Analysis of Financial Crisis and Corporate Finance - Coursework Example

Financial Crisis and Corporate Finance Table of Contents Introduction 3 Characteristics of Recession 3 The Great Depression(1930) 4 Financial Crisis of 2008 5 Causes of the Financial Crisis 5 Mechanism of the Crisis 6 Consequences 7 Role of Government 8 Corporate Finance 8 Conclusion 9 Bibliography 10 Introduction The world is said to have encountered the most severe financial shock of all times. The present financial recession was initiated by the American economy. However, the whole world came under the trickledown effect. Therefore, the recession of 2008, could be aptly called a “Global Recession.” The improvements in communication and information technology have merged the world into one whole unit. Trade among different countries has been facilitated. Moreover, financial transactions can take place between two countries oceans apart. Therefore, the whole world got entangled up into the financial crisis along with United States of America. Characteristics of Recession A recession is usually represented by business cycles. The business cycle incorporates three periods throughout the cycle. It includes recession followed by recovery and then trough (peak). This cycle repeats and the trough slow down eventually resulting in a recession. The recession period is characterized with very slow economic activity. An economic recession neglects the economic concept of the Philip’s Curve and the indirect relationship between inflation and unemployment. Instead, the prevalence of high inflation rate and a high unemployment rate makes the situation worse. During this period there is low consumer demand which is mainly due to two reasons: 1) Lower Purchasing Power due to high inflation and low income 2) Uncertainty about the economic conditions The consumers tend to save (if they have enough income) for future purposes as high uncertainty prevails in the economy. The extent of recession may vary from country to country and so does the period from where it would start recovering. The Great Depression (1930) The concept of recession of financial crisis is not novel for the world. America in 1930 experienced the greatest recession which was termed as “The Great Depression.” This is referred to as the darkest period in the history of America. The American economy was experiencing a boom in 1920s. Industrial output was increasing in spite of the not very high demand from the consumers. Ford Motors launched its car that was affordable by ordinary people as well. The manufacturers were encouraged to avail credits for their production which in the other hand did not have demand to that extent. Moreover, there was a persistent crisis in the agricultural sector. This might have contributed towards the low demand. The economy was also inflated due to the credit boom which was due to the help provided to UK whose economy was facing persistent deflation accompanied with high unemployment. On October 29, the famous Black Tuesday, the stock market crashed eroding the confidence of people. An atmosphere of uncertainty rose and consumer demand fell down considerably. In 1930, several banks went bankrupt. Some called in for the loans they had rendered also when the people did not have the financial strength to pay. This pressure accumulated with uncertainty of declaring bankruptcy, people started collecting their savings from the banks. The persistent fall in savings resulted in low investments. The combination of low output high unemployment was severe. Moreover, reduced saving and thus, low investment posed a negative multiplier impact on the economy. Thus, recession got severe and transformed into a Depression. Some measure were taken by President Roosevelt to rectify the deep crisis but the release of the U.S economy is credited to the World War II when there was a huge demand for ammunitions and weapons from the European World. Financial Crisis of 2008 The recent financial crisis is most commonly attributed towards the house loans/mortgage market and the credit crunch. However, this is not the only cause of the recession that is prevailing today. There are several other background causes that led to this devastating financial position of the world. Causes of Financial Crisis According to Marxian School of thought the fall in the rate of profit from about 22% to 12% caused the twin evil of high unemployment and inflation (Moseley, 2009). This resulted in low real wages which meant lower savings and a decline in the investment of the country. The solution that was adopted were the expansionary fiscal and monetary policies which did result in higher employment and output but at the same time exacerbated the inflation. In order to raise the profits capitalists focused on cost cutting techniques. These mainly related to cutting the wages of workers by introducing speedup techniques, lowering down health premiums /health benefits and retirement benefits (Moseley, 2009). This overtime did result in the expected profits for the American capitalists who had excess money in their hands. However, investment did not increase that greatly as the earned profits were not invested in any sort of ventures. The profits were distributed and conspicuous and luxury oriented consumption was done. The main problem that arose was that the capitalists had money to lend but there were no borrowers. Therefore, they decided to focus upon the general public and introduced the concept of mortgage loans. This led to a revolution in the credit market and bank lending to households increased from 30 percent in 1970 to 50 percent in 2006. The total value of home mortgages tripled between 1998 and 2006. And the ratio of household debt to disposable income increased from 60 percent in 1970 to 100 percent in 2000 to 140 percent in 2007 (Moseley, 2009). With time and lots of money at hand the credit worthiness of borrowers was given a back seat and NINJA (no income, no job, and no asset) loans were granted. It was believed that the price of houses would increase persistently and so initially loans were granted at a teaser rate (low rate). It was believed that when the price of houses would rise, the mortgage could be renewed by paying the previous one. Mechanism of the Crisis The housing market crash was the focal cause of the financial crisis. By 2006 the house prices started to decline. The real estate market crashed. The problem arose due to the securization of the house mortgages. Commercial Banks in the United States started selling these mortgaged loans as securities to investment banks not only in USA but all over the world. The securities were rated as low risk AAA securities and passed on. The commercial banks and the mortgage companies greedily passed on loans without proper checking the credit worthiness. Investment banks also gained from this. However, the final receiver of the mortgage security was contented on the AAA rating, unknowing that the rating companies were private and welcomed income. Therefore, the rating companies had a boom period during this time. By 2007 the prices of the houses fell severely. The NINJA borrowers failed to pay back their loans. This triggered the beginning of the recession as the banks had no money left. The defaulters on loan grew day by day. Due to a lack of liquidity the banks stopped lending and hence, people who needed loans from the bank for their business operations had nothing to do. The credit crunch required maintenance capital to loan ratio by reducing lending. Consequences The global impact has been severe. Consumer confidence has been thrashed. There is low aggregate demand in the economy. The interest rate in U.S has fallen down to about 1% and thus, consumers are not willing to save. Bank borrowing is minimal. The low liquidity in the economy is producing a negative multiplier due to low investments in the economy. Downsizing has been at its peak with unemployment rate being 9.4% in December 2010(Bureau of Labor Statistics).The Consumer Price Index has been 0.4 which has been greater than the previous years (Bureau of Labor Statistics). Workers are being laid off from jobs and some are working overtime without extra salary. Moreover, the filing of bankruptcy under Section 11 by several market leaders such as Lehman Brothers and General Motors resulted in loss of jobs to many. This has further added to the inability towards non-payment of loans. The crises have had spillover effects over the whole globe such as the Greece Crisis. Role of Government The role of the government has been useful but not to a great extent. According to Richard C. Cook, “Everything the Federal Reserve and the U.S. Treasury Department are trying to do to stem the tide of the self-destructing U.S. financial system is a stopgap. They are locking the barn door after the horse—many horses—have already escaped, and they know it.” The government tried to adopt expansionary policies. Not only this but the Fed realized its role and for the first time in history, leant to investment banks. It also bailed out Lehman Brothers and the Insurance Company AIG. The Democrats coming into power realized the vast disaster financially. They have introduced health reforms which would be increasing government spending and might serve as a stimulus to increase demand and reduce the effects of the negative multiplier. Corporate Finance Corporate Finance deals with the strategic financial issue in order to add value to firm/country. Presently, the U.S banks are reluctant to provide loans to the public. Although the government did somewhat show a willingness towards the loans to be given out. But the banks are in no position to do so. The corporate investment in the field of Real Estate had been immense. The real estate bubble has said to be artificial by many analysts. According to Michael Burry (2010), ““It’s an artificial market. The private mortgage market is practically nonexistent; 96-97% of mortgages are flowing through Fannie and Freddie now. I think Fannie and Freddie are exercising a tremendous amount of power over the market by withholding properties from sale and not forcing foreclosure, the foreclosure process (Burry,2010). The investment at this stage is stagnant. Previously there has been great investment. Today savings are not existent due to downsizing. Moreover, people are reluctant due to the uncertainty in the market. Therefore, in order for the corporate finance to flourish and investments to take place some significant steps are essential. Conclusion It is a fact that consumers are risk averse. The prevailing conditions would not emerge as very demand yielding. The government needs to take some crucial steps. Demand side stimulus is the requirement of the economy at this time. The government needs to increase its spending, just like President Roosevelt did during the 1930 by provision of jobs for the people. The Real Estate Market should be regulated. Houses in my opinion are a necessary good. Like health and education, the government should pick up responsibility of providing it. The mortgages if administered through government loans could have been more viable and prosperous. Social Conventions and social responsibility fall upon humans. Therefore, the citizens should realize their civic responsibilities towards re-payment of loans. Bibliography (2009), Causes of Great Depression Available from: http://econ.economicshelp.org/2008/10/causes-of-great-depression.html [Accessed: March 27, 2011]. Moseley, F. (2009), The U.S. economic crisis: Causes and solutions, International Socialist Review (64). Available from: http://www.isreview.org/issues/64/feat-moseley.shtml [Accessed: March 27, 2011]. Cook, R.C. (2008), Impacts of the Financial Crisis: The U.S. Is Becoming an Impoverished Nation, Center for Research on Globalization. Available from: http://www.globalresearch.ca/index.php?context=va&aid=10271 [Accessed: March 27, 2011]. Stewart, H. (2008), IMF says US crisis is 'largest financial shock since Great Depression'. Available from: http://www.guardian.co.uk/business/2008/apr/09/useconomy.subprimecrisis [Accessed: March 27, 2011]. (2008), US in 'once-in-a-century' financial crisis: Greenspan, Breitbart. Available from: http://www.breitbart.com/article.php?id=080914181841.fsmkqu8s [Accessed: March 27, 2011]. (2010), Michael Burry on the Financial Crisis, the Housing Market, and the Fed, Wall Street Pit. Available from: Michael Burry on the Financial Crisis, the Housing Market, and the Fed [Accessed: March 27, 2011]. Read More