Causes of the 2008 Global Financial Crisis - Case Study Example

The financial crisis of 2008 has been one of the severest financial crises that the world bodies have faced since the depression of 1930. The causes which led to the financial crisis are still a topic of discussion but major factors which have been identified to lead towards the crisis are the failure of multinational companies, rapid decrease in the value of the assets, increase in government intervention all around the globe and a change in other economic activity which resulted in widespread depression. To deal with such a situation in the near future a market and regulatory changes have been made so that the chances of such a situation can be reduced (Wadhwani, 2008). This paper analyzes the different reasons which can be attributed to the global crisis of 2008 and linking the same with different macroeconomic and past findings so that future policies which will help to sustain such an economic depression can be developed. One of the prime reasons which have been identified for the global crisis of 2008 is the global housing bubble collapse. It was seen that the US housing prices on a national level collapsed by 40% which affected the securities which were linked to them causing great effect to the financial markets (Ryuhei, 2009). Stock markets all around the globe started to fall creating a liquidity credit in the market thereby affecting the liquidity position in the global economy. The US economy was experiencing heavy growth rates during the 1940’s which is shown in the chart below where the economy continued to witness rapid growth until the crisis Figure 1: US Financial Growth Rate till the Crisis The event before the crisis showed a period where the US housing prices were overvalued which led to the crash. The entire world fraternity was of the notion that housing prices always go up and don’t move downwards which led towards over valuation of the houses (Ahearne, Gagnon, Haltmaier and Kamin, 2002). Low initial rates on adjustable rate mortgages (ARM) and low down payment further ignited the situation as people with the motive of short term speculation indulged into activities which were improper. The housing bubble burst created a problem of refinancing and with continuous increase in the ARM people started to default in their payments as shown below Figure 2: Rate of change in house price. Shaded areas refer to recession. This further had an effect on the liquidity leading to minions of dollars being wiped off from the asset base. The series of incidents led towards a situation through which the world economy started to witness the beginning of the global crisis. This was a phase where the housing prices outpaced the economic growth and were increasing at a pace of 124% which further increased speculation activities and the linkage of different securities with the housing prices due to securitization further complicated the issue and created a stance where world economies started to witness a downturn and had an impact on economic growth (Dasgupta and Prat, 2006). The other reason which can be attributed to the global financial crisis was the availability of easy credit. Low interest rates ensured easy credit which made the Americans raise easy credit from the market. The perceived rate in 2000 was 6.5% and with the chances of the economy facing a deflation and the dot com bubble burst finally made the Fed lower the rate by another 1% thereby further ensuring easy credit. This led to a trade deficit which made the US financial assets prices to move leading to a decrease in the yield from government bonds (Honkapohja, 2009). The increase in the current account deficit forced the US government to borrow more and more money from abroad. The borrowed funds were used to finance the consumption expenditure instead of capital expenditure with the expectation that the prices would check and the economy would slowly be able to come out the current account deficit. The situation instead worsened which multiplied the complexities and led towards the crisis (Veron, 2009). The fact that the loans were unmanageable along with the inverse relationship between asset prices and interest rates multiplied the speculation activities and increased the risk thereby multiplying the chances of an economic crisis. The other reasons which have been identified to lead towards the global financial crisis are the increase in the subprime lending. Subprime loans are those which are riskier than conventional loans and arise due to poor credit rating of the borrower and lower down payment. It was identified that in 2004 subprime lending consisted of 20% of the US housing market (Sen, 2010). The prime reason which was attributed to the increase in the subprime lending was because of poor government policies and intensifying competition among the financial institutions. The relaxation of the net capital rules by Securities and Exchange Commission (SEC) increased the leverage for the banks thereby providing an opportunity through which they were able to raise easy money. This thereby provided more money to the riskier borrower who were unable to pay the credit in due time. This resulted in subprime defaults which increased to 25% in 2008 from 10% to 15% in 2006 (Barrell and Davis, 2008). This created liquidity crunch and led towards money being wiped off from the economies which thereby resulted in a subprime crisis and finally led to economic recession. Another reason which was identified and contributed to the global financial crisis is the increase in predatory lending. Predatory lending refers to a process of lending where people take loan for unscrupulous activities. One such example is the switch and bait techniques where loans taken at lower interest rates were swapped for higher interest rate (Ianchovichina and Sudarshan, 2007). This is a form of speculation activities people take loan and then pass on the same towards investment activities for a higher rate of return. People entering into such transactions looked at ensuring that no transactions were shown in the books which led towards false documentation and increase in frauds. This created a situation where money was squandered and the purpose was not recognized leading to an increase in unscrupulous activities which had an impact on the performance of the economy. This was backed by the fact that improper reforms and rules made it easy for people to misappropriate the funds. The lack of reforms to deal with the rapid changes which were seen in the banking sector multiplied the complexities. The creation of new accounting techniques which allowed off balance sheet financing was taken advantage of (Ghosal and Miller, 2006). Different financial institutions started to use this method as a form of financing and didn’t show the finances in the balance sheet or their financial statement. This increased the leverage for the financial institutions making them riskier as shown below Figure 3: Leverage in US Financial Institutions The increase in the leverage for five financial institution in US clearly highlights the manner in which leverage increased which multiplied the level of risk leading to more defaults thereby causing the financial crisis to hamper the growth of the economy (Barrell and Karim, 2008). The problem was compounded by the fact that financial deregulation was easy and common which made it easy for the financial institutions to raise the required finance. This ensured easy finances at predetermined rules and regulations which created a liquidity crunch and had an impact on the overall growth prospect of the economy. Another reason which can be attributed towards the crisis is the development of innovative financial products which were not tested and were new. Some of the products which were developed are ARM (adjustable-rate mortgage), CDO (collateralized debt obligation), CDS (credit default swap), CMO (collateralized mortgage obligation) and MBS (mortgage-backed security). The development of different innovative financial products increased the risk as reforms and regulations to check the risk associated with the same was not developed (ESCAP, 2008). This created an atmosphere where increased securitization led towards an instance where risk multiplied and finally had an effect on the prices of securities. This led to a situation where the prices of security started to fall rapidly leading to a crash in the stock market (Nanto, 2009). This wiped out the little liquidity which was present in the system and further raised alarms and made it difficult for the world bodies to deal with the financial crisis which the economies were facing. The financial crisis of 2008 was thereby a culmination of different factors which were through easy financing, easy credit availability and poor government regulations. To deal with such a crisis in the future it is important that the world economies look at developing market and regulatory developments so that the economies become better placed and are able to deal with the looming financial crisis. Working on the different aspect and strengthening the overall reforms which will be aimed at strengthening the world economies will provide the required impetus through which such a situation is better dealt in the future. This helps to draw the required reforms for the future through which such risk gets reduced and the overall impact for the economies is positive leading to better growth and reduction of financial crisis in the future. References Ahearne, A., Gagnon, J., Haltmaier, J. and Kamin, S. (2002). Preventing Deflation: Lessons from Japan’s Experience in the 1990s. International Finance Discussion Papers 729 (Washington: Board of Governors of the Fed, June) Barrell, R. and Davis, P. (2008). The Evolution of the Financial Crisis of 2007-8, National Institute Economic Review 2008, 206, 5 Barrell, R. and Karim, D. (2008). Could Early Warning Systems Have Helped to Predict the Sub-Prime Crisis? National Institute Economic Review 2008, 206, 35 Dasgupta, A. and Prat, A. (2006). Financial equilibrium with career concerns. Theoretical Economics 1, 67-93 ESCAP, (2008). Economic & Social Survey of Asia & the Pacific 2008: Sustaining Growth and Sharing Prosperity, United Nations, New York. 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