The Unsettled Conditions in Capital Markets - Case Study Example

Capital Markets Table of Contents Introduction 3 Reasons of Financial Crisis in 2007 4 Future plans for the regulators and users of capital market tocope with Financial Crisis 9 Conclusion 11 Reference 13 Introduction ‘Recession’ is one of four stages of economic cycle. The policy makers and the Government authorities are responsible to avoid and control this recession period by formulating and implementing relevant and effective strategies. As per the economic cycle theory, there are four stages that an economy has to experience. These are slump, recession, recovery and boom. The four stage of economic cycle is considered to be natural. However, during the recession period, an economy suffers from various economy crises. At such situation, the regulators aim to evaluate and rectify the existing economic policies and bring changes for the improvement of economic conditions. This report will attempt to deal with economic crisis of 2007. This crisis was not a natural crisis as described in economic cycle theory. Some major carelessness has been identified that caused this crisis in 2007-2008. This recession stage was very tough period for the entire World economy including the first world countries. In fact, the first world countries like US and other European countries were major victims of this crisis. The leading regulators of world economy like International Monetary Fund (IMF), World Banka and Federal Reserve etc have taken necessary steps and implemented policies for bringing stability in the World economy. The primary purpose of this paper is to discuss prime reasons for this crisis and evaluate responses taken by users and regulators of the capital market. In order to serve this, the paper will discuss important facts relating to the Financial Crisis of 2007. This paper will deal with two major sections. The first section will explain the securitization and mortgage activities during 2007 and these two activities were the major reason for the Financial Crisis of 2007. The second section will discuss and evaluate the role of regulators in controlling the crisis and their future plans. Finally, this report will present a conclusion of the entire discussion and analysis. Reasons of Financial Crisis in 2007 The recession period of 2007 – 2008 is known as the ‘Financial Crisis’ as the world economy faced the financial crunch during this period. The poor standard and unsystematic activities of financial sectors were the prime cause that brought the financial crisis. The American financial market was the root of the financial crisis and financial market of USA, Europe and Australia were severly affected (Paulson, 2008). The Financial Crisis of 2007 was a gradual process that can be traced since 2000 -2002. Housing sector had the major contribution in the growth of American economy. The most of percentage of total expenses of American citizens was for buying houses. The increasing demand of houses caused a massive hike in the price of houses in America and other European countries. The increasing demand of the houses led to develop the securitization market. The banks and other mortgage loan providers started to exploit this opportunity without following a proper systematic method and they overlooked the fatal consequences. The regulators of the banking sectors were considered to be the most responsible for this crisis. The Banking Law Committee of America identified several deficiencies in controlling the entire sector. They failed to implement proper policies for checking risk management activities. “The deficiencies in banking supervision were caused in part by the speed of innovation and development in the marketplace that outpaced the risk management process of financial institution and their supervisors” (American Bar Association, 2009). The mortgage and securitization are the two major financial instruments. In American financial market, mortgaging was used as an important method for offering housing loans. The financial institution like banks used the ‘sub-prime mortgage’ policy for offering loans to the house buyers. With the increasing prices of house, the sub-prime lending rate experienced a massive growth. The following figure represents the prevailing situation of American sub-prime market and house prices. Figure 1: House prices and mortgage originations (Source: Sanders, 2008) Initially, the financial institution found it as the most suitable option for lending purposes. The banks did not take any steps to figure out the credit rating of the individual borrowers. The subprime lenders increased their loans significantly without any proper regulation. The sub-prime loans lead to create high securities in the market. The leading subprime lenders offered more than $1 trillion loan during 2005 and 2006. The following table shows that amount of loans offered by the top 25 sub-prime lenders. Table 1: Top 25 sub-prime lenders and their loan volume (Source: Catanach, 2009) The above figure shows that the top 25 sub-prime lenders collectively provided total loan of $997,538,108,000 and all high interest lenders offered $1,379,831,861,000. Most of the borrowers turned default as they were unable to repay the loan amount. The most of the loans were offered at sub-prime credit rate without any proper documentation, bond or credit checking. The unconventional mortgage product like asset backed commercial paper was the major instrument for providing loans to borrowers. Many banks developed their mortgage and lending policy for supporting the ‘refinancing’. However, these policies were unsystematic and unrealistic. 80% of these unsystematic sub-prime mortgage loans were securitized by the sub-prime lenders (Gorton, 2008). The securitisation of the assets were very high during 2007. “In 1996, about $450 billion in these various kinds of assets were securiturized and this grew to about $2.3 trillion by 2006” (Fligstein and Goldstein, n.d.). This led to expand all types of consumer credit market. The following figure shows the securitization of different assets. Figure 2: Securitization of Other Assets (Source: Fligstein and Goldstein, n.d.) The asset back commercial paper (ABCP) is an effective instrument for providing loans. Since 2001 till 2006, the ABCP was a major trend of the financial market of America and other European countries. The risk averse-investors started to retrieve from the ABCP market after the French Bank BNP Paribas stopped withdrawing funds from the mortgage backed security market on August 7, 2007. This caused an abrupt end of ABCP market in 2007 (Acharya and Schnabl, 2009). The following figure presents the outstanding ABCP from 2001 to 2009. Figure 3: Rise and Collapse of ABCP Commercial Paper (Source: Acharya and Schnabl, 2009) The above graph shows rise and fall of ABCP after the bankruptcy of Enron in 2001. The use of the ABCP varied according to countries. The following figure shows the growth of ABCP in the seven largest economies of the world. Figure 4: Growth in bank-sponsored ABCP by country (Source: Acharya and Schnabl, 2009) The above graph shows that the use of bank-sponsored ABCP increased surprisingly in US financial market followed by Germany. Future plans for the regulators and users of capital market to cope with Financial Crisis The Financial Crisis of 2007 has taught the world economy a bitter lesson for its unsystematic way of operation and negligence of regulators. The users and the regulators of the capital market rectified the underlying issue responsible for the sub-prime crisis. The leading international organisations and major regulators presented their future plans to control economy stability. In order to develop necessary plans for stable financial market, the Government of Financial Stability has presented some financial regulatory reforms. In this respect, the foremost task is to promote the regulation and supervision of the financial institutions. The previous section has discussed that due to improper regulations, risk in the market increased drastically. The financial market regulation should be comprehensive. For example, financial instrument policies must bring efficiency in the market. The investors are very vital for the growth of the financial market and the financial regulatory must take necessary steps for protecting the consumers from the abuse of financial institutions. The Government must supervise the financial activities of its economy and it should use necessary tools for managing financial market. For maintaining the financial activities, the regulatory authorities must develop international standards. For example, the accounting standards followed by the companies must be transparent and reliable (Department of Treasury, n.d.). The Committee on the Capital Market Regulation has identified important issues of the financial market and recommended some areas of improvement. This organisation primary focuses on principle based regulation that strives to enhance the effectiveness of financial market. Some of the important recommendations are discussed below. Review of the capital requirement: the capital regulation must improve its regulation process for the baking and other lending sectors. Framework for resolution procedure: in order to safeguard the bankruptcy of the financial institutions, there must be effective resolution procedure. The collapse of financial institutions leads to affect the investors and consumers of financial market. Revision of securitization policies: securitization policies of financial market must be reformed considering the systematic risk of market. The regulators must measure the liquidity of the market on a regular basis. Improvement of accounting policies: standard accounting policies will reflect fair value and real picture of the organisation. It will be easier to assess the performance and risk of the companies. In order to meet above recommendations, the regulatory structure and international coordination are very vital. However, the US Government is now aiming to bring new structural development by implementing necessary policies (Committee on Capital Markets Regulation, 2009). The African developing nations were also affected due to the global down turn of 2007. These African countries have proposed important recommendations for enhancing the international financial system. Their recommendations include “increasing policy space”, “debt sustainability framework (DSF)” “voice and participation” and “promoting trade” (United Nations Economic and Social Council, Economic Commission for Africa and African Union Commission, 2009). Conclusion The growth of an economy depends on its economic strength and stability. The financial sectors have become one of the most important factors for an economy. The government and other regulatory authorities are responsible for supervising the financial sector. The unsystematic and ineffective regulation policies may lead to serious consequences. The financial crisis of 2007 is a proper example of regulatory negligence. This paper has presented the role of mortgage and securitisation activities for unsettled conditions in capital markets since 2007 due to financial crisis. The regulators of the American financial market were unable to identify and to control the increasing market risk. Banks and other lending organisations increased the use of the sub-prime mortgage and asset back securities. The lending processes were unconventional and risky as the lenders did not take any steps to measure the increasing risks. The increasing house prices were the major factor that increased the demand of the sub-prime lending. Due to high credit market, the securitization of assets also increased that raised risk of the market. The default rate of borrowers increased drastically and this caused bankruptcy of many large and small banks and other financial institutions like Fannie Mae and Freddie Mac, Lehman Brothers and Bear Sterns (Eisenbeis, 2009). However, the financial regulators have realized their responsibility for financial crisis. These organisations have developed plans for ensuring stable financial market for future. Their recommendations and future policies primarily focus on standardisation of regulatory structure. The government and regulators of capital market must implement policies for measuring the market risk and it should use several effective tools for controlling the risk of the market. In this respect, maintenance of proper transparency should be made inevitable for each organisation. This will help the regulators to supervise their activities efficiently and effectively. Reference Acharya, V. and Schnabl, P. November 2009. Do Global Banks Spread Global Imbalances? The Case of Asset-Backed Commercial Paper During the Financial Crisis of 2007–09. [Pdf]. Available at: http://www.imf.org/external/np/res/seminars/2009/arc/pdf/acharya.pdf. [Accessed on November 23, 2010]. American Bar Association. September 2009. The Financial Crisis of 2007-2009: Causes and Contributing Circumstances. [Pdf]. Available at: http://www.abanet.org/buslaw/committees/CL130055pub/materials/201001/causes-report.pdf./ [Accessed on November 23, 2010]. Catanach, A. December 14, 2009. 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