Origin of the 2007-2009 Global Financial Crisis - Essay Example

THE FINANCIAL CRISIS 2007-2009 The severity of the financial crisis of the 2007-2009 forced policymakers, academics, and regulators rethinking the contours of the present financial system. Moreover, this financial crisis severely affected financial markets and other diverse financial institutions. It is believed that the crisis started with the decline in the US housing prices and the associated increase in the delinquencies of the subprime mortgages. Thus, the understanding of this crisis and the responses of financial intermediaries and institutions such as Investment Banks, the Structured Investment Vehicles, Commercial Banks, Mortgage-backed Securities, Bond/Stock Rating Agencies, and other authorities can help investors and business decision makers to assess the financial risks and opportunities during the normal economic times. In addition, it’s difficult to understand the financial crisis of the 2007-2009 because the bank run was not publicly visible. Additionally, the financial instruments and markets were not that actively involved. In fact the run happened in the over-the-counter markets when financial institutions and firms ran on some of the financial intermediaries. The mainstream economics provides some of the analysis of the 2007-2007 financial crisis, notwithstanding, the observations of the Paul Krugman and The Economist. The New Keynesian School and the “New Theory of Intermediation” not only vividly provides the analysis of the contribution to the economic welfare that is provided by the financial intermediaries such as the banks, but also the account of how the dynamics that surround commercial banks can lead to bank failures, which can have implications on the real economy.1 Origin of the 2007-2009 Global Financial Crisis The 2007-2009 Financial Crisis is the most difficult task given that various commentators have chosen varied trends or events to identify the crisis. It is argued that the ultimate point of the origin of the financial crisis of the 2007-2009 was the credit boom that manifested itself in the extremely indebted economy of the US; and a very high appetite for the risk by investors. The 2006 real estate market collapse is the closest point of the origin of the crisis. The failure rates of the subprime mortgages are known to be the first symptom of the credit boom that tuned to bust. For instance, the Reserve Bank of Australia (RBA) (2007:3-4) provided an early argument that the increased delinquency rates on the United States subprime mortgages from the middle 2005 was the catalyst for the crisis. Further, from 2005-2007, the delinquency rates of the US subprime mortgages from the middle, increased from approximately 1.47% to 2.11%. 2 Therefore, due to the lack of the supervision and the weak monetary policy, the risk of the credit derivatives ended up becoming a systematic risk. Consequently, the mispricing in the capital markets became another underlying cause of the financial crisis. The residential mortgage delinquency rates led commercial mortgage delinquency rates throughout the financial crisis. However, it distinguished between the intermediate impact of the crisis on the financial markets and the “spill over effects” to the other economies. The general increase in the LIBOR-OIS spreads in the August and September 2007 was the first series of the events that constituted the emerging financial crisis. The financial factors of the crisis have been widely given a considerable attention by many commentators. However, there exists some ambiguity over the trend or event that marked the beginning of the crisis. Whilst the losses were majorly broad based and unanimously affected both the commercial banks and the investment banks, the investment banks were particularly affected given their high sizeable portfolios and high leverage of the structured credit products. While the financial institutions were suffering from the write downs, they were also being squeezed in the other areas too. For instance, the US investment banks recorded a loss of about $14bn while the six major commercial banks recorder a loss of about $6bn. The banks’ strategy of trying to unload the risk off balance sheet didn’t work well due to the awareness of the investors of the complexity underlying the various asset backed securities. The investors reacted with a sharp increase in the risk aversion. As the asset backed securities were brought back into the balance sheet, the banks reacted by declaring writedowns in accordance with the principle of the fair value accounting. Additionally, the banks reacted by selling the assets in order to reduce the leverage thereby setting in motion a vicious circle of the asset liquidation and the decline in the prices across a vast range of the assets. Financial integration played a key role in the spread of the crisis virtually worldwide. The banks’ undercapitalization greatly explains the persistance of the financial crisis and the continuing efforts by the government in injecting the vast sums of the public funds into the banks.3 The problem of the asymmetric information is linked to adverse selection and moral hazard. Adverse selection is the problem whereby the investors are unable to distinguish between the high-risk borrowers from the low-risk borrowers before making the investment. Moral hazard is the likelihood that one might take action after he or she has entered into a contract that may make the other worse-off. In the financial markets, the investors experience the problem of making sure that the borrowers use the funds as intended. During the period of the 2007-2009 financial crisis the high interest rates attracted the borrowers that were less creditworthy. A small business that is close to be declared bankruptcy was less concerned about having to pay the high interest than would a borrower in the better financial health. The moral hazard was also depicted in the stock market. The problem of the principal-agent problem was clear. The managers/agents were pursuing their own interests rather than those of the shareholders/principals. Question Two The concept of “Exchange Rates Assume there are two countries, The US and Bahrain” can be derived from the Purchasing Power Parity (PPP) that allows one to estimate the exchange rate between two countries /currencies can be in order in for the exchange rate to be in par with the purchasing powers of the two countries. This assumption helps to minimize the international comparison that arises due to the use of the market exchange rates. Additionally, this helps US and Bahrain in making comparisons because their exchange rates stay fairly constant. Exchange rates unanimously affect the Prices of the Goods and Services in US. An exchange rate is the number of units of one currency that is exchangeable for unit of the other. The United States uses a system of the flexible or the floating exchange rate that is determined by demand and supply of the dollars. One of the key determinants of the exchange rate is the differentials in inflation. As the general rule, the countries with a consistently lower inflation rates can exhibit rising currency value. In general, a weaker domestic currency can stimulate exports while making imports more expensive. The rise in currency value implies that the purchasing power increases relative to other types of currencies. Countries with higher inflation tend to depreciation in their currency in relation to their trading partners thereby experiencing increased price of the goods and services. For instance, high exchange rate in the US reduces the price of the imported goods and services and vice versa. Consequently, the increased prices of the goods and services make the US exchange rates to rise. While an increased demand for the imports for US goods by Bahrainis is an indication of the growing economy and robust domestic demand, it can also affect the exchange rates. However, it’s even better if these imports are made of more productive goods like equipment and machinery as this will improve the Bahrain productivity over the long-run. The increased demand of the Bahrain for the US imports implies that the US products are selling at relatively lower prices. This, therefore, implies that as Bahrain demands more and more of the US products, their demand for the US currency increases. This increase in the demand for the US currency by Bahrain pushes the price of the US currency higher, making their currency to appreciate. The result is the increased exchange rate between the US and Bahrain. The exchange rates and the interest rates are closely related. The “benchmark” interest rates from the central banks influences the retail rates the financial institutions charge the customers that are borrowing money. When the interest rates increases, so do the yields of the financial assets that are denominated in that currency; this subsequently leads to the increased demand by the investors causing an increase in value of the currency that is in question(Bahrain currency). If the interest rates on the financial assets of Bahrain are increased, it will lead to the appreciation of the exchange rates. The value of the currency may change, but usually in relation to that of the other currency. Pegged currencies are usually favored by the smaller, developing countries that desire to promote the stability of the currency so as to facilitate the international trade. Several advantages/benefits can be identified of the exchange rate pegs and in particular to Bahrain. First, is that the central bank credibility. The Bahrain’s central bank credibility can be improved by the anchoring of the exchange rate to a stronger currency like the US dollars. Secondly are the trade costs. The trade costs can be lowered by the reduction of the hedging and the transaction costs when Bahrain is trading with the monetary union. A good example is the European Union and the upcoming East African Monetary Union. The third advantage is the political reasons. Bahrain stands to improve its diplomatic influence or a precursor to the deeper union that characterizes these unions. For these reasons in explaining the prevalence of the pegs amongst the commodity exporters, one must argue that the commodities reduce the credibility of the central bank or the increased hedging or transaction costs. Fourthly, through pegging, Bahrain stands to benefit from the fixed exchange rate regime simply for the purposes of trade and export.4 This can subsequently help Bahrain in keeping the domestic exchange rate low. This can subsequently help it to support the competitiveness of its goods as they are being sold abroad. The pegged of currency for the Bahrain in terms of the US dollars not only adds to the earning outlook, but it also supports the rising standards of living and the overall economic growth of the country. Additionally, the country stands to benefit in the protection of its domestic economy. This is because the foreign exchange swings adversely affects the economy and its economic outlook. Therefore, by pegging its currency to the US dollars, the country stands to shield its domestic currency from the volatile swings thereby reducing the likelihood of the currency crisis. The main cost that Bahrain may incur in the event of pegging its currency to the US dollars is the need for it to maintain a large amount of the reserves, as its central bank will be constantly selling or buying the domestic currency. China is one of the perfect examples that is experiencing this. Before repealing of the fixed rate scheme in the 2010, the Chinese foreign exchange reserves significantly grew each year so as to maintain the U.S dollar peg rate. Thus, the increased currency reserves are likely to cause a monetary supply that can cause the prices to rise, which can consequently cause havoc to Bahrain. References Acharya, Viral, Thomas Philippon, Matthew Richardson, and Nouriel Roubini. "The financial crisis of 2007‐2009: Causes and remedies." Financial markets, institutions & instruments 18, no. 2 (2009): 89-137. Duca, John V., John Muellbauer, and Anthony Murphy. "Housing markets and the financial crisis of 2007–2009: lessons for the future." Journal of Financial Stability 6, no. 4 (2010): 203-217. Frenkel, Jacob A., and Harry, Johnson G. Eds. The Economics of Exchange Rates (Collected Works of Harry Johnson): Selected Studies. Vol. 8. Routledge, 2013. Read More