the subsequent months. Between the years, 1999 to 2005 the mortgages were risk-free since the borrowers would sell their homes with a profit in case they feared the increasing payments on the mortgages (Bates, 2012 p 239). However, many economists viewed this as a disaster waiting to happen in case the property value of the American Market declined 1. How financial innovations lead to an economic crisis, precisely the role of securitization of the mortgage market The benefits of financial and economic change are renowned widely and appreciated all over the world. Example is the financial innovations that have enhanced the growth of the credit market a process that has lasted for almost 15 years. The primary function of finance is to transfer funds from savers to other individuals and firms who utilizes the resources I productive activities. It is a fact that financial innovations of Automatic Teller Machines (ATMs) and credit cards have been of many benefits to the majority of the consumers all over the world. However, not all the financial innovations are useful and have desirable consequences, a good example is the situation of the financial crisis that had recently occurred. The hallmark of the financial crisis is the securitization as a model of financial innovation. The change helped in the process of shifting from traditional banking to modern business. Securitization is a form of financial engineering where financial institutions pool assets that include the car loans and mortgages, repackage them and sell them to investors. There are two forms of securitization which is the pass-through securitization and tranched securitisation. As a matter of fact as it shall be evident later in this paper, collateral debts obligations are directly linked to tranched securitization (Bates 2012, p240). One of the way in which securitization caused the financial crisis can be traced from the financial intermediaries that operates in the markets and plays their roles in conjunction with investors. When banks are involved, in securitization of any form of loans and leverage, financial market crisis will always occur. The bank crisis will result in the economic crisis. In addition, another way that securitization can cause financial turmoil is when they are viewed as disruptive innovations. Disruptive innovations usually cause a shift in everything that comes before then and hence can cause a financial crisis if not correctly observed. 2. How the adverse selection and moral hazard contributing factors to this crisis The crisis of subprime mortgages was a whole moral issue. According to an excerpt by Bates, (2012 p 242), house crash of 2008 is a period where the stock market value declined to an approximate value of 30% in relation to its total value. It is one of the most difficult situation e most difficult times in the American history of the stock market. He further states that those who were present in those times would hardly forget the negative implications of the collapse (245).Subprime mortgages that started in the year 1999 played a great role in the collapse of the market (Cooper, 2010 p56). They are mortgages that were offered to consumers who have little earnings or savings as compared to the amount of their savings. The initiative was carried out by Federal Mortgage Association with an aim of ensuring everybody owned a home. However, these mortgages were high-risk loans hence there were hefty terms and conditions attached to them. They accrued high interests and variable payments.. Between the years, 1999 to 2005 the mortgages were risk-free since the borrowers would sell their homes with a profit in case they feared the increasing payments on the mortgages (Bates, 2012 p243). However, many economists viewed this as a disaster waiting to happen in case the property value of the American Market declined The major cause of the subprime mortgage market collapse was the defaulting by the homeowners. A large number of the owners had defaulted due to the increasing payments, but the prices of buying a home were decreasing. Consequently, they lost their homes and were declared bankruptcy. The only way that they could have moved out of the problem was either by paying the increasing payments or by selling their homes. However, their homes were worth less than the mortgages prices. Despite the entire ordeal, financial market remained stable and kept on increasing until October of 2007. Notably, Dow Jones Industrial Average (DJIA) attaining a high of 14,164 on October 9, 2007 (Farmer 2013, p 695). Sadly, by December 2008 the turmoil had started taking its roots. The economy of U.S was now in a recession. In July 2008, the DJIA had recorded the worst decline in a record of two years of below 11,000. On Sunday September 7, 2008, the financial market had fallen to approximately 20 % since October 2007 when it was at its peak (p 699). 3. Role of the Government According to Farmer, (2012 p697), house bubble is a financial problem that occurred in the U.S due to fall in the price of houses. During the crisis, it was characterized by borrowers refraining from paying the mortgages due to the decreased values of the properties. The housing bubble started in the year 1991. At that period, the house index stood at 17% but by the year 2008 it had declined to 6%. This contributed adverse effects on the U.S financial stock market. The net price of property shares by the investors declined from one dollar to 0.97 cents. Between 1991 to 2007 the demand for the houses had doubled from 264 billion dollars to 586 billion dollars. Many economists have claimed that the bubble started in the year 2006 the demand grew up to five point one percent that is approximately 123.8 billion dollars. However, after the end of the bubble period in three years the demand had fallen back to 351.3 billion which was last witnessed in the year 1995 (Farmer 2012, 701) Most of the Government policies over the years are the ones to blame for this turmoil. The Clinton and Bush Government had introduced policies on home ownership and credit transfer which lead to the housing bubble (Glaeser & Nathanson,2014 p56). The three policies that the Government reviewed and amended are Community Reinvestment Act, the affordable housing, and the Government-sponsored enterprises. According to an article by Spiegel (2011 , p 1775), he claims that these policies were vague and misguided; tax laws further amplified the problems. Government imposed the property and mortgages and this lead to an increase in the interests that homeowners were to pay. Bank regulatory policies also contributed significantly to the financial crisis of 2008 (Jurgilas & Lansing, 2013, 657). 4. Long-term impact of the government’s intervention, particularly the ballooning of the national debt? To prevent such a financial turmoil in the future new regulations of the financial system are not much important. However, the Legislature should consider amending the U.S housing policies since it is the cause of the problem (Shiller 2012, p 24). Other facilitators of the crisis whose practices should be reviewed are greedy investment bankers, rating agents who are not competent, homeowners who do not put into consideration future market shifts and mortgage brokers. However, all the individuals were following the Government policies. Conclusion From the research, it is evident that the events that caused 2008 financial crisis are as a result of irrational thinking and abandoning rational thought (Münnix et al 2012 p77). Further to that, it is undisputable fact that the measures put in place by the American Government were meant to benefit all the citizens equally including the poor. However, to some point in time the Government lost its focus and this lead to a financial crisis. Considerably, as the prices of homes accelerated, lenders who had been accredited to the Government devised more tricks to keep the prices afloat never minding on the dire consequences of their practices. Putting into consideration the unprecedented growth of the subprime mortgage market and the implications of the investments the financial turmoil of the year 2008 was not a deliberate occurrence but it was unforeseeable. My findings from this research had shown that the financial crisis was controllable and solvable before the consequences escalated. Had the Government regulated banks, and banks regulated the mortgages the crisis would not have occurred in the first place. References Bates, D. S. 2012 US stock market crash risk, 1926–2010. Journal of Financial Economics, 105(2), 229-259. Cooper, G. 2010.The origin of financial crises: central banks, credit bubbles and the efficient market fallacy. Harriman House Limited. Farmer, R. 2013The Stock Market Crash Really Did Cause the Great Recession (No. w19391). National Bureau of Economic Research. Farmer, R. E. 2012 The stock market crash of 2008 caused the Great Recession: Theory and evidence. Journal of Economic Dynamics and Control, 36(5), 693-707. Glaeser, E. L., & Nathanson, C. G. 2014 Housing bubbles (No. w20426). National Bureau of Economic Research. Hudomiet, P., Kézdi, G., & Willis, R. J. 2011 Stock market crash and expectations of American households. Journal of Applied Econometrics, 26(3), 393-415. Jurgilas, M., & Lansing, K. J. 2013 Housing bubbles and expected returns to homeownership: Lessons and policy implications. Available at SSRN 2209719. Münnix, M. C., Shimada, T., Schäfer, R., Leyvraz, F., Seligman, T. H., Guhr, T., & Stanley, H. E. 2012) Identifying states of a financial market. Scientific reports, 2. Shiller, R. J. 2012 The subprime solution: How today's global financial crisis happened, and what to do about it. Princeton University Press. Spiegel, M. 2011. The academic analysis of the 2008 financial crisis: round 1. Review of financial studies, 24(6), 1773-1781. Read More