Financial Crisis of 2007-09 and its Impact - Research Paper Example

Running Head: FINANCIAL CRISIS OF 2007-09 AND ITS IMPACT Financial Crisis of 2007-09 and its Impact Introduction The development of the housing industry in a country is dependent on the housing policies of the government of the country and by a number of other external factors like the demographic and the socio-economic situation along with some administrative, legal and political factors (Boelhouwer & Heijden, 1992). The financial crisis of 2007-09 had its roots in the housing market of the United States, which later spread throughout Europe and a number of other countries. The financial crisis had an adverse effect on the economy of the US and the UK in particular. The financial crisis also had a negative impact on employment, rules of banks and a decrease in the house prices. The only region in Europe that did not report the overvaluation of property was Germany but all the other countries like Ireland, Finland, France, etc, were left with a large number of houses. This paper discusses the financial crisis of 2007-09 and closely examines the causes and effects. The paper begins with a brief history of the financial crisis moving on to the financial crisis itself. The sub-prime mortgages are also discussed in detail in order to develop a better understanding of the crisis. The impact of the financial crisis on the housing market is then discussed along with the efforts made by the governments to recover. After that the impact of the financial crisis on the financial institutions, banks in particular, is discussed followed by the measure that could have been taken to avoid the whole situation. In the end of the paper, the conclusion is given. History During the first half of the nineteenth century, the need for better housing accommodation was deeply felt as there was a significant increase in the industrial population due to the industrial revolution (Français, 2010). Many European countries were recovering from the consequences of World War II, and reconstruction of the houses was one of the most prominent problems (Français, 2010). The restoration of the housing industry became the top most priority of the governments in the UK, which resulted in an increased GDP growth of the region in the 1950’s and 1960’s (Hamilton, 2005). Even though measures were taken by the governments to control the housing situation, the housing shortage remained a big problem throughout the Eastern, encouraging many countries like Poland, to invest a high amount of money in the housing industry and the building program. By the end of 1970’s, the building societies began giving out loans to people in order to purchase property, known as mortgages. There was an increased demand of mortgages which was not being met by the building societies and as a result these non-profit financial institutions had to compete with other profiting financial institutions and banks that were offering similar services. Halifax and Abbey are the examples of these building societies. As the number of institutions offering mortgages increased, the demand for owner occupied property too went up. This increase in the demand of housing resulted in an increased price of the property, giving the financial services industry an opportunity to make profit by encouraging people to take loans for other purposes, such as cars and holidays, using the increased value of their property. Sub-prime mortgages are mortgages that are given to people who are not qualified to get a prime mortgage due to unacceptable standards of their earnings, employment position, and credit card history (Ziegel, 2010). In simple words, sub-prime mortgages are given to people who are eligible to get a prime mortgage on the basis of their income and other financial assets. The root cause of this crisis was the extensive purchasing of mortgage-based securities by a large number of banks all over the world. Mortgage based securities are debt obligations representing the cash flow claims from mortgage loans, or in simple words, they are securities that are backed by assets, especially property. Banks all over the world purchased MBS either for themselves or for their clients. The sub-prime financial crisis first began in the United States when the housing bubble was burst, which gradually spread across countries causing a global financial crisis in 2007 and 2008 (Meili, 2008). Impact of Financial Crisis 2007-09 on the Housing Market The financial crisis was not limited to one industry or market but spread like a fire in the global economy. The inflation rose to a record high and the impact of financial crisis on the global economy resulted in the loss of thousands of jobs and closure of many organizations. The housing industry too suffered a great deal as the prices of houses fell for eighteen months straight in Ireland, “contracting the economy by 0.5 per cent in the second quarter of 2008, following an earlier decline of 0.3 per cent” (Adeloye, 2009, p. 3). It was soon predicted by the International Monetary Fund [IMF] after the housing bubble burst in the US, which the conditions in Europe are going to be just as bad, if not worse than that of the United States. It was also observed by IMF that the house prices in the UK were overvalued by 20 to 30 per cent. By the end of 2008, a 14 percent decline was noted in the house prices in the UK and it was predicted than it would further decline by about 10 per cent (Magee, 2010). Compared to 2007, the asking price of houses fell down by 2.9 per cent in 2008 (Property Wire, 2008). The declining house prices also had an adverse impact on the deposits which fell down from the peak level of 24.05 per cent in 2003, to about 18.1 per cent in 2007 (Ford, Sepencer, Wallace, Wilcox, & Williams, 2008). The housing market of Finland appeared to be one of the most developed markets of the world before the financial crisis of 2007-09, as it saw a boom period because of its favourable economic growth and a good tax system from 2001 to the second quarter of 2008 (Economic History Association, 2010). After the financial crisis of 2007-09, even the housing market in Finland was adversely affected and the house prices by 7.5 per cent from 2007. The main reason for the decline in the house prices in Finland was that the banks increased the repo rate by 4.025 per cent, which had a significant impact on the loans available in the market, bringing down the demand of houses (Property Wire, 2008). Even though there was a decrease in the number of the house prices and an increase in the interest rates from November 2004 to July 2007 in the UK, a high level of equity withdrawal was observed (Ford, Sepencer, Wallace, Wilcox, & Williams, 2008). It is estimated that the equity withdrawal was of about 23,000 mortgage products in the first six months of the credit crunch (Ford, Sepencer, Wallace, Wilcox, & Williams, 2008). The house prices kept declining throughout 2008 in many countries, especially the ones in Europe. This downturn in the UK housing market also had an adverse affect on many constructions firms as a high number of them going out of business went up by 15 per cent in 2008 (Property Wire, 2008). The impact of the financial crisis of 2007-09 was more severe than the impact of the recession of 1989-93 due to excessive debt taken in the real estate industry. Road to Recovery The main cause of the financial crisis of 2007-09 was the sustained housing and the boom in the mortgage market, the deteriorating macroeconomic climate, and the credit crunch. In order to recover from the crisis, a large sum of money was received by the UK government. A 26 billion euro stimulus plan was introduced in December 2008 by the President of France, Nicolas Sarkozy to be spent on public sector investment in order to recover the financial crisis. New and sustained special liquidity schemes were also introduced by the Bank of England to help ease the blockage in the housing market along with the 50 billion euro offer to support the collateral swaps with the leaders on specific terms (Bank of England, 2008). Moreover, the European Central Bank [ECB] cut the euro zone interest rates by half a percent to 2 percent in January 2009, and further decreased the rates by four times in the September of 2009 (BBC News, 2009). A huge gap was witnessed in the supply and demand of houses in the first quarter of 2010, but the mortgage market is easing which can also lead to inflation in the near future (Lambert, 2010). The UK government is standing by the reforms of 1997 which were established by the Financial Services Authority as a single financial regulator, along with taking the responsibility for the financial stability in the region (Ford, Sepencer, Wallace, Wilcox, & Williams, 2008). The mortgage lending institutions are now being strictly supervised by the regulators. The real estate market has been in the phase of reconstruction and has grown to some extent in the present year. It was reported by the Halifax that the average house prices is up by 5.2 per cent (Global Property guide, 2010), but according to the Market Oracle, are likely to fall by 1.5 per cent in 2011 (Faulkner, 2009). It has, however, been concluded that the house prices in UK are likely to rise again after declining in the second and third quarter of the year 2010 (Pollock, 2009). Impact of Financial Crisis 2007-09 on Banks – The Case of Northern Rock The impact of the financial crisis of 2007-09 on the banks was severe. The banks in the biggest economy of Europe, Germany, had offered the sub-prime mortgages just like the banks in US did and so the consequences were quite similar. The people were unable to pay back the sub-prime loans leading the economy into recession (The China Post, 2008). The number of banks collapsing after he financial crisis of 2007-09 has been increasing in the US, which highlights the fact that nothing was done by the US legislators to protect the depositors and investors of the banks. The prominent features of the recent financial crisis were the unemployment, tightening of banking regulations, and the low house prices, that negatively affected the public confidence. The recent financial crisis is linked with the housing industry and a high number of sub-prime mortgages which increased due to the elimination of the anti-usury law in the US (McCoy & Renuart, 2008). Another fact which contributed to the crisis was that leveraged loans are not as safe as they used to be. Main reason for this is that these loans were being issued with very little capital structure support and so their recovery rates were much lower in magnitude (Acharya, Philippon, Richardson, & Roubini, 2009). The following figure shows the prices of LCDX series from May 2007 to January 2009. It can be seen in the figure that the prices of LCDX began to drop significantly and was at a dangerously low level by January 2009. Figure 1. LCDX Pricing, May 2007 to January 2009. “The LCDX index is a portfolio credit default swap [CDS] roduct composed of 100 loan CDSs referencing syndicated secured first-lien loans” (Acharya, Philippon, Richardson, & Roubini, 2009, pp.18). Source: Bloomberg. Credit boom and the housing bubble are determined to be the main cause of the recent financial crisis. The banks began giving big loans to people who were not capable of paying the loan back on basis of their property. As the property price decreased, the borrowers had nothing to pay back the banks and an increase in the number of defaulters was noticed. In simple words these financial firms “took a huge asymmetric bet on the real estate market” (Acharya, Philippon, Richardson, & Roubini, 2009, p. 110). The securitization of loans made it very hard to detect the associated risks in the whole financial system, increasing the number of sub-prime mortgages (Bicksler, 2008). Northern Rock, a UK mutual building society, converted into a bank in 1997, and was the first bank to be influenced by the financial crisis. After converting its status to a bank, Northern Rock did not pay much attention to all the options available in the banking business and was more focused on issuing sub-prime mortgages for the purpose of housing. The bank, like many other banks in the US and UK, adopted the strategy of securitization and funding completely based on the securities that were backed by sub-prime mortgages. The bank was well reputed in the financial markets and had never been questioned on the quality of its assets (Llewellyn, 2010). Even though Northern Rock was not exposed to the sub-prime mortgage market in the US, it still was unable to avoid getting caught up in the financial crisis because of its securitization strategies. When the financial crisis first emerged in 2007, Northern Rock was unable to pay back the loans to the money market and was forced to receive financial assistance from the Bank of England to replace funds that could not be raised by the bank. This resulted in panic which was soon spread leading Northern Rock to a bank run. The bank failed to securitize and issue new mortgage assets while it also had to face the increase in the interest rates. The bank also failed to convince its customers that the bank was solvent and speeded up the downfall. How the Financial Crisis Could Have Been Avoided By the Northern Rock? The main cause of the financial crisis was the high number of sub-prime loans that were given out to many people for the purpose of housing. The whole crisis could have been avoided by closely regulating the institutions that made bad decisions about giving out loans and in the case of Northern Rock, by focusing on its liquidity management. The signs of the financial crisis were apparent back in 2006 when foreclosure of a large number of houses was seen and it was apparent that many other houses were going to end up the same way. The main cause of the crisis faced by NR was its business model that had many flaws. NR was the only bank in the UK, the main business strategy of which was securitization which is why it was the first bank that became bank run right in the beginning of the financial crisis. This could have easily been avoided by the bank by making a stronger business model. Securitization shouldn’t have been the centrepiece of their model because of the high risks related to it. The bank should have had a business model that could survive in the time of stress. Another root cause of the downfall of NR was its exposure to the MBS market. In the summer of 2007, the credit markets dried up as a result of the decline in the value of the property. This resulted in confusion in the value of mortgage backed securities globally, which resulted in funding problems for the bank. NR could have avoided the crisis by reducing its exposure to the risks in the MBS markets by supervising the loans it had given. The governing board of the bank failed to successfully monitor the risk model of NR. Conclusion It can be concluded that the financial crisis of 2007-09 was not the result of a single bad decision but instead was a chain reaction to a number of bad decisions made many people. The root of which is the deregulation of the housing industry followed by the sub-prime loans given to people who could not afford it. After the burst of the housing bubble, the governments were left with a huge stock of houses with no buyers. The impact of the financial crisis was intense and far reaching, affecting many markets around the globe. The housing industry suffered the most along with the financial institutions. Many banks around the globe had to shut down, especially in the US as nothing was done to save them by the government. In Europe, much financial aid was given by the governments to help stabilize the economy. The financial crisis could have easily avoided had someone taken notice of the signs that appeared back in 2006. The crisis is, however, said to be over but its impact is still apparent in many economies. References Acharya, V., Philippon, T., Richardson, M., & Roubini, N. (2009). The Financial Crisis of 2007-2009: Causes and Remedies. Financial Markets, Institutions & Instruments, 18 , 89-137. Adeloye, M. (2009). The implication of global economic recession on sustainable housing in Lagos megacity. ISA INternational Housing Conference (pp. 1-15). Glasgow: ISA. Bank of England. (2008). 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