Reasons for the recent global financial crisis - Essay Example

? Reasons for the recent global financial crisis Introduction The cause of the recent financial crisis and economic recessions has been attributed to various factors in the economy (Freedman 2010). The initial trigger of the financial crisis has been traced to the toxic mortgage backed assets whose decline in value and uncertain duration led to massive losses in the U.S economy. Fannie Mae and Freddie Mac were both taken over by the US government. Lehman Brothers was declared bankrupt since it could not increase its capitalization (Joseph 8). Merrill Lynch was bought by the Bank of America while American International Group (AIG) was rescued by the Federal government through an $ 85 billion capital bailout. Washington Mutual which is currently the largest bank failure was purchased by J P Morgan Chase. The crisis can be traced to the failure of the real estate market due to subprime lending which saw the commercial and residential housing prices increase for a decade from 1990 (Freedman 2010). The Asian financial crisis of 1997-1998 saw the economies in Asia generate huge current account surpluses which were invested offshore in economies like US and UK in order to keep the nominal exchange rates low. The US stock prices went high due to the influx of capital. The high growth in economic demands and especially in China saw commodity prices such as minerals, oil and food soar up from late 2004 to late 2007. Explanations for the financial crisis There are numerous explanations and arguments which have been proposed as the causes of the 2008-2009 financial crisis and the recessions. The entire explanations combine together to give an overview of the severity of the crisis. The bursting of the housing bubble resulted to decline in housing prices where consumers were forced to cut down spending. Another shock was the sharp rise in equity risk premium which led to rise in cost of capital further declining the rate of private investments in the world economy (Freedman 2010). Failures of real estate values and subprime lending It has been proposed that the immediate trigger and cause of the crisis was the bursting of the housing bubble which had initially had picked in 2007 particularly in countries like US and UK. The burst of the housing bubble led to massive loan defaults which led to the decline in the values of the mortgage backed securities (Freedman 2010). The subprime mortgages were risky since their true values were hidden in the house price appreciation which allowed mortgage refinancing. The real estate bubble was occasioned partly by easy credit in the economy which was facilitated by expansionary monetary policy of the Federal Reserve where the Fed funds rate was cut from 6.5% in 2000 to 1% percent in 2003 (Freedman 2010). Innovations in the financial system resulted to collateralized debt obligations and other derivatives which fueled the housing bubble. Losses of US subprime mortgages were estimated at $ 250 billion dollars in 2007 while the decline in the stock market capitalization was $ 26,400 billion dollars from the period July 2007 to November 2008. Weak banking regulations and poor risk assessment methods forced coupled with the government regulations which blended the operations of mortgage providers and investment banks saw many risky and unqualified customers access the housing mortgages (Freedman 2010). According to the Securities Industry and Financial Markets Association, the aggregate collateralized debt obligations issuance expanded from USD $ 150 billion in 2004 to US $ 500 billion in 2006 before increasing further to US $ 2 trillion by the end of the year 2007. The value of the Mortgage backed assets held in banks’ books, insurance companies and other major financial institutions explains how the burst of the housing bubble led to massive losses to holders of the mortgage backed securities. However, subprime mortgages had higher interest rates after the initial offer and only 43 percent of the adjustable rate mortgages were subprime (Longstaff 29). Bad quantitative risk models in banks (Basel 2) Many economists have blamed the Basel 2 framework for the bank capitalization inadequacy. The framework provides for the banking rules and regulations which are issued by the Basel Committee on Baking supervision. The primary objective of the framework is to capital utilization in the bank is risk sensitive and to identify and separate the credit risk from the operational risk. The implementation of the regulations which should have come to effect in 2004 was delayed by four US Federal banking agencies which are the Federal Deposit Insurance Corporation, Office of Thrift Supervision, Office of Comptroller of Currency and the Board of Governors of the Federal Reserve System (Freedman 2010). Rating agencies failures Credit rating agencies have been cited as principal contributors to the credit crunch and financial crisis. The rating agencies are expected to accurately identify the riskiness of the financial securities and institutions and report transparently their findings to the stakeholders in the financial system. The AAA tranches of the mortgage backed assets and collateralized debt obligations exhibited a high rate of default most of the times that was expected since their trading prices were below their face values (Freedman 2010). Rating agencies such as Standard & Poors, Fitch and Moody’s used the quantitative statistical models which are based on Monte Carlo simulation to predict the probability of default and the risks that were inherent in the derivative instruments (Freedman 2010). The models were incorrect since the calculations were based on the default probabilities from the data collected in the period 1990-2000 when mortgage default probabilities and rates were low due to escalating housing prices. The models could not predict the housing bubble burst since the mortgage backed securities and financial institutions were rated highly. Financial innovations and new financial derivatives presented challenges to the rating agencies since no historical return and default data was available which could be used in the risk assessments. Some rating agencies deliberately inflated their ratings in order to maximize their consulting fees because financial institutions were contracting the highest rating agencies (Joseph 8). Underestimation of aggregate risks Financial innovations created the illusion that default risks held by the lenders, banks and other financial institutions could be diversified. The perception ignored the strong inter-dependencies in the financial system that was created by the financial innovations. Globalization of the financial system and international banking interdependencies led to capital flight for safety when the mortgage backed securities started declining in values. The banks scaled down the inter-bank lending due to fear of counterparty defaults. Financial institutions tightened their lending practices by implementing stringent borrowing procedures which ultimately dried up credit availability in the economies (Casu 2011). Mark-to-market accounting The Financial Accounting Standards Board (FASB) requires all financial institutions to report their current or fair market values of the securities they hold in the books accounts. Critics of this accounting requirement argue that banks are forced to recognize prices based on such prices that prevail in distressed markets since the prices are believed to be below the long term fundamentals values of the security (Freedman 2010). These losses that are recognized by the banks will undermine the market confidence and exaggerate the banking problems. Generally, market uncertainty will increase if the investors perceive published the financial statements to be unreliable (Walter 15). Shadow banking system Most of the risky and worst performing mortgages were financed by the shadow banking system. High competition in the economy from the shadow banking system pressurized the traditional mortgage lenders to lower their lending rates which increased the mortgage accessibility. The shadow banking system was not subject to stringent regulatory control hence the entities created maturity mismatch since they borrowed short term in the liquid markets and financed long term investments in the illiquid markets. The shadow banking system increased the leverage level since risky financial activities which were initially conducted by regulated banks that had deposit insurance and safety net through regulation migrated to the shadow banking service providers. In early 2007, variable rate demand notes, tender option notes, commercial paper conduits, and structured investment vehicles had a combined asset base of almost $ 2.2 trillion (Nouriel 9). Assets financed through triparty repos jumped overnight to $ 2.5 trillion while those in hedge funds were close to $ 1.8 trillion. In overall, the five largest investment banks had a balance sheet of $ 4 trillion against $ 6 trillion for the five largest commercial banks. Private bonds in the economy in the commercial mortgage backed securities segment and collateralized debt obligations stood at $ 2 trillion in 2006 but declined to less than $ 150 billion in 2009 where most of the issuances were backed by Federal Reserve TALF program. The SEC had relaxed the net capital rule of 2004 hence investment banks attained high leverage ratios since even the Consolidated Supervised Entities Program which was applicable to the largest investment banks was voluntary (Walter 15). Off-balance sheet financing Beginning early 1990s, the banking regulators encouraged the off-balance sheet finance as a means of managing banking risks. Most of the banks established off-balance sheet entities including structured investment vehicles that could engage in speculative investments (Heffernan 2005). Credit default swaps and over-the counter derivatives Credit default instruments that were developed initially as a risk management tool increased the risk exposure to the market participants. The use of the credit default swaps shifted from risk management to speculation (Jongho 708). The credit default swaps were unregulated hence the market participants had little information on the inherent risks. Defaults in Bear Stearns triggered uncertainty in the market where other counterparties in the derivative markets were forced to default due to declining prices of the securities (Heffernan 2005). (Source, Freedman 2010). Fraudulent lending, bad corporate governance, predatory lending and lack of transparency in mortgage finance More than half of the mortgages purchased by Citi Bank were not written according to the policies. Countrywide Financial advertised for low interest home loans but included detailed contract terms where consumers would repay the mortgages using adjustable rates. This led to negative amortization whereby the interest paid would be greater then interest paid. Once the housing prices declined, homeowners in the adjustable rate mortgages could not afford the monthly payments hence faced foreclosures on their homes (Walter 15). Many participants in the mortgage industry contributed to the issue of bad mortgages since they felt not accountable for their actions (Moshirian 508). Many contractual agreements had no recourse against the securities issuer hence the non-bank mortgage lenders collapsed since they were forced to take back the defaulting loans. Moral hazard problem Government occasioned subprime lending to help the low income households led to a moral hazard in the mortgage lending. Fannie Mae and Freddie Mac’s affordable housing projects led to many banks to issue imprudent mortgages since they were guaranteed of government assistance in case of default (Niinimaki 2009). According to the banking theory, availability of collateral reduces the bank risk even when the borrowers have insufficient means to refinance the loans (Casu 2011). The fluctuation in value of the collateral generates a moral hazard between the banking regulators and the banks. The banks gamble with the collateral and refrains from the costly customer evaluation to focus lending decisions on the availability of collateral (Freedman 2010). Conclusion Various causes have been attributed to the recent financial crisis. The subprime lending and burst of the housing bubble that saw decline in the mortgage backed assets was the primary trigger of the crisis. Low risk assessment methods, rating agencies failures and unregulated financial system contributed to the crisis. Imprudent accounting practices and complexity of the financial instruments contributed to the crisis. Shadow banking system which was deregulated and the government assistance programs together with securitization created a moral hazard problem. Bibliography Casu, B. 2011. Introduction to Banking. London. Prentice Hall. Heffernan, S. 2005. Modern Banking. New York. John Wiley & Sons. Freedman, J. 2010. The U.S Economic crisis. New York. Rosen Publishing. Jongho, K. “From Vanilla Swaps to Exotic Credit Derivatives,” Fordham Journal of Corporate & Financial Law, Vol. 13, No. 5 (2008), p. 705. Joseph R. “The Summer of‘07 and the Shortcomings of Financial Innovation,” Journal of Applied Finance, vol. 18, spring 2008, p. 8. Longstaff, F. A. 2010. “The subprime credit crisis and contagion in financial markets”. Journal of Financial Economics, In Press, Accepted Manuscript, Available online 3rd March 2010. Moshirian, F. 2011 “The global financial crisis and the evolution of markets, institutions and regulation”. Journal of Banking & Finance, Volume 35, Issue 3, Pages 502-511. Niinimaki, J. 2009. “Does collateral fuel moral hazard in banking?” Journal of Banking & Finance, Volume 33, Issue 3, March 2009, Pages 514-521. Nouriel, R. “The Shadow Banking System is Unraveling,” Financial Times, Sep. 22, 2008, p. 9. Walter, L, “How to Solve the Derivatives Problem,” Wall Street Journal, Oct. 10, 2008, p. 15. Read More