The Current U.S. Economic Crisis and Potential Fixes - Essay Example

TABLE OF CONTENTS 0Introduction 1How Did the Current Financial Crisis Developed 2 Why did the Current Financial Crisis Developed 2.0 Current Solutions to fix the Current Financial Crisis 3.0 Conclusion Recommendation and the Way Forward 1.0Introduction Major Banks in the United States and Europe have recently suffered significant losses as a result of the recent credit crisis. This calls into question the adequacy of baking regulation both at the national and international scene1. For example, Northern Rock, a medium-sized Mortgage provider in the United Kingdom UK almost collapsed as a result of the credit crunch. In like manner, Bear Stearns an upper tier US investment bank was only rescued from the crises by the Federal Reserve Bank2. In addition other major investment banks such as Merrill Lynch, Citigroup, UBS, and JPMorgan have all announced negative earnings in their last financial reports as well as plans to lay off a significant number of workers. This paper carries out an analysis of how and why the crisis occurs and it evaluates the effectiveness of current measures used by the government to solve this crisis. The rest of the paper is organized as follows: Section 2 looks at how the crisis occurred, section three looks at the causes of the crisis that is why the crisis occurred; Section 3 looks at the regulatory environment and current solutions; and the last section provides some conclusions and recommendations. 1.1How the Current Financial Crisis Occurred Sub-prime loans are loans offered to borrowers with no prior track record of good credit history3. Due to the risk inherent in the loans, they are often issued at very high interest rates so as to compensate for the extra risk that they carry4. A sub-prime crises or credit crunch is said to exist when a significant number of sub-prime loans have been issued to unscrupulous borrowers5. These crises pose difficulties to both financial institutions and the borrowers. The outbreak of the recent sub-prime crises came after warning signals of write-downs in the value of mortgages late last year6. House prices in the U.S witnessed an unusual growth between 1997 and 2005. For example, prices increased by approximately 85% during this period. The period 2001 and 2005 witnessed the highest rates of appreciation7. Sub-prime delinquencies and foreclosures were therefore mitigated by house price appreciations during these years. This is so because borrowers facing difficulties to make regular mortgage payments could depend on the appreciation of the value of their property to solve their financial problems by refinancing the mortgage and withdrawing cash from the increased equity in the house thereby sustaining the new mortgage for a while. Borrowers could repay the principal by selling off the property8. Appreciation in property prices therefore significantly improved the performance of sub-prime loans9. However, Ellis (2007) argues that house prices began to decline in 2006, and as at October 2007, prices were down by approximately 3.2% of their peak in the second quarter of 2006. Banks and financial institutions were expected to face an uphill earnings battle early this year. “…certainly, we will not be at the levels of profits we saw within the last 12 months”. This is a quote by Mark Batty, a financial services analyst at PNC wealth Management Philadelphia, which manages about $77billion of assets10. According Ellis (2007) investment banks and brokerages in the S&P 500 such as Goladman Sach a member of the Fortune 500 and Merrill Lynch a fortune 500 member as well were expecting to experience a 10% decrease in earnings growth in the fourth quarter of 2006. Diversified Financial firms like Citigroup another Fortune 500 company and JPMorgan a Fortune 500 company as well were not exempted; they were all expected to report a 1% decline in earnings growth11. In addition, banks are currently facing declining demand for mortgages and home equity loans as well as rising illiquidity and foreclosures among home owners. Bank of America recently announced its intention to get out of the wholesale mortgage market and it is planning to retrench 700 workers following a huge drop in earnings. The demand for asset-backed loans such as commercial paper has witnessed a drop. Financial services firms depended a lot on real estates as a means of backing their loans to debtors. Companies and financial institutions rely on these loans to raise short-term loans and a fall in demand implies that earnings to financial institutions will remain under pressure12. According to Ellis (2007) pure play investments banks like Goldman Sachs, which survived the crises are expected to witness an increase in earnings. Earnings estimates for these banks according to Wall Street are expected to rise. Goldman Sachs witnessed encouraging results because it nicely positioned itself during the sub-prime crises this summer of 200713. Banks However, Merrill Lynch witnessed a $3.4billion loss in mortgages14. Banks have so far written down more than $20billion in losses arising from the sub-prime crises or credit crunch. 1.2Why the current Financial Crisis Occurred Previous studies on financial crises and sub-prime crises in particular have focused on what causes the crises. For example Peak and Rosengren (2005) cited in Miyajima and Yafeh, 2007) argue that banks tend to “prop” virtually bankrupt companies for old loans (“ever-greening loans”). Accordingly, as the banks’ positions deteriorate, banks tend to shift more and more loans to their worst clients15. Banks therefore prevent foreclosures by artificially keeping alive poorly performing loans; in addition the banks tend to “gamble” expecting that the government will eventually bail them out by providing an injection16. For example, Peak and Rosengren (2005) cited in Miyajima and Yafeh (2007) “describe the misallocation of credit in Japan associated with perverse incentives faced by banks to provide additional credit to weakest firms in order to avoid the realization of losses on their balance sheets”, which in turn led to the Japanese Financial crises or credit crunch in the 1990s. In their study of the impact of the Japanese financial crises on non-financial firm17 however, find no evidence in support of alleged misallocation of loans to support drowning bank clients. Employing an event study to model how these crises affected the returns of these firms during the financial or banking crises they find that not all firms and industries were equally affected by the Japanese banking crises18. In particular, “small companies, high leveraged companies, low tech companies with poor credit ratings were most affected by the crises. Consequently, Miyajima and Yafeh (2007) conclude that this is consistent with “credit crunch” theories which state that companies with limited access to financial markets are sensitive to changes in bank lending. Burderkin (2007) investigated the causes of the Shangai credit crunch of 1934 by taking a closer look at silver flows, and deflation. The evidence suggests a significant relationship between “policy-induced” driving up of U.S silver and Chinese exchange rate appreciation and price deflation19. Burdekin (2007) also find that the reversal of the silver flow into Shangai led to a credit crunch in the city. Historical Influence According to Mauldin (2008) the United States has an idea of market fundamentalism, which has become a dominant ideology. This ideology holds that markets are self-correcting. A series of crisis including the international banking crisis of 1982, the bankruptcy of Continental Illinois; and the failure of Long-term Capital Management in 1988 have occurred during the 1980s in the US. These crises have all warranted the intervention of the government through the Federal Reserve late in the crisis. There is therefore a historical precedence in the recent subprime crisis that significantly affected Bear Stearns. Like previous crises the Federal Reserve had to intervene with more than $30billion to bail Bear Stearns out of the crisis. Mauldin (2008) suggests that regulators have precedents they should be aware of. In the case of Northern Rock, there appears to be no historical precedence. The last bank run in the UK was Overend Gurney in 1866. (Brown, 2008). Northern Rock therefore occurred only after 142 years later while the last crisis in the US were in 1988 for Long-Term Capital Management, that is 20 years ago. In addition, the US also suffered the worst accounting scandals in 2002 from the Enron Corporation. Systematic or Institutional Influence To a greater extent one can attribute the crisis to institutional influences. Most of the banks perpetuating the recent crisis had business models that enabled them to depend a lot on the wholesale market for their funding. Liquidity in the market suddenly dried up following the credit crisis. For example, Northern Rock could not secure funds from institutional investors when it was subsequently clear that the company may not be able to repay these loans given its huge outstanding mortgage loans. In like manner Bear Stearns was unable to get additional funding from the wholesale market. However, to a lesser extent, systematic influences too played their role in the crisis. These can be blamed in the area of regulation. Regulatory authorities seem not to have properly defined minimum risk compliance requirements for banks and thus these banks too on excessive risks which suddenly led to their present predicaments. In addition regulatory authorities failed to describe minimum risk compliance requirements for banks. In the US for example, banking regulation is done by a multiple number of regulators, which in turn may lead to confusion. 2.0Solutions Governments and central banks have been engaged in a number of measures to tackle the credit crunch. For example, Governments in Asia are in the process of turning state controlled pension and other investment funds in an effort to help stem falls in domestic equity markets20. Asian central banks announced earlier on December 13th 2007 that they would refrain from joining their North American and European Counterparts in taking emergency action to boost market liquidity21. According to Minder and Nakamoto (2007) booming Asian economies also reduced their need for corporations to tab debt markets. For example, it was estimated by Société Générale that Chinese companies now use retained earnings to finance 60% of their working capital requirements. The US government and the Federal Reserve have engaged in a series of measures to stem the crises. The Federal Reserve recently reduced interest rates by 0.75 percentage points. This move received both positive and negative reactions. Approximately 60% of delegates voted in favor of the move saying that central banks have lost both their focus and control with respect to their economic governance22. President George Bush on Friday January 18th 2008 announced a $150billion package to help stem the crises23. Following announcements by the Federal Reserve to eliminate the crises, stock markets in the US witnessed slight increases in value. On December 12 2007, the Dow Jones Index was up by 1.5%, The S&P 500 index also witnessed a 5% increase while the NASDAQ witnessed a 2% increase. A partnership was entered between the Federal Reserve and other central banks in Europe, Canada, Britain and Switzerland to create a credit facility that banks could exploit in order to provide loans to individuals and businesses24. 3.0 Conclusion and Recommendation This paper therefore recommend to banks such as Northern Rock and Bear Stearns to change their Business models. Regulatory authorities must also take measures to ensure that these crisis do not occur in future. Mayes (2000) drawing from examples on banking regulation in New Zealand suggests a number of policy measures that may be adopted by the UK Financial Services Authority (FSA). These include ensuring the quality of corporate governance of those financial institutions wishing to be registered as banks, with high accounting and independent auditing standards; public disclosure of substantial information about the risks individual banks face so that market disciplines can be applied – including extending Value at Risk measurement to the whole of the bank’s activities; placing the responsibility of the prudential operation of each bank on its directors and management, with penalties and financial liability for false statements; and avoiding putting taxpayer funds at risk, by making it clear that no bank is too big to fail and focusing the role of supervisors on ensuring that they have the power to step in and prevent adverse consequences to the system as a whole when a bank gets into difficulty25. In this direction, the moral hazard inherent in bank supervision and the costs of supervision could be significantly reduced. This paper recommends to other banks such as Citigroup, Merrill Lynch and UBS to emulate the example of Goldman Sachs by holding a diversified portfolio and devising appropriate hedging strategies to hedge against such risks in the future. in addition, appropriate forecasting techniques that can enable them forecast what may occur in a given market also need to be put in place so as to avoid taking the wrong positions in future. In addition, the board of directors of each financial institutions needs to monitor management more precisely to ensure that the decisions they are taking are in line with maximizing shareholder’s value, ensure that they do not take too much risk and that the risks that they take are within the confines of the risk limits of the company. Regulatory bodies such as the Federal Reserve Bank, the SEC, the Bank of England and the Financial Services Authority (FSA) also need to monitor investment banks more closely to ensure that they do not take too much risk and that they have appropriate risk management strategies in place. The Northern Rock episode for example has been blamed on failure on the part of the FSA and the Bank of England to carry out their duties as financial services regulator and lender of last resort respectively26. In like manner, the problems of Merrill Lynch, Citigroup and UBS may be attributed to failure on the part of the Federal Reserve and the SEC to play their roles as lender of last resort and securities regulator respectively.  References Avgouleas, Emilio’s, (2008) Financial Regulation, Behavioural Finance, and the Global Credit Crisis: In Search of a New Regulatory Model" . Available at SSRN: http://ssrn.com/abstract=1132665 Brown, Elizabeth F. (2008), "The Tyranny of the Multitude is a Multiplied Tyranny: Is the United States Financial Regulatory Structure Undermining U.S. Competitiveness?" U of St. Thomas Legal Studies Research Paper No. 08-03 Available at SSRN: http://ssrn.com/abstract=1008969 Burdekin R. C.K. (2007). US pressure on China: Silver flows, deflation, and the 1934 Shanghai credit crunch China Economic Review. Chambers A. (2008). The Board’s Black hole – filling their assurance vacuum: can internal audit rise to the challenge? Measuring Business Excellence, vol. 12, No. 1, pp 47-63.  Ellis D. (2007). More pain than profits ahead for banks. A repeat of the third quarter bust is unlikely, argue analysts, but housing woes and credit market tightness should keep a lid on earnings. CNNMoney.com October 26 2007: 10:51 AM EDT Mauldin J. (2008). Fixing The Credit Markets to Avoid Another Credit Crisis. Available online at:http://www.marketoracle.co.uk/Article4609.html Mayes, David G., (2000) "A More Market Based Approach to Maintaining Systematic Stability" (August). Financial Services Authority Occasional Paper Series No. 10. Available at SSRN: http://ssrn.com/abstract=428000 or DOI: 10.2139/ssrn.428000 Miyajima H., Yafeh Y. (2007). Japan’s banking crisis: An event-study perspective. Journal of Banking & Finance, vol. 31, No.9, pp. 2866-2885 Schumer C. E., Maloney C. B. (2007). The Subprime Lending Crises. The economic impact on Wealth, Property values and tax revenes, and how we got here. Report and Recommendations of the Joint Economic Committee, October 2007. Shaffer S., Hoover S. (2007). Endogenous screening, credit crunches, and competition in laxity Review of Financial Economics. Schooner Heidi Mandanis and Taylor M. (1999). Convergence and Competition: The Case of Bank Regulation in Britain and the United States Michigan Journal of International Law, Vol. 20, No. 4 Read More