Market Crash and its Contributing Factors - Research Paper Example

Market Crash and its Contributing Factors Stock market is known as one of the most vital areas of a market economy, as it provides companies with access to capital and investors to own companies and overall it participates in the economic growth (Pindyck, Page: 334, American Economic Review, 1984). In spite of its numerous functions the risk involved in such market refuses the investors to enter into market. So whenever the customers are asked why they do they fear, the reply would be ‘fear of market crash’ (Ng, Page: 207, Journal of International Money and Finance, 2000). Market crash is a condition where the market decline rapidly with adverse end results, especially a rush of selling. It can have a tremendous effect on the customer’s interest and can also bring huge damage to economy and to the market's reputation. But it can perceive positive impact when it offers immense opportunities to the investors to buy the stocks with optimal potential fair value in long-term strategic investment, so that the market will eventually bounce back and those buyers can reap long-term results. The markets and the investors have witnessed good times and bad times in history. The series of market crashes have, in one way, weakened the stock markets and, in another, strengthened to undertake the challenges and avail opportunities for better future (Johansen, Page: 167, Oxford Bulletin of Economics and Statistics, 1990). The optimism for future growth in both developed as well as emerging markets shall set new pathways to fortune hopefully avoiding the pitfalls on both micro and macro levels. The compliances and regulations shall pave a safer haven for the stock markets to evolve. This term paper is an attempt to discuss the market crash in general. The paper also examines the role of various agencies such as brokers, I-banks and U.S. Treasury in attempting to curb the subprime crisis in the United States of America. Market Crash - A Perspective In a market economy it is quite possible for stock markets to take off and rise rapidly for a period of time. A stock market crash refers to a sudden decline in the stock indices and deterioration in the value of stocks and securities over a span of time (Francis, Page: 475, Journal of International Money and Finance, 1998). It can offer excellent time for the buyers to buy stock with promising future returns. During the crash it is desirable to an investor to hold on stocks without selling as the panic selling by other investors can bring down the market prices below fair value. So as the price falls the buyers pour in and buy, leading the market to regain its valid position. This is how the market mechanisms operate during Market crash. The History of Prominent Market Crashes It has been evident since 1800 that the market crashes and slides have been predominant in global markets and have paved their way till the present day (Ding, Page: 83, Journal of Empirical Finance, 1993). The various economic and psychological factors such as unexpected and adverse economic developments worldwide, the lack of regulations, the impacts of investor sentiments, more complicated financial investments, international trading-related risks, etc., have contributed to the series of market crashes. The globalization and cross-border trading had their own set of pressures on the global stock markets and investors. How Does a Market Crash Happen? The anarchy is assured and can be absolute if primarily we can appreciate how balance markets accommodate clamminess and as well how market clamminess can breach down. Besides, the bearings offer a branch of opportunities, threats and disturbances for the investors to cope with. The balance markets accommodate clamminess by facilitating trading and allowance investors to advertise their balance to added investors for cash. A stock market should alluringly blot liquidity-driven sales after any change in aegis price (Chen, Page: 153, The Financial Review, 2001). The amount in an ideal stock market changes alone as per the new advice about the approaching banknote flows, whether absolute allotment or ambiguity of returns. As far as clamminess sales and purchases are not accompanying at all, they tend to offset one addition with actual beneath the impact on price. The beyond and added concentrated the market, the bigger the pooling, the beneath the market amount is afflicted by clamminess trading. This will result in casual changes of adapted clamminess sales and purchases (Cotter, Page: 669, International Review of Financial Analysis, 2004). In banker market, the market-makers blot clamminess imbalances by trading for their own account. In the bargain markets, the specialized traders jump in to buy and advertise rapidly, so sometimes the apparatus which provides the market with clamminess can be ashore by the blitz of affairs which after-effects in a crash (Jacobsen, Page: 479, Journal of Empirical Finance, 2003). The mechanisms which accommodate clamminess to the market are not in a position to handle such an abundant blitz of selling. The above could cause is volume. The market-makers accommodate clamminess by affairs up balance if there is an balance of advertise orders and for this they charge acclaim to accounts the purchases, which is not calmly accessible in abundance. This happened in 1987 blast if banks became afraid about brokers rapidly accretion borrowings and were not accessible to accommodate more (Najand, Page: 93, The Financial Review, 2003). Another analytical acumen why the clamminess advancement apparatus does not stop the abatement is that it is not the albatross of market-makers. The boundless affairs not alone constitutes clamminess imbalance, but it as well reflects the change in sentiment, i.e., the change in fair price. Even if the market-makers are accommodating to blot clamminess imbalances, they are not in a position to yield it on abiding value; and if they do it, the market collapses. For instance, in 1987, instead of affairs to acclimatize the balance of advertise orders, experts on New York Stock Exchange (NYSE) unloaded their own inventories abacus to the bottomward burden on prices (Najand, Page: 93, The Financial Review, 2003). Thus, as there shall be issues, so shall the regulations chase and evolve. Factors Contributing to Market Instability or Market Crash The uncertainties about long-run value of securities create disturbances in the markets, and motivate the investors to indulge in the bankruptcy. Taking seriously investors must educate themselves to understand about the mechanisms of the markets and how this long-term value of securities can be a wiser investment rather than speculating for short-term instant benefits. The possible factors contributing to market crash are: Influence of uncertainty and risk: There is no particular standardized value in the market; so opinion may differ from one investor to another. Like some investors are optimistic and favor a long-term positioning while some others are pessimistic and favor a short-term positioning. But market favors the optimistic investors than to the pessimistic, which raises the price (Alberg, Page: 1201, Applied Financial Economics, 2008). Influence of noise traders: Such traders are spontaneous and keep on betting so that the rising trend continues, without giving due logical consideration to fundamental analysis. When the market rises rush of such traders is seen. Hence their buying increases the price to more and more, giving them capital gains for achieving their expectations. Thus phenomenon of rapid rise in prices followed by peak and then a sudden crash is bubble (Alberg, Page: 1201, Applied Financial Economics, 2008). This creates market instability. Influence of limits on short-selling: Short-selling is optimal when there is positive and optimistic perspective. But a thin line crossed can potentially contribute to a crash as the investors become illogical and oversell. This creates market imbalance. Influence of quality cycles: It is related to quality inherent in the investments themselves. The greedy and hungry investors are always seeking for new and innovative investment avenues. To cater their needs, the markets started offering more of new and creative investment avenues but only at the cost of deteriorated quality in order to cater to quantity. This is well related to concept of `killing the golden goose'—for example, the Internet bubble in Japanese stock market and US stock market boom of late 1920s (Koutmos, Page: 277, Journal of Economics and Business, 1988). Increasing importance of institutional investors and foreign investors: Institutional investors trade in large volumes and are agile, reactive and better informed than individual investors. Their reactions have far-reaching impacts, which give them bargaining power in their hands. They are much recognized in markets and do their dealings in stock through intermediaries. They do not cease to influence stock markets for their volume of trading. Besides above factors, international political issues can sometimes influence the markets. To the experts view when international cooperation influences national policies, the new economic order of a global economy becomes fragile and equity markets decline. Thus intensity of factors determines the quantum of market slide. The various trade imbalances also globally affect the markets and induce volatility in derivatives markets, the commodity markets, and the financial system at large which is influential to a great extent. Three Sub Topics The Role of Various Agencies in the End of Subprime Effect The Role of Brokers It is estimated subprime mortgage crisis can bring a huge damage to 2.5 million people across US in terms of losing their homes to foreclosure this year (Pagan, Page: 15, Journal of Empirical Finance, 1996). The daily business of real estate is an eye-watering glimpse of the industry's slide into anarchy. Dishonesty became endemic in loan applications. It was seen by the end, 70% of submissions from brokers to the real estate were deceptive. Properties supposedly, objectively appraised were overvalued spectacularly (Pagan, Page: 17, 1996). Around bisected of loans were on homes over-egged by up to 10%, a division had prices abstract by 11% to 20% and the blow were "so overvalued they defied all logic" (Ragunathan, Page: 79, Journal of International Financial Markets, 1999). It went from ambiguous brainless to absolute insane. The angle of `acceptable risk' artlessly went out of the window. The margins aeroembolism in the industry and no one was accouterment for the risks. Seemingly amaranthine account of tricks were acclimated by brokers to advance arguable loans. Many artlessly withheld information, such as the actuality that a homebuyer was accepting an added accommodation to pay for a drop or that a couple, affairs on the base of collective income, was in fact planning to divorce. Others would dispense abstracts by animadversion up pay slips application desktop publishing programs. So members were forced to stick to one broker than shopping around because each broker would check their credit record and through sheer fact of being officially checked fragile credit scores often fall. The industry in Texas was barely regulated; mortgage salespeople were sponsored by a registered broker, 250 different loan officers were attached to a single one-man office measuring about one square meter (Ragunathan, Page: 79, Journal of International Financial Markets, 1999). The Role of I-Banks The reasons behind ongoing financial crisis are several, but the most important is that Wall Street's investment banks wield too much power. The investment banks became vulnerable to the subprime mortgage crisis when mortgage-backed securities were sold to a number of investors after having it purchased from mortgage companies or commercial banks and then transforming them with a bit of financial engineering called securitization (repackaging various kinds of assets as securities). The Moody's Investors Service and Standard and Poor's were the poorly rated financial products such as collateralized debt obligations and mortgage-backed securities. Followed by monoline insurers, which sold insurance for both products went bankrupt. The most worrisome is that major financial institutions are still piling up losses from derivative products such as CDOs and CDSs. So the possibility of financial institutions to go bankrupt with additional losses is more. The Role of US Treasury This agency made a dramatic decision to place the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Company (Freddie Mac) in conservator ship with the government taking over the management. Since the Great Depression in 1930s Conservator ship (or bailout, takeover, nationalization) was one of the most sweeping government interventions. Though they are Government-Sponsored Enterprises (GSEs), their shares are publicly traded on the New York Stock Exchange. So they are, effectively quasi-private/quasi-public. They own more than $5 tn in debt and mortgage-backed securities. GSEs fulfilled the American dreams of millions people of home ownership. Their leverage is at roughly 50 times their capital, compared to about 10 times for typical commercial banks and 30 times for investment banks (Taylor, Page: 25, John Wiley & Sons, 1996). The Fannie and Freddie have become so large that they wield too much political influence. The decisive action of the US Treasury was welcomed by most investors and the central banking community. But to the supporters of the bailout, these institutions are too big to be allowed to fail. 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