Analysis of the Global Financial Crisis - Coursework Example

Analysis of the Global Financial Crisis The global financial crisis, from which the world has not yet recovered, actually began with the decline of housing prices in the US starting in 2006, although it would take nearly three years for the impact to be fully felt. Once the “housing bubble” burst, the crisis proceeded along two distinct but closely-related paths, exponentially worsening as time passed. The first path was the housing and mortgage business in the US. Median home prices in the US rose steadily from 1990, and increased very rapidly between 2000 and 2005. (ThinkReliability, 2009) As home prices rose, the supply of houses increased as speculative developers sought to profit from the higher prices. In order to actually sell the increasing supply of new houses, credit standards for buyers were lowered, including lower required qualifications, very small or in some cases no required down payments, and low introductory ‘teaser’ and adjustable interest rates on mortgages to attract customers. The result of the compromises by the lending industry to increase the number of housing customers was to put a great many people who did not actually have the financial resources to afford homes at those prices into debt. Because down payments were small, and monthly payments were reduced because of lower interest rates, consumer spending actually increased during the 2000-2005 period. This was aggravated by the availability of credit that had spread from the mortgage market to other forms of consumer lending; owning a home allowed consumers to take out lines of credit against their homes’ (inflated) equity, often from the same banks or lending companies who had arranged their mortgages. (ThinkReliability, 2009) The supply of customers for new homes was not limitless, however, and eventually the housing market reached a point of over-supply. Once that point was reached, housing prices began to rapidly decline, and along with them, the equity value of existing homes. To make up the shortfall in revenues from the new housing customers who were no longer coming in, banks and lending companies began to increase the interest rates on adjustable-rate mortgages, increasing homeowners’ monthly payments. Many homeowners who could afford a home at, for example, a 4% interest rate suddenly found themselves being charged much higher interest rates, which made their mortgage payments exceed their monthly budgets. Because existing home values were based on overall home prices, when the prices dropped the equity in existing houses did as well, sometimes disappearing altogether or becoming negative, i.e., the homeowners actually owed more than what their houses were worth; in March 2008, over 10% of US homeowners – almost nine million borrowers – had negative equity in their homes. (ThinkReliability, 2009) Reduced equity meant that homeowners could not borrow against, and lower home prices meant that they could not sell their houses for the amount that had already been borrowed against them, either in mortgages or equity lines of credit. And of course, the number of homes being put on the market by homeowners seeking to escape their debt simply aggravated the over-supply problem, driving home prices even lower. Home foreclosures increased as consumers defaulted on their loans in growing numbers, and this too added to the over-supply problem and even worse, left banks and lending companies holding bad loans. It was at this point that the second path of the crisis began to be revealed. In 1999, the Glass-Steagal Act, which had separated commercial banking from the financial markets in the US in the wake of the Great Depression of the 1930s, was repealed, leading to the rapid growth of what was then called the “New Financial Architecture.” (Crotty, 2008) In relation to the housing and mortgage industry, this allowed banks and lending companies to package loans into derivative “mortgage-backed securities” and “collateralized debt obligations”, which was felt to be reasonable because, in theory, it spread out the credit risk of loans. Because of low interest rates at the time, these securities were popular among investors because of their comparatively higher return than that of more traditional securities, such as corporate bonds. (Crotty, 2008) As demand for MBS and CDO products increased, their prices increased as well, which made many of them over-valued even without taking into account the risk of default of the homeowner/borrowers on which the whole system was based. The model also further reduced the incentives for lenders to monitor the credit risk of their borrowers, since the risk could simply be passed along the financial food chain. (Roubini, 2008) In hindsight, the problem should have been obvious. Without assurance that the homeowners could repay their loans, i.e. were sound credit risks, the entire system would collapse as soon as defaults and foreclosures began to occur. Any derivative based on a defaulted loan instantly became worthless, and banks, lending companies, and other investors who had large portfolios of these discovered that their own wealth had suddenly disappeared. Because of poor regulations and guidelines on capital reserves, much of the capital that banks and financial institutions could use to back the issuing of credit for businesses disappeared as well, leading to a tightening of credit. This led to a business slowdown, increases in unemployment, and further reductions in consumers’ incomes; lower incomes meant more defaults, and so on, and the crisis became a self-feeding cycle. (Roubini, 2008; ThinkReliability, 2009) It became a global crisis because of the close interconnected nature of the financial world; MBS and CDO derivatives were traded around the globe, so when the housing bubble burst in the US, investors everywhere were affected. Shortcomings in Financial Regulations that Contributed to the Crisis The biggest, or at least most immediate, flaw in the financial regulations that contributed to the global financial crisis seems to be the removal of the restrictions under the Glass-Steagal Act that prevented banks from using deposits to “finance speculative market activity,” (Crotty, 2008: 5) in other words, allowing them to create and trade in MBS and CDO derivatives. Part of the reason financial regulators might have been inclined to ease these controls was the experience in the US of the savings-and-loan crisis of the mid-1980s. Capital ratio requirements based on risk and limits on overall risk for individual institutions had not prevented that crisis, because the issue of risk concentration was not really addressed; some banks that failed in New England, for example, were under the limits for overall risk exposures, but had most of their risks concentrated in one part of their portfolios, specifically real estate. Thus the impacts of shocks in the real estate market were magnified. (Vittas, 1992) So it seems the problem was perceived not as an issue of adequate capitalization or risk level, but in restrictions on diversifying the risk, spreading it out so that external economic problems in one area would not have as great an impact overall. Allowing banks to participate in the financial markets would theoretically be a way to spread credit risks, and the creation of derivatives was a natural development of a means to access the market, and finance more lending through the sale of previous loans. Long before the crisis, some analysts had already recognised a flaw in the Basel Accord’s capitalization requirements that would lead to excessive risk-taking. Under Basel, banks are required to maintain capital at specific percentages of broad risk categories; for mortgage loans and loans to anyone other than governments or banks in OECD countries, the percentages are 50% and 100%, respectively. The first problem is there is no differentiation of risk within the broad categories; a loan to an established, creditworthy business with a high credit rating counts for as much as a loan to a risky start-up business. (Oatley, 2000) High-risk loans have higher returns, and so lenders are encouraged to take more risks. The second problem is that the lack of restrictions on derivatives coupled with the lack of specificity in the risk categories allows banks to securitize and bundle assets that fall into lower risk categories, thus reducing capital requirements and making more capital available for lending. (Oatley, 2000: 38) Beyond all that, the biggest flaw seems to be that once a number of loans are bundled into an MBS or CDO and become a tradable asset, the reality that they represent a certain amount of risk is overlooked. Taken to a ridiculous extreme, that means that banks could – and apparently did – use someone else’s risks maintain part of their capital requirements to cover their own risks. “Spreading out the risk” turned out not to be a safety measure, but only a means of spreading destruction. Changes Needed in Financial Regulation US President Obama has made a number of proposals that, if adopted, would help to prevent some of the conditions that led to the global financial crisis, such as limiting the size of banks, banning them from participating in proprietary and private equity trading, and prohibiting them from dealing in hedge funds. (Anderson, 2010) These measures would greatly reduce, if not entirely eliminate, the market for MBS and CDO derivatives, and remove the toxic threat those represent. Limiting the size of banks, although the details are not explained, conceivably would help to protect countries’ financial systems in case of a bank failure, because a ‘bail-out’ would not be needed, or would at least be smaller. These proposals, however, do not address the fundamental issues of adequate capitalization and better assessment of credit risks. While the eight percent capitalization requirement of the Basel Accord might actually represent an adequate level, the assets that can be included should be restricted to ones that are sounder, and the securitization of assets must be limited. In addition, Basel’s risk-weighting categories must be expanded to more accurately reflect credit risks, and possibly should require weighting of over 100% for the riskiest loans. The difficulty in implementing these changes, of course, is in the delicate balance between allowing the financial market the freedom it needs to continue to support economic growth and regulating it enough to prevent widespread disaster. In addition, any international framework must be flexible enough to allow countries to adjust their own regulatory frameworks, because the pace of innovation in the banking and financial industry quickly renders old regulations obsolete. (Oatley, 2000) Perhaps the simplest changes that can be made, and the ones that most closely address the root causes of the crisis, are in the consumer credit assessments in individual countries. After all, if banks can be required to maintain a certain level of capitalization against credit risks, it may not be unreasonable to expect the same of consumers. Basic rules governing income requirements, down payments, and interest rates might be in order. That is something which would certainly ignite a firestorm of protest among banks and lenders who would perceive it as micro-managing their lending business, but on the other hand, everyone everywhere has been feeling the effects of their inability or unwillingness to apply sound judgment on their own, and it is something the world can ill-afford to allow to happen again. Conclusion The global financial crisis began with the rapid decline in home prices in the US as a result of over-supply, which led to an increase in loan defaults, and the loss of value on the enormous number of derivative securities into which those loans had been packaged as investment products. Clearly, better assessment and management of credit risk, stronger regulations regarding capitalization of financial institutions, and limits on the creation of derivatives would have greatly reduced the impact of the crisis. Nevertheless, those shortcomings in financial regulation and management were not the root cause of the global financial crisis. If the housing market in the US had not expanded so rapidly, there would have been no over-supply, and ultimately, no crisis. How and why that boom occurred, and what could be done to prevent it from happening again, is still a bit of a mystery and deserves further study. References Anderson, Richard. (2010) “Obama’s banking proposals: the impact on Europe”. BBC News [Internet], 22 January 2010. Available from: . Crotty, James. (2008) “Structural Causes of the Global Financial Crisis: A Critical Assessment of the ‘New Financial Architecture’”. Political Economy Research Institute Working Paper Series Number 180. University of Massachusetts – Amherst, September 2008. Oatley, Thomas P. (2000) “The Dilemmas of International Financial Regulation”. Regulation, 23(4): 36-39. [Internet] The Cato Institute, Winter 2000. Available from: . Roubini, Nouriel. (2008) “Ten Fundamental Issues in Reforming Financial Regulation and Supervision in a World of Financial Innovation and Globalization”. RGE Monitor [Internet], 31 March 2008. Available from: . ThinkReliability. (2009) “2008-2009 Financial Mess – Cause Map™”. [Chart] Available from: . Vittas, Dmitri. (1992) “Policy Issues in Financial Regulation”. Country Economics Department Policy Research Working Paper WPS910. The World Bank, May 1992. 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