The Main Triggers of the 2007-2008 Financial Crisis Identified by Alan Blinder in After the Music Stopped - Coursework Example

Factors that triggered the 2007-2008 financial crisis Introduction The paper assesses and discusses various causes of financial crisis as highlightedby Alan Blinder in his book “After the music stopped”. Additionally, the paper will evaluate perspective and contribution of the US policy makers, presidents, the Federal Reserve and the US Treasury in this regard. Seven causes of financial crisis Housing debt and housing bubble Figure 1 (University of Dayton Law Review, 2009) The housing bubble initiated parallel to the stock bubble in the mid 90s. Higher stock returns made wealthy consumers invest significantly in real estate property such as houses. The sudden increase in demand triggered the property bubble, as supply of housing properties was observed to be relatively fixed in the short run. Consequently, increase in demand and price of the houses can be observed in figure 1. Researchers observed that, instead of controlling their purchasing habit, consumers incorporated price rise in their expectations. The expectation of future price rise made consumer invest more in properties even if that was based on loan. Different data sets of that period suggest that housing bubble was crated only based on speculation rather than fundamentals of the property market. The Federal Reserve further contributed and fuelled the housing bubble by reducing various mortgage interest rates. The Chairman of the Fed further suggested to consumer to invest more in adjustable rate mortgages instead of fixed rate mortgages. Extraordinarily, low level of interest rate made consumers invest more and more and as a result, consumption was observed to be booming during that period while saving declined to a rate less than 1%. It was further observed that, more than 80% of housing mortgages and subprime mortgages were funded by private institutions. It was also observed that, the US policy makers did not pay any heed to the growing disequilibrium of consumption and saving; instead, GSE securitisation of mortgaged backed securities was replaced by unregulated securitisation (Baker, 2008; University of Dayton Law Review, 2009). Leverage Figure 2 (The Wall Street Journal, 2014) Leverage is a provision that permits a financial institution to raise its potential gains or losses regarding a particular situation or product beyond the feasible level that would be possible with a firm’s own funds or assets. Leverage can be of three kinds, namely, balance sheet, economic and embedded leverage. Balance sheet and economic leverages are most direct and common form, while embedded leverage is an indirect leverage provision which is created when market exposure of a firm is significantly higher than underlying market factor such as security. During the financial crisis of 2007-08, almost all private financial institutions was observed to have exposure to significantly high level of embedded leverage multiple layers structured products (World Bank, 2009). Figure 3 (Source: Federal Reserve Bank of Boston, 2009) It was also ascertained that, during the period of financial crisis, all the three kind of leverage coexists due to excessive trading of various structured financial products. High level of unpredicted financial exposure was a consequence of heavily unregulated financial sector and unprecedented financial innovation, which however, was ignored by the Fed as well as the US Treasury. Most financial institutions were found highly levered due to various off-balance sheet transactions and MBSs (Mortgage backed securities) and SIVs (Structured investment vehicles). Reports suggest that, failure of investment banks such as Lehman Brothers, Merrill Lynch and Bear Stearns could be blamed on the Securities Exchange Commission (SEC) because, during 2004, the organisation changes certain rules and allowed these prominent investment banks (including Goldman Sachs and Morgan Stanley) to keep the leverage by more than double amount in their balance sheet (Miles, 2011). Shadow banking In past one decade, dramatic transformation has been observed in the financial sector all over the world. In this regard, shadow banking is considered as one of major failures of the financial system that caused the financial crisis of 2007-08. Shadow banks started gaining attention of economists as their role in conversion of home mortgages to securities increased considerably since 2004. During this period, the traditional banking system was replaced by an innovative model based on the philosophy “originate and distribute”. A continuous process of unregulated financial innovation resulted in creation of mortgages and loans and selling them as securities to various investors. These structured products were mostly sold by the name of collateralised debt obligations (CDOs) where banks and other financial intermediaries after keeping their spreads, distributed the principle and interest related to the mortgages to the investors (Brunnermeier, 2008). Between 2005 and 2008, shadow banking activities occupied greater share of business than the traditional banking activities (The Economist, 2013). Figure 4 (Source: The Economist, 2013) Prior to the financial crisis, practice of credit risk transfer heightened significantly and remained unchecked by the governing authorities such as the Fed, the US Treasury and the SEC. Reports by IMF suggest that, during 2007, the net worth of the global shadow banking system was as high as $62 trillion which reduced to $59 trillion at the time of the crisis. The shadow banking system comprised about 27 percent of total financial intermediation during 2007. A number of commercial investment bank and their shadow entities collapsed during the crisis because, investors started withdrawing fund when they raised doubts about the actual worth of the CDOs. Consequently, the highly geared banks had to pay them by liquidating their real assets as the real worth of CDOs was equivalent to zero (Kodres, 2013). Disgraceful practice of subprime lending Figure 5 (Source: Levitin and Wachter, 2012) According to Bianco (2008), there are a number of factors that contributed towards the subprime crisis and this included housing bubble, interest rate that touched historically low value, Alan Greenspan’s modification in Fed’s Policies and the ultimate bubble bust. The author observed in the research that, subprime lending was an essential factor that contributed towards increased home ownership and demand of housing properties during the bubble creation phase. It can be seen in the figure 5 that house ownership increased from about 8% in 1997 to 69% in 2006 and share of subprime lending grew at the same rate during the same time span. In addition, it was also observed that, house buyers took advantage of high value of their property and low interest rate to refinance a second or a third property on mortgage. Consequently, in 2007, household debt in the US was about 130 percent of net income of consumers. It is noteworthy that, subprime lenders are generally those who have poor credit histories and the interests charged on these loans are generally a few percent higher than that on prime loans. Under traditional banking, financial institutions generally avoid indulging in subprime lending in order to keep a check on their non-performing assets. However, the subprime market grew from 9 percent to 25 percent between 2002 and 2005. Ironically, the condition of labour market was worse as wages lagged and job were downsized due to recession during the peak of bubble, yet subprime and Alt-A category loans comprised more than 40% of total loan issued during that period (Levitin and Wachter, 2012; Bianco, 2008). Financial complexity Financial systems are relatively complex and this complexity is reflected in two forms, either through the structure of financial system or in the form of financial instruments that has been developed as a result of financial innovation. Financial instruments such as derivatives were once referred as financial weapons of mass destruction. Studies suggest that, the instruments created out of financial innovation were highly unregulated and during 2008, the net worth of these instruments were around $60 trillion from $6 trillion in 2004 as it can be seen in the figure 6. Instruments such as Credit default swaps (CDS) also played a significant role in this regard (Risk Management Society, 2013; University of Maryland, 2010). Figure 6 (Source: Federal Reserve, 2013) Organisations such as, American International Group (AIG) were observed to be heavily involved in underwriting CDSs as during good time, the company gained significant amount of revenue therein. During that period, AIG underwrote more than $80 billion CDS with reserve of on $20 billion. The insurance giant was on the brink of collapse as these CDS were bought by everyone ranging from bankers, lobbyists to investors. AIG was bailed out by the US Treasury as a number of large banks were heavily dependent on the survival of the company and US economy would have gone depression for an extremely long period if, AIG collapsed. In this regard, the US policy makers were to be blamed as well, because legislation regarding regulation of financial section that was passed in 2000 very well exempted the OTC derivatives from various disclosures and regulatory rules such as, meeting capital adequacy requirements (University of Maryland, 2010). Poor incentive based compensation structure and role of rating agencies The sudden surge of excessively risky loans was introduced and nurtured in the financial system only because of high level of misplaced incentives flow from various sectors for selling and financing housing mortgages. Appraisal was recognised as the first place where incentives were observed to be misplaced significantly. During the housing bubble, it was found that, mortgage issuers earned their incentives on the basis of the amount of mortgages they created instead of holding the same. The same trend was applicable for appraisers as well. Baker (2008) revealed that, appraisers got greater amount of incentives when they adopted high side bias in the appraisals. The securitisation process of the secondary market reflected greater degree of incentive misplacement. It was noticed that, the secondary market was responsible for providing incentives to mortgage issuers for approving mortgages where they had perfect knowledge of borrowers’ inability to payback. The next stage involves banks where they purchased these loans to create Mortgaged Backed Securities (MBS). These banks also earned significant amount of incentives from various investment banks in terms of fees for processes the MBS instead of hold them. For banks, selling MBS of poor quality was a critical issue and they needed appropriate credit rating for convincing consumers. Banks requested credit rating agencies to rate this bond and high rating invited greater incentives. Consequently, even poorest quality MBS were rated as AAA by prominent credit rating agencies. The banks created CDOs which were essentially a mixture of MBS and other classes of assets so that layered financing products can be offered. Following the CDOs, CDS came in the market so that questionable quality of CDOs is hedged from the investors. The underwriters of CDS were also compensated fairly well for promoting CDOs. Between 2004 and 2007, it was observed that, intensive structure and compensation packages placed significant emphasise on large scale premiums and bonuses that executives in the financial sector earned from short term profits. Besides the executives, the CEOs of most financial institutions also earned millions of dollars as incentive for selling the MBS. The same holds true for a number of hedge fund managers of many bankrupt companies (Baker, 2008). Recommendations by the author Alan Blinder provided in his book a set of ten steps also known as ten financial commandments to prevent the financial industry from future crises. The author has advised the regulatory authorities related to financial sector to not forget the consequences of the financial crisis of 2007-08 and have asked for greater degree of intervention and minimum level of self regulation. The author also suggested companies should treat shareholders with utmost respect and strengthen their risk management process. Leverage has been advised to keep at minimum and derivatives should be regulated and traded at exchanges. The author also recommended to register every asset on the balance sheet and to fix perverse compensation. He further recommended consumers to check sources, prior investing into any securities (Economist’s View, 2013). Reference list Baker, D., 2008. The housing bubble and the financial crisis. Real world Economics review, 46, pp.73-81. Bianco, K.M., 2008. The subprime lending: causes and effects of mortgage meltdown. [pdf] CCH. Available at: [accessed 31 October 2014]. Brunnermeier, M.K., 2008. Deciphering the 2007-08 Liquidity and Credit Crunch. [pdf] Princeton University. Available at: [accessed 31 October 2014]. Economist’s View, 2013. Financial collapse: a 10-step prevention plan. [online] Available at: [Accessed 31 October 2014]. Federal Reserve Bank of Boston, 2009. Could a Systemic Regulator Have Seen the Current Crisis? [online] Available at: [Accessed 31 October 2014]. Federal Reserve, 2013. Interconnectedness and Systemic Risk: Lessons from the Financial Crisis and Policy Implications. [online] Available at: [Accessed 31 October 2014]. Kodres, L.E., 2013. What is shadow banking? [online] Available at: [accessed 31 October 2014]. Levitin, A.J. and Wachter S.M., 2012. Explaining the housing bubble. Georgetown Law Journal, 100(1177), pp. 1179-1258. Miles, D., 2011. What is the optimal leverage for a bank? [online] Available at: [accessed 31 October 2014]. Risk Management Society, 2013. AIG, Credit Default Swaps and the Financial Crisis. [pdf] Risk Radar Report. Available at: [Accessed 31 October 2014]. The Economist, 2013. Financial regulation: Out of the shadows. [online] Available at: [[accessed 31 October 2014]. The Wall Street Journal, 2014. Debt Rises in Leveraged Buyouts despite Warnings. [online] Available at: [Accessed 31 October 2014]. University of Dayton Law Review, 2009. The Great American Housing Bubble: Re-Examining Cause and Effect. [pdf] University of Dayton Law Review. Available at: [Accessed 31 October 2014] University of Maryland, 2010. The Role of Derivatives in the Financial Crisis. [online] Available at: [Accessed 31 October 2014]. World Bank, 2009. Crisis response: public policy for the private sector. [pdf] World Bank. Available at: [accessed 31 October 2014]. Read More