Reasons for Financial Crisis - Essay Example

Running Header: Financial Crisis Student’s Name Instructor’s Name: Course Code: Date of Submission: Reasons for Financial Crisis Financial crisis is a situation when demand of money rises quickly relative to its supply. The financial crisis of 2007 to present is a financial crisis that was triggered by a liquidity shortfall in the banking system of United States. This led to collapse of major institutions, stock markets downturns and the ‘bail out’ of banks by the state governments around the globe. Because of financial crisis, many areas like housing finance suffered greatly leading to several evictions and foreclosures. Key businesses in the world failed with consumer wealth declining. There was also a decline in economic activities throughout the globe. It worsened stock markets throughout the world and made it become highly volatile. Consumer confidence decreased significantly as financial fear spread throughout. There has been arising reasons and issues on the reasons for the rise of financial crises. The sub-prime crisis and housing bubble were the main reason behind the financial crisis as argued by Longstaff (2010). Financial sectors deterioration in Europe and US affected national sectors of finance in many parts of the world leading to global financial crises. As a way of containing the crisis, some governments offered blanket guarantees to their creditors and depositors. Other governments became full owners of their banks introducing regulation for their financial systems. Financial crisis was caused by many factors directly or indirectly although the main trigger was US subprime mortgage crisis. The interdependence and complexity of various causes including competing, organizational, economic, and political interests have been the reasons behind the crisis. Some of the results were a fragile financial system such as dependence on short term funding markets, complex financial securities, and imbalances in international trade as argued by Moshirian (2011). Other effects were increased stress on high corporate and consumer debt levels. Some regulatory and market based controls did not guard the financial system or measure effectively the buildup of the risk. According to Niinimaki (2009), the immediate cause of financial crisis was the bursting of the US housing bubble. Financial crisis started directly with the real market. This was in 2007 where it started with credit crunch. This is when US investors lost confidence in the value of sub-prime mortgages leading to liquidity crisis. This is actually where the crisis started with focus being on the subprime mortgages and unscrupulous lenders, with blame on unsustainable real estate that began collapsing in 2006. The excess capital required for the real estate pushed a large amount of money into the US mortgage market. This was mainly due to securitization, and 80 percent of US mortgage is securitized. Afterwards, the idea of higher returns aroused. Mortgages were offered to high-risk borrowers at a higher cost of mortgage rates. The subprime mortgages were put in large asset pools where the Mortgage Backed Securities were made. The mortgage were broken into pieces and grouped then packaged with other similar mortgage pieces. Financial instruments and vehicles including SIV, CMO, CDO, and MBS among others looked like great solution to assets great demand and that results of such securitized subprime mortgages would be greater. Nevertheless, securitization arises from the fact that it does not give protection against systematic risk. Unfortunately, the systematic risks were not prices into the pools of subprime mortgage. The credit rating agencies failed to take into account possible systematic risk. They praised the low risk securities with AAA rating. This led to mutual funds, banks, pension funds, some market funds, and other investors in the world purchase those securities thinking that they were safe, Riskier securities also had their clientele. This made the market attract large amounts of these securities. The homeownership rate increased due to subprime lending in US with approximately 5million people owning homes. There was a belief that house prices would continue to appreciate. This encouraged many subprime borrowers get more adjustable-rate mortgages. This resulted to rates going down with prices of the houses moving up to unsustainable levels relative to rents. Asset prices in the real estate market unlike stock market rose with creation of more assets through construction. The construction of new housing units between 2001 and 2007 surpassed the formation of new households in 2006, the rise in housing prices ceased. This made many subprime borrowers unable to pay their mortgages. The housing bubble and in particular the excesses of the market in subprime mortgage arose. The subprime mortgage lender were begun to be declared bankruptcy by March 2007. The financial authorities and Federal Reserve said that it was an isolated phenomenon yet it has gained some crisis proportions according to Robert, (2010). The failure by the homeowners in United States who had taken sub-prime loans to repay back led to failure of the housing market. With plummeting of home values, borrowers found themselves having negative equity. This led to banks repossessing houses and lands that were already worthless compared to how the banks had loaned out initially. This made banks to have liquidity crisis making giving and obtaining loans become difficult. Subprime mortgage losses triggered a major turmoil in mid 2007 in the international financial system. However, the small size of US subprime market did not deter the spread of this effect to the global financial markets and institutions even to those that did not have direct exposure to the subprime mortgage market. Financial institutions were shaken with systematic weakness in financial sectors with share prices of large, small, and investment banks dropping significantly between July 2007 and March 2008 as illustrated by Markus, (2008). Banks ceased to trust other banks resulting to a disruption of interbank lending. This spread beyond financial markets to affect every aspect of economy. Governments throughout the world struggled to rescue their financial institutions that continued to worsen leading to more crises through the world economies as their financial institutions faced serious liquidity issues. The global financial crisis entered another phase when Lehman Brothers collapsed in September 2008. The dramatic change in the ability of creating new credit lines dried up money flow and eventually slowed economic growth including buying and selling of assets. In addition to easy conditions of credit, pressures from both competition and government have been greatly associated with increase in subprime lending years before crisis. Other organizations that played a key role in the expansion of higher-risk-lending included U.S. investment banks as well as government sponsored enterprises such as Fannie Mae. Some other structural factors or reasons that led to current economic crisis included the domineering model of the 30 years. This is confusion between deregulation of markets and free markets through over-reliance on equilibrating/self-regulatory virtues of the market. Another cause of the financial crisis was due to dramatic increase in the capital market roles in the process of financial intermediation. This increase in the roles of the capital markets had a great effect on increasing the risk of financial failures. Although use of new global financial instruments spreads out the risk, it increased the risk while reducing transparency. Lack of transparency made it difficult for the financial analyst to determine the effects of high mortgage borrowing would have on the economy. There were also unconcealed conflicts of interests among those who were involved in the market according to Markus, (2008). Increasing inadequacy of structures of incentive within the financial industry with high levels of risk taking was another reason behind financial crisis. A culture of irresponsibility was another reason behind the rise of economic crisis. The executive compensation with recklessness reward other than responsibility has been the major issues towards failure of economic institutions. Americans bought homes with taking and accepting responsibilities due to too high lending leaving less capital in the economic system. Another reason behind the global financial crises was increased debt burden also referred to as over-leveraging. There was an increased in debt or over leverage of U.S. households and other institutes of finance years preceding the financial crisis. This heightened their susceptibility to the housing bubble collapse worsening the consequent economic downturn. US debt of household as a percentage of annual disposable personal income was 77percent in 1990 compared to 127percent at the end of 2007. There was an increase of US home mortgage relative to GDP to 73percent in 2008 from 46percent in 1990s. US private debt was 290percent of GDP compared to 123percent of GDP in 1981 as illustrated by Robert (2010). Ignorance of economic regulators in US also contributed greatly to the economic crisis. They failed to identify and even rectify the loopholes in the existing rules. Economic regulators and economy analyst failed to identify earlier the effects and implications of the rising US consumer spending especially on housing mortgage. At some instances, US Federal Reserve kept the interest rates at extremely low levels for a long period so as to evade an economic downturn. This created abundant liquidity in the system promoting an extravagance culture while beyond means. US spent more than it could finance hence leading to debts with savings decreasing significantly (Robert 2010). Assumptions that financial markets participants would be able to know the regulation of the financial market or system also contributed to the crisis. This is because if more professionals had participated in the analysis, the effects would not have been that adverse. According to IMF, failure of macroeconomic policy was one of the causes of the recent financial crisis. Macroeconomic failed to take into account the systematic risks build up in the financial system as well as in the housing markets. The other contributor of financial crises is mismatch in assets and liability. This mostly occurs in banks where they fail to have an effective link between the short-term liabilities that include individual deposits and the long-term liabilities such as giving loans. Smith (2007) shows that this mismatch is likely to lead to bank run thus resulting to bankruptcy for example Bear Steans Company collapsed in 2008 since it failed to finance its long-term investments. In attempt to mitigate financial crises, various governments have introduced regulatory policies. The main goal for this is to enhance transparency and accountability. These governments have introduced systems that show regular reporting of the accounting processes and ensuring that the financial institutions have sufficient assets needed to meet their goals as illustrated by James (2009). In conclusion, the major reason that can be associated with the financial crisis is US subprime mortgage crisis. This led to failure of other institutions including banks and other lenders due to high differences between the lending and borrowing. However, lack of clear monitoring of price changes and assumptions that significant changes would have an effect on the economy was another aspect that can be greatly attributed to the financial crisis. In the near future, it seems that financial crisis may be reduced since globalisation is increasing. To mitigate the crises, governments should introduce effective fiscal policies which ensure that financial institutions have enough reserves to control borrowing. The IMF should also initiate other methods of stabilizing international currencies in order to reduce loss of value against the US dollar. This will reduce inflation and therefore mitigate the spread of financial crisis. References James, C 2009, ‘Structural causes of the global financial crisis: a critical assessment of the ‘new financial architecture’’, Cambridge Journal of Economics, vol. 33, no. 4, pp. 563-580. Longstaff, F. A. (2010), ‘The subprime credit crisis and contagion in financial markets, Journal of Financial Economics, vol. 97, no. 3, pp. 436-450. Markus, K 2008, ‘Deciphering the Liquidity and Credit Crunch 2007-2008, Journal of Economic Perspective’, American Economic Association, vol. 23, no. 1, pp.77-100. Moshirian, F 2011, ‘The global financial crisis and the evolution of markets, institutions and regulation’, Journal of Banking & Finance, vol. 35, no. 3, pp. 502-511. Niinimaki, J 2009, ‘Does collateral fuel moral hazard in banking?’ Journal of Banking & Finance, Vol. 33, no. 3, pp. 514-521. Robert, W 2010, Lessons from the financial crisis: Causes, Consequences, and Our Economic Future, John Wiley & Sons, Inc., New Jersey. Read More