The Impact of the Economic Crisis - Literature review Example

Economics Introduction The key issue that has developed to what is being called a crisis situation by analysts such as Essen (2008) is the result of the subprime mortgage investments made by various financial and lending institutes in America. Not only has that caused a panic in the credit market, Wall Street also felt the effects of this crisis and the stock markets saw tremendous erosion in terms of the capital values of stocks triggered by rapid selling. In essence, the present situation is the combined results of risky decisions and rash actions that were undertaken months ago by investors seeking to get huge returns. At the same time, the government appears to have remained blissfully unaware of the developing situation until it came to a point where massive injections into the economy had to be made in order to prevent a total collapse. Even these injections such as the $700 billion approved by the senate and the congress may not be enough to reverse all the damage (Skillings, 2008). Background The financial crisis that is presently in the American economic system began as a result of the subprime lending issues. At the present, the crisis appears to be in full swing as major banks, long established financial institutes and even insurance companies have failed to keep their commitments. Local and international investors seem to be panicking since no one is sure how the economy will come out of the mess and how long it would take for total recovery. Essen (2008) suggests that the panic and the crisis can be attributed to the lack of checks and balances created for the lending market that the government is supposed to regulate. Less regulation and greed have led to a situation where the investments made by banks in the housing market are not good for any of the stakeholders except those who wanted to see short term results. The Situation This is certainly troubling situations since the finance sector is perhaps the most heavily regulated sectors of the economy. However, it seems that wherever the financial magicians can find a loophole, they would exploit it. The subprime market was seen as virgin territory which could lead to great returns but the risks were perhaps underestimated. In fact, the risks were perhaps even ignored altogether and that has brought the American economy to a point where individuals are openly calling it the “worst financial crisis since the Great Depression (Essen, 2008, Pg. 1)”. The full impact of the economic crisis may only be understood years after it is over but it is agreed upon by Essen (2008) and Garrett (2008) that the basic cause of the crisis are the recent high risk decisions of different banks who gave out large amounts of money to borrowers but they did not perform proper risk evaluations. Instead of looking at the risks of the investments, the banks were more focused on the possible returns that could have led them to gaining huge profit margins. It seems that the managers who were leading these banks were more focused on short term profits and sales figures rather than look at the long term outlook of their loans (Essen, 2008). This can also be attributed to the way in which the American market is structured since the market seems to react more to short-term performance than stable growth. This leads Clendenning (2008) to bemoan the greed of financial institutes and suggest that American banks in general seem to have had a ‘casino mentality’ while making the decision to get into the subprime mortgage market. Many banks seem to have understood the risks but the lure of the rewards was simply too great for them. Interestingly, the crisis was created during a time of economic stability where housing sellers and mortgage brokers recommended to their buyers that they should get into mortgages that needed little or no cash as a down payment for the house they were purchasing. Moreover, these mortgages and the required payments for buying houses were given out without fully examining the risks associated with the loans since they belonged to the subprime market. When the fundamentals of risk management were ignored, banks and financial institutions became overexposed and defaults only led to the investments being turned into lost causes. It is entirely possible that the crisis could have been kept limited to one or two banks that had dealt heavily in the subprime market but the debts the subprime market owed to the banks were traded and sold as high risk investments to other firms. Even international investors were brought into the fold as they were given expectations of high returns. These high returns were nowhere in sight as the subprime market started defaulting. In 2007, In June 2007, the Bear Stearns’ hedge fund came under pressure and eventually collapsed. This shook investor confidence and the company itself lost value to a point where it became unable to deal with its liabilities (Essen, 2008). Political Performance The government’s performance in handling the crisis both in its initial and late stages left a lot to be desired. While some investors saw that something had gone wrong with the market, the government could not see the looming crisis. The Federal Reserve as well other government bodies supported those who suggested that the market forces would bring about a correction in the situation and the economy would get better (Garrett, 2008). However, investors in the housing market did not like what they were seeing and other funds that had made investments in the subprime market also started losing their value. The public too was confused as differing opinions offering warnings or support were given on the media. However, the continual downward slide of economic indicators led both the American Federal Reserve and the European Central Bank to pour billions into the global economy to keep a disaster at bay. However, even that did not restore confidence and institutions such as Lehman Brothers and even AIG insurance were found to be collapsing (Essen, 2008). Beyond these companies, lenders such as Fannie Mae, Fannie Mac and even JP Morgan found themselves to be in trouble. Antitrust Mechanisms The American government announced that it would take over Fannie Mae and Freddie Mac which is seen by Kaletsky (2008) as a means of bailing out these organizations. While some have objected to this action since it does not allow market forces to deal with collapse, others such as Skillings (2008) have suggested that government is still the best party to look towards if there is to be a real solution for the problems in the economy. Despite the lack of foresight, it is still the government and the central banks of the world that can lead the global economic system out of the crisis situation. Antitrust tools which partly nationalize the banking system or the government having oversight abilities on the workings of banks could certainly prevent such meltdown from taking place in the future. It must be noted that such a step would be drastic indeed since it goes far beyond the idea of regulation and brings up the question of government ownership. Cost Benefit Analysis While government owned mortgage companies may have an unfair advantage in terms of competing with privately owned companies, they have a benefit of operating with the guidelines presented by the government that may have a better eye on the overall economy than a private company. The government could actually stop handing out credit to those who are at a higher risk of default without concerning itself with performance issues and creating shareholder value. Even in situations where the government owns a part of the company, the idea of focusing on short term results might be replaced with long term growth and the creation of stability. However, there is also an associated cost as government run enterprises may turn out to be inefficient. Particularly in monopoly situations where government monopolies may create situations where lending companies command a considerable amount of power and not optimize their performance based on market situations. This is certainly a concern since the economy can pay a heavy price for such inefficiency. Considering the cost of the meltdown itself and the possible impact of nationalization, it is perhaps a better idea to prevent such meltdowns from happening in the future through stricter regulations . Conclusions For the investors who had shares in companies that have collapsed, there is no easy answer except that they took a risk and that did not meet with success. Many Hedge funds and Real Estate Investment Trusts have lost their value with this crisis and it appears that no one profited from the subprime mortgage investments except for those who were able to get out of the market early on. Instead of remaining an American crisis, the issue has spread to countries as far off as Australia, China and India even though Europe and the US are most affected. As described by Clendenning (2008) this is a wakeup call for the American government and the American banks to focus on real business and not think about making quick money. It can be certainly expected that the American government will respond with several new acts of congress and create new regulations to make sure that similar financial issues are not created in the future. Without fully understanding and knowing the risks involved, investment decisions can go wrong in a big way therefore regulations that require more scrutiny for credit and a deeper examination of the risks involved are likely to be created once the government is able to do so. Simply put, these regulations would certainly tighten the functioning of the market and may make it harder to obtain credit in the future. Word Count: 1,688 Works Cited Clendenning, A. 2008, ‘US casino mentality blamed for planets meltdown’, [Online] Available at: http://ap.google.com/article/ALeqM5gOZTtahVNy4kICgeQueTNyWQybJAD93H9HL80 Essen, Y. 2008, ‘Financial Crisis: US calls on world to save banking system’, [Online] Available at: http://www.telegraph.co.uk/money/main.jhtml?view=DETAILS&grid=&xml=/money/2008/09/22/cnpaulson122.xml Garrett, E. 2008, ‘Perry: Federal government inept at solving financial crisis, other problems’, [Online] Available at: http://www.dallasnews.com/sharedcontent/dws/news/nation/stories/DN-perryecon_01tex.ART.State.Edition2.26d5efa.html Kaletsky, A. 2008, ‘Financial crisis could get much worse’, [Online] Available at: http://www.theaustralian.news.com.au/story/0,25197,24365062-5014020,00.html Skillings, J. 2008, ‘Ballmer: Congress must stabilize financial crisis’, [Online] Available at: http://news.cnet.com/8301-10805_3-10054252-75.html Read More