The US financial crisis of 2008 - Essay Example

The US financial crisis of 2008 The US financial crisis was a process and not an event. Signs of fragility in the financial sector were present from 2007. This continued and a tipping point reached in September 2008, when a number of large financial institutions based in the US collapsed. The most notable examples were the Lehman brothers and AIG (Marshall 1). As from 2007, maintaining financial stability, rather than taming inflation was the Federal Reserve's main goal (Jickling 1). Although the Federal Reserve tried to manage the emerging crisis, the issues present were so complex, such that they defied conventional solutions. It is not easy to identify the precise cause of the crisis. There were a number of factors that contributed to the crisis. The combination of the diverse factors led to a toxic potent mix that eventually reached a tipping point in September 2008, heralding the beginning of the full-blown financial crisis. The causes of the crisis can be divided into two. In the first group, there are long term structural problems within the US economy. These were deeper latent issues that existed for some time with seemingly no ill effects to the economy. The first was too much debt. From 1980 to 2007, the total debt per person in the country rose from just below US $ 4 000 to around US $ 30 000 (Federal debt per person US 1). The perception that the housing market had perfect price inelasticity fuelled the debt accumulation. Americans using the value of their homes for refinancing believed the value of their homes will continue rising without affecting the demand for housing. This debt levels were too high for a healthy economy. The looming structural deficits also played a role. Medicare and Social Security off-balance sheet debt was likely to increase the US insolvency, reducing investor confidence on the country. The US has had trade deficits consistently for some time. The deficits are mostly because of the dollar having a reserve currency status and undervaluing of the Chinese Yuan. This led to the decline of the US export industry, and the dependent manufacturing base. Internal deficits mirror the external trade deficit. The government cannot borrow indefinitely, and the large internal deficits contributed to the crisis (Jickling 2). The rating agencies had a hand in the crisis. The market relies excessively on the ratings given by the rating agencies. Laws and regulations that allow the use of ratings as a basis for permissible investments buttress this dependence. However, the rating agencies have a poor regulatory framework. The rating agencies are an oligopoly and, did not provide accurate rating assessments. Some of the AAA ratings given to the subprime mortgage-backed securities were later downgraded to junk status. Rating agencies' failure was due to use of poor economic models, conflicts of interest and poor oversight. The US tax code was also a contributory factor. The tax code is inefficient and has complex rules. It also has tax expenditure subsidies exploited by the suave Wall Street operators. Another factor leading to the outbreak of the financial crisis is deregulation of the financial sector and the markets. The SEC in 2004 liberalized the net capital rule. Consequently, investment bank holding companies were free to run extremely high leverage ratios (Jickling 3). The SEC's Consolidated Supervised Entities meant to police the largest investment banks was an ineffective voluntary program. Other laws, for example, the Commodity Futures Modernization Act (CFMA) and the Gramm-Leach-Bliley Act (GLBA) give financial institutions carte blanch to undertake risky transactions that were unregulated in a vast scale. The laws placed too much faith in self-regulation and robustness of the market. By 2007, most financial institutions had accumulated large debts with dubious credit worthiness. The deregulation led to the invention of spurious financial instruments that enriched the financial sector at the expense of everybody else. In this category, the most important was the very low interest rates and a weak mortgage regulatory framework. The low interest rates flooded the market with cheap money. The marginal productivity from investing in government bonds fell, as interest rates remained low. To obtain a higher return on investments, traders began betting on the mortgage market that gave relatively high return. This speculation led to a boom in the mortgage market and a real estate bubble formed. Traders, using complex financial instruments were able to dress sub-prime mortgages as safe, stable high return investments. These instruments were then sold to unsuspecting investors. The period leading to the tipping point in 2008 witnessed the development of black box derivatives (Jickling 3). The aim of the derivatives was to minimize risk. Critics feel that those developing the instruments were not minimizing risk. They had lost track of it. The trader mentality in Wall Street contributed to the financial crisis. In 2007, the average amount of time of holding stocks was about six months. Traders are always hunting for the deal that gives the maximum return in the shortest time for their investment. This led to the aggressive buying and dumping of shares in the bourse. These activities destabilized an already fragile market. In 2007, there were signs of financial fragility. The cheap and easy credit dried up, and companies began to feel the squeeze. The event most credited with triggering the chain reaction that eventually caused the financial crisis and economic recession is the burst in the housing bubble. The market experienced unprecedented growth and appreciation in value from the 90s to the noughties (Marshall 10). Mortgage lenders decided to reduce the marginal cost of doing business by increasing and diversifying their lending portfolio in the housing market. The growth was due to the seemingly inexhaustible supply of cheap money and speculation. Although it is in 2008 that the collapse of large financial organizations signaled the beginning of the financial crisis, the events in 2008 were a culmination of a credit crunch that began in 2006. The bursting of the housing bubble led to the bursting of other asset bubbles and triggered the credit crisis. The housing bubble burst when borrowers in the sub-prime mortgages were unable to honor their financial obligations. This caused an increase in foreclosures. Consequently, credit rating agencies downgraded their ratings of asset-backed financial instruments. The increased risk hampered the ability of the owners of the financial instruments to pay interest. For example, S&P reduced its ratings on two asset-backed bonds from triple A to triple C within one day in August 2008 (Marshall 7). In essence, this turned top quality bonds into junk. This created the credit crisis and institutions as well as individuals found it extremely hard to access cash. This exacerbated an already volatile crisis and the default rates in the sub-prime mortgage market increased rendering many mortgage-backed financial instruments worthless. The beginning of 2008 saw the purchase of Countrywide Financial, a mortgage lender, by Bank of America after it ran into financial difficulties. Bear Sterns an investment bank with a large portfolio of mortgage-backed securities was unable to recapitalize, and Morgan Chase acquired it in a government-backed takeover in March 2008. With mortgage defaults increasing, more mortgage lenders got into trouble. The largest mortgage lender in the US, Indy Mac collapsed in July 2008 while the government took over Fannie and Freddie Mac September 2008. Towards the end of 2008, the mortgage industry had collapsed (Marshall 8). The woes afflicting the mortgage market soon spread to the financial sector. In September 2008, the Lehman Brothers failed to get the capital to underwrite its downgraded mortgage-backed financial instruments and filed for bankruptcy (Beckman 1). The collapse of the housing market caused a ripple effect on the financial system due to the complex web of financial instruments used to underwrite them. This was done through the securitization process. Households bought mortgages from mortgage lenders who then sold them to mortgage bankers. The mortgage banker then sold the mortgage to investment bankers who bought many mortgages and then turned them into mortgage-backed securities. They then sold them to investors (Marshall 16). The investment bankers called the bundled mortgages mortgage backed securities (MBS) or collateralized debt obligations (CBO). To manage the risk associated with the MBS and CBOs, banks created a financial derivative - credit default swap (CDS). The CDS insured a holder of the MBS or CBO against the risk of default in return for a fraction of the expected high return from the investment. The insurer, AIG, which had a monopoly in the CDS market, was overwhelmed with claims once the MBS and CBOs became worthless due to the high default rates. It was unable to underwrite the claims and went under. All of these financial instruments created a web that ensnared ordinary investors. The whole layered system relied on the mortgage buyer being able to honor his or her monthly payments. A default by the buyer made all of the financial instruments potentially worthless. When the defaults happened, they wiped off the value of the instruments making many investors lose their investments. This caused the recession. Works Cited "Federal debt per person US" Data 360. n.d Web 9 December 2013 Beckman, K. "What Caused the Financial Crisis and Recession?" The Conference Board of Canada. 16 February 2010 Web 9 December 2013 Jickling, M. "Causes of the Financial Crisis Congressional Research Service." April 2010. Web 9 December 2013 Read More