The Recession of 2008 and the Great Depression - Essay Example

Recession of 2008 and Great depression Answers Question one (C) Question two Question three (B) Question four (A, B and C) Question five (A, B and D) Question six (A, B and C) Question seven (D) Question eight (F and G) Question nine (B and C) Question ten (C and E) Question eleven (A, B and C) Question twelve (A, C and D) Question one The principle significance of losses on mortgage-backed securities in the recent financial crisis led to losses on the balance sheets of financial institutions. The housing bubble resulted to financing of home ownership using low interest rates. Consumer spending was facilitated by second mortgages which were secured by price appreciation. By September 2008, the average US housing prices declined by more than 20%. As the prices declined, borrowers with adjustable rate mortgages could not refinance the mortgages with the rising interest rates. Defaults and foreclosures increased as the housing prices failed to appreciate as anticipated (Halm-Addo 2). HSBC which is the global largest bank wrote down its holdings of subprime mortgage backed securities by $ 10.5 billion while more than other 100 mortgages companies were either shut down or suspended their operations.US and European Banks lost more than $ 1 trillion on toxic assets during the financial crisis. Northern Rock which was a British bank, was highly leveraged could not obtain credit in the financial markets. Bear Stearns collapsed in March 2008. Other financial institutions made bad losses and were subject to government take over. Lehman Brothers, Fannie Mae, Freddie Mac and AIG made a lot of losses during the crisis (Halm-Addo 4). Question two Various limits to arbitrage can help explain why assets were selling below their fundamental level at the height of the financial crisis. Constrains to short selling does not account for the assets selling below their fundamental prices. Short selling was evident since investors made speculative short sale bets against the financial assets which made the prices to decline. For instance, short selling led to drop in the value of Lehman Brothers stocks. US Securities and Exchange Commission imposed at temporary ban on short selling since it this method of trading reduced the market confidence and the stability of financial assets (Halm-Addo 40). Question three The “too big to fail” notion led to moral hazards, bail outs and increased the Fed’s balance sheet. Adverse selection was not caused by the notion of “too big to fail”. The notion created moral hazard since the financial institutions engaged in predatory lending like Countrywide Financial which advertised low interest rate loans for home refinancing. The notion made banks to borrow short term in liquid markets and purchase long term illiquid assets which were risky. The notion led to the bail out where $ 700 billion Troubled Assets Relief Program was created to rescue the important institutions which were collapsing (Halm-Addo 1). Financial institutions had invested heavily in the mortgage backed securities and credit default swaps. Banks participating in the plan included the Wells Fargo, Goldman Sachs, Citigroup, and Bank of America, JP Morgan Chase and Morgan Stanley. The notion caused the Fed to increase the size of balance sheet since it was forced to adjust the deposit insurance from $ 100,000 to $ 250,000. The Fed also was forced to increase money supply in the economy in order to avoid the deflationary spiral. The Fed provided two stimulus packages amounting to $ 1 million. The Fed purchased US $ 2.5 trillion of government debt and troubled private assets from the banks. The Fed also raised the capital of the national banking system by $ 1.5 trillion by purchasing new issues of preferred stocks from major banks (Halm-Addo 5). Question four Funding liquidity is most related to losses of risk capital, haircuts and counterparty risk. Funding liquidity is the ability of the firm to meet efficiently both the expected and unexpected current and future cash flow and collateral needs without interfering with the operations and financial conditions of the firm. The funding liquidity is assessed using the net stable funding ratio and the liquidity coverage ratio. Funding liquidity affects the losses in risk capital in the form of the market liquidity risk where the firm cannot easily offset a position due to inadequate market depth. The funding liquidity is also associated with counterparty risk. Funding liquidity risk, credit risk and market risk will arise when there is need of collateral where counterparties are involved in the derivative market. The price volatility of the asset being provided as collateral is main source of the funding liquidity risk. If the market value of the collateral declines, the bank has to provide additional collateral (Halm-Addo 23). Question five Lack of adequate deposit insurance and high leverage ratios is most responsible for the banking “runs” during the 2008-2009 financial crises. Maturity mismatch was also a cause since Bear Stearns had financed was not ordinary deposit taking bank but chose to finance huge long term investments by selling short term maturity bonds that were backed by commercial papers. The deposit insurance was low since Wachovia bank experienced high runs when most institutional investors withdrew their deposits below the $ 100,000 limit which was the value of deposit insurance. Mortgage Lender Indy Mac Bank relied heavily on high cost and brokered deposits which created high leverage ratio on its financial accounts. The depositors withdrew 7.5 percent of the bank deposits (Halm-Addo 17). Question six The genesis of the “bubbles” of various sorts has been implicated to low interest rates, excessive optimism about growth rates and underestimation of risk. Lower interest rates encouraged borrowing from 2000 to 2003 when the Federal Reserve lowered the Federal funds rate from 6.5 percent to 1 percent. The high current account deficit also lowered the interest rates since the US was borrowing money from foreign markets. The bubble can also be attributed to underestimation of risks since lack of transparency on the bank’s risk exposure prevented the markets from correctly pricing the risk. Market participants did no accurately estimate the risks involved in innovative financial securities such as the Mortgage backed securities and CBOs. For instance, banks estimated that $ 450 billion of CBOs were sold between 2005 and 2007 but among $ 102 billion of them had been liquidated. The pricing of risk was more complex due to the innovative financial securities (Halm-Addo 6). Conflict of interest between professional investment managers and institutional clients also led to toxic investments since the managers over-priced credit assets. Credit rating agencies also gave high rating to risky and highly leveraged institutions thus facilitating the sale of mortgage backed assets. There was high optimism on the expected growth of the housing sector, since 2000, the average US housing prices had increased four times hence speculators thought the trend would maintain. The housing bubble thus resulted from homeowners refinancing their homes at lower interest rates or using the second mortgages which were secured by price appreciation. The collateralized debt obligations allowed the financial institutions to obtain investor funds and finance the subprime mortgages (Halm-Addo 8). Question seven Counterparty risk in the repo market is related to the LIBOR. The counterparty risk is such that the counterparty may fail to return the securities at the end of the transaction hence the lender keeps the cash collateral. In the repurchase agreement, the holder of the security sells it to counterparty and agrees to buy it again on pre-determined date. The “repo rate” reflects the rate on the cash advanced but also considers the coupon and yield of the fixed income security offered as the collateral in the repo transaction. The repo rate is always lower than the bond interest rates. The lender of cash earns the repo rate while the lender of the security earns the coupon which the bond pays less the repo rate. In November 2008, the repo rate in the $ 4.5 trillion U.S Treasury repo market declined almost to zero whereby the investors would rather have held the securities rather than the cash. The repo rate had decreases to 1 percent in October hence a lot of settlement fails were experienced in November (Halm-Addo 56). Question 8 Both the Great Contraction and 2008-2009 financial crisis have similar characteristics. The two recessions increased a decline in the stock market. During the Great contraction, stock prices skyrocketed by more than four times from 1921 to 1929 which led to speculation of the stock prices. Between 1928 and 1929, the Federal Reserve raised the interest rates to stem the price increases in the stock market but the prices continued to increase to levels where investors could no longer anticipate any future earnings from the stock. The US investors lost confidence in the stock market where the price declines made many investors liquidate their stocks. The stock prices declined by more than 33% which ultimately led to the stock market crash on the “Black Thursday” where many stocks have been purchased on margins using loans which were secured by the stock value (Halm-Addo 187). The US also experienced banking panics in 1930, 1931 and 1932 which culminated to the “banking holiday” where all banks were closed to allow for an inspection of their accounts by Federal officials. By 1933, one-fifth of all banks had failed due to the runs on the deposits. A binding “zero lower bound” on interest rates was not a characteristic of both the Great Contraction and 2008-2009 financial crisis. The zero lower bound on interest rates is the point where there is liquidity trap hence central banks should increase the interest rate in order to stimulate growth in the economy. In December 2008, the was a zero percent nominal interest rates but while during the Great Contraction, the interest rates where high since the Federal Reserve contracted the money supply by increasing the interest rates. It means the interest rates should not be negative (Halm-Addo 197). Question 9 Unexpected deflation and especially aggregate demand driven deflation, raises the unemployment level when the nominal wages are rigid. With sticky wages, the prices of commodities will fall which leads to an increase in real wages. Unexpected deflation can lead to debt deflation where redistribution of wealth from debtors to creditors is caused by the declining prices (Halm-Addo 273). Question 10 A period of rapid recovery from the Great Contraction in the United States was associated with initial decreases in real wages. The economic recession began in 1929 and lasted until 1939. The rapid recovery was not associated with rise in real interest rates since the decision to stem money supply by US Federal Reserve in 1931 raised the interest rates hence creating contracting the output level in the economy. The depression resulted in drastic decline in output, high unemployment and acute deflation in most of the Western economies. The recovery in the US began in 1933 when the output grew rapidly at the average rate of 9% per year betweens 1933 to 1937. The rapid recovery was interrupted by a second recession that occurred between 1937 to 1938 when the US severed a severe downturn. The US output finally returned to its long run growth trend in 1942. The largest recovery was however initiated when Germany invaded France at the beginning of World War Two since countries like Britain increased the military material purchase from the US which caused the US to increase its budget on military (Halm-Addo 198). Question 11 Moral hazard is the risk that the presence of a contract will affect on the behavior of one or more parties to the contract. Examples of moral hazards are in insurance contracts where the coverage of the loss may increase the risk-taking appetite of the insured. Each party to the contract may have the opportunity to make gains from acting against the principles laid out in the agreement. For instance, when a sales person is paid fixed salary with no commissions, he may not have the incentive to work hard and close more sales because his stays in the same economic position regardless of the sales volumes. Moral hazard is reduced by imposing responsibilities on both parties to the contract. For moral hazard to exist there must be a contract hence examples include people who have access to cheap health insurance who eat and smoke more and the increase in the fraction of bank deposits which are insured which may result to riskier bank portfolios (Halm-Addo 153). In insurance industry, moral hazard occurs when the client changes his behavior in a way which increases costs to the insurer. People whose parents died young take out more life insurance hence this is a moral hazard as the insurer has no adequate information on the seasons for their action. People who have a tendency of selling their faulty cars are an example of adverse selection since the buyer is not aware of mechanical conditions of the car hence a case of hidden information. During the 2008 recession, banks exhibited moral hazards in their operations since they were assured of government bail out. $ 29 billion bail out to bondholders of Bear Stearns encouraged Lehman Brothers and other investment banks to delay in raising additional capital. Mortgage securitization by Fannie Mae and Freddie Mac created a moral hazard on the borrowers (Halm-Addo 14). Question 12 A rise in discount rate will increase the federal funds rate hence it becomes more expensive for the commercial banks to borrow money from the Fed. The rise has a contraction effect since it reduces the amount of credit available in the economy. The rise has an indirect effect since the commercial banks increase the interest rates charged on loans to customers. Individuals will be affected by the rise on the interest rates charged on mortgages and credit cards especially if they have variable interest rate. Individuals will have lower disposable incomes while businesses find it expensive to borrow money for expansions purposes. The rise of the discount rate will also affect the stock market indirectly. Treasury securities are the preferred investments since they experience corresponding increase in the interest rates. The risk free rate of return will increase while the total returns which investors demand from investing in stocks will also increase. The required risk premium which is the additional risk above the risk free rate decreases while the potential returns from stocks decline or remain unchanged. The investors feel the stocks are more risky hence invest more in risk free assets thus discouraging the speculative behavior (Halm-Addo 29). Works cited: Halm-Addo, A. The 2008 financial crisis: the death of an ideology. New York. 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