Combatting Global Financial Crisis - Case Study Example

POLITICAL ECONOMY OF MONEY AND FINANCE (Student Name) (Course No.) (Lecturer) (University) (Date) The 2007-2008 global financial crisis is the worst economic crisis every experienced in history since the 1930s Great Depression. The crisis saw the collapse of the major financial institutions, prolonged unemployment, extremely high-interest rates, very low investment rates and a general drop in worldwide stock markets. Following failures in the major businesses, the government together with businesses took the initiative to respond to the financial crisis and also took measure to prevent future financial crisis. This study examines securitization as a measure taken to combat the financial crisis. The study also analyzes the role played by securitization in the 2007-2008 global financial crises. Securitization Securitization refers to a process where assets and future cash flows are converted into marketable securities (Jobst, 2008). Various cash flows and financial assets are pooled together and converted to financial instruments which will be repackaged and sold to investors as securities. Assets that are securitized are those that produce cash flows. Securitization, therefore, promotes liquidity and funding in the marketplace as assets are converted into cash without losing their values. Illiquid assets such as mortgages are can be sold, and the investor in the mortgage gets the highly liquid money (Levinson, 2005, pp.94). Securitization process Securitization involves mortgage-backed securities and asset-backed securities. Mortgage-backed securities The mortgages offered by banks and other financial institutions are highly illiquid. Individual retail investor or a group of investors purchase the mortgage as a type of bond, and the bank maintains it as an asset in its balance sheet till maturity. The bank blocks the funds in the loan so as to meet its growing fund requirement. Securitization of the mortgage-backed securities occurs when the bank unlocks the blocked funds (Levinson, 2005, pp.95). Several parties are involved in the securitization process, and these include the originator (the bank or financial institution holding the assets), special purpose vehicle (the facilitator of the deal) and the investor. When the assets mature, the originator transfers the blocked funds to the special purpose vehicle who then transfers it to the investor. In this way, securitization turns the mortgages into liquid assets. The financial institution also gathers a number of mortgages into a pool and divides the pool into shares. The institution will then sell the shares as securities, and the buyers of the securities have the right to collect the payments from mortgage payments (Jobst, 2008). The financial institution, therefore, creates cash and can also use the same money to lend to the home buyers. Asset-backed securities Investors use asset-backed securities as an alternative to investment in corporate debt. Asset-backed securities are backed by a number of assets such as loans, company receivables, leases, credit card debt among others. The financial institution pools a group of illiquid assets which cannot be sold individually into financial instruments (Levinson, 2005). The originator of the loan turns the loan into marketable securities. The special purpose vehicle buys the loans and securitizes them by selling them through a trust. Once the trust has purchased the loans, he repackages them as interest-bearing securities and gives them to the investment bank which sells the securities to the investors by underwriting them. The interest-bearing securities are insulated by the special purpose vehicle which provides the bankruptcy remoteness. Roles played by securitization in the global financial crisis of 2007-2008 The rise of securitization The issue of Private-label mortgage-backed securities and collateralized debt obligations took place from 2003 to early 2007 (DiMartino & Duca, 2007), and the issuance of these securities grew exponentially during this period. The purpose of the mortgage-backed securities and collateralized debt obligations was to expand the household loans. These securities were very attractive because they offered higher rates of return following the high-interest rates on mortgages. More investors purchased their securities due to extremely high rates of return. Subprime mortgage lending rates were very high, but investors still managed to obtain the mortgages as financial institutions extended loan facilities to them. The U.S credit lending capacity increased as they were able to access vast amounts of money from fast-growing economies and other oil-exporting countries like Dubai between 2002 and 2004 (Rosen, 2007). Securitization facilitated greater credit supply to the ultimate borrowers. It is however very unfortunate that the financial institutions could lend money without considering the creditworthiness of a borrower. They cared less if the borrowers were likely to default their loans. The financial markets experienced an influx of traders who wanted to take advantage of making riskless profits. These persons engaged in unsound risk management practices as they did not mitigate risks as they conducted transactions. Their riskless trading coupled with excessive leverage contributed to the vulnerability of the financial systems (Montgomery, 2010). The traders did not exercise proper due diligence, and thus, their transactions involved reckless decision making. They did not give a damn after all the were taking no risks and the returns were very high. As fate would have it, the high returns from securities did not last long. Mortgage originators started engaging in unethical practices by passing bad loans to security mortgage issuers. The security issuers, in turn, packed the loans into risky securities and sold them to unsuspecting investors. Loan originators extend loans to borrowers without caring if the borrowers were likely to default as they did not have the intention to hold on to those mortgages or the financial products produced from those mortgages. Flaws were evident in corporate governance of the financial institutions since there was a lack of transparency. There were complexities in the securities held and off-balance sheet arrangements, and this is believed to be what contributed to bankruptcy. Accountants used complex securities and off balance sheet derivatives. Policy makers had very little understanding of the financial system and thus did not recognize the roles played by investment banks and hedge funds. No strict regulations were imposed on financial institutions, and they, therefore, behaved recklessly. How securitization resulted in 2007/2008 financial crisis As financial institutions extended more loans to the borrowers at high-interest rates, the households become increasingly indebted (DiMartino & Duca, 2007). The repayment of loans was very expensive, and the economy suffered the recession. It reached a point where households could no longer pay their debts and a significant number of the major financial institutions that originated and securitized the mortgages became bankrupt, were forced to merge or bailed out (Montgomery, 2010, pp.108). The bankruptcy resulted in a significant number of the collapse of large financial institutions, for instance, the U.K Mortgage Bank. The high rates discouraged borrowing and thus investments remained at a standstill. Some resources remain unutilized whereas some capital goods remained unsold. For this reason, most individuals could not find jobs. Factories were forced to declare some of the workers redundant because they could not afford to pay them. Households were there forced to reduce their spending on businesses, and this resulted in the collapse of many firms. Consumers faced severe global recession but had little about it. A decline in the market value of subprime mortgages was also evident. Loan originators began resetting adjusted rate mortgages at extremely high-interest rates, and the consequence of this move is greater monthly payments (McKenzie, 2009). Investors could no longer purchase mortgage-backed debt and other securities. The private financial system refused to support lending, and it, therefore, became very hard for borrowers to refinance their loans. This problem was rampant in the economies of Europe and U.S. As the world economy entered into a great recession period, economic growth stagnated (Rosen, 2007). Firms reduced their production capacity, and this resulted in the loss of gross domestic product. U.S was the most troubled nation as housing prices fell below the market value and U.S stock fell at the same time too. Unemployment continued to elevate, and life became much harder for households. The disposable income was too small to cater for their household consumption. Securitization also contributed to the global financial crisis since it did not consider the time value. A number of asset-backed securities had shorter amortization periods in comparison to conventional mortgages, and this increased the risk of loss. It is evident that securitization resulted in misaligned incentives as it amplified systemic risk by concentrating it on the financial sector (Rosen, 2007). As a consequence of this, the financial sector suffered significant turmoil. The securitization process did not consider the matching principle while converting assets to marketable securities. Banks were taking long-term liabilities while their balance sheets had more short-term assets than the long-term assets. Maturity matching was the biggest problem to the financial institutions since they could not service their long-term liabilities. The banks did not have enough current assets to meet their obligations and were therefore declared insolvent. Some funding markets were illiquid and could not roll over their maturing liabilities. The securitization process was characterized by a conflict of interest as it reached a point where originators and special purpose vehicles were offering low-quality mortgages. They took advantage of the information asymmetry since investors had limited access to the information generated by quality control firms. The unscrupulous arrangers provided misleading information to the unsuspecting investors, and thus investors’ decisions were uninformed. They, therefore, bought securities that saw them lose their money. Credit rating agencies are however to blame for this. Another significant problem experienced with the securitization that led to the financial crisis is the failure to diversify the investment portfolio. The private securitization concentrated on non-traditional securities and investors purchased more of these securities than the traditional private securities (McKenzie, 2009). The investors’ portfolios were not well diversified, and this exposed them to high risks and losses. The spread between these nontraditional securities was great and was characterized by high market variations. The poor performance of the securities resulted in the loss of consumers’ investments. Consumers’ loss in confidence in financial institutions following the losses in the mortgages changed the consumers’ saving behavior. As consumers saw large financial institutions collapsing, they resolved to hold their cash rather than investing them in banks. The gap between the demand of money by borrowers and supply of money by banks and other financial institutions widened since banks did not have sufficient money to create credit. The economy remained at a standstill since the supply of money became a big problem. Conclusion Securitization is attributed to be the cause of the world financial crisis of 2007/2008. However, the biggest blame lies on the part of supervisors and regulators because they failed to monitor the activities involved in the securitization. Securitization has proven to be beneficial as it provides liquidity in the market. However, stringent measures need to be put in place to ensure that there are no selfish interests by the trading parties. Be doing this, the economy will not land in a similar economic crisis. References Debelle, G. (2009) ‘Whither securitization?’, Reserve Bank of Australia Bulletin, December, pp. 43-53. Retrieved at: http://www.rba.gov.au/speeches/2009/sp-ag-181109.html DiMartino, D., and Duca, J. V. (2007) ‘The rise and fall of subprime mortgages’, Federal Reserve Bank of Dallas Economic Letter, (2:11), pp. 1-8. Retrieved at: https://www.dallasfed.org/assets/documents/research/eclett/2007/el0711.pdf Jobst, A. (2008) ‘What is securitization?’, Finance & Development, (45: 3) Retrieved at: http://www.imf.org/external/pubs/ft/fandd/2008/09/basics.htm Levinson, M. (2005) ‘Securitisation’, from Guide to Financial Markets, Profile Books, pp. 94-114. Lee, M. (2007) ‘Subprime mortgages: a primer’, National Public Radio. Retrieved at: http://www.npr.org/templates/story/story.php?storyId=9085408 McKenzie, D. (2009) ‘All those arrows’, London Review of Books, 25 June. Retrieved at: http://www.lrb.co.uk/v31/n12/donald-mackenzie/all-those-arrows Montgomery, J. (2010) ‘Neoliberalism and the making of subprime borrowers’, in Konings, M. (ed.), The Great Credit Crash (London: Verso), pp. 103-108. Rosen, R. J. (2007) ‘The role of securitisation in mortgage lending’, Chicago Fed Letter, (244), November.http://www.chicagofed.org/digital_assets/publications/chicago_fed_letter/2007/cflnovember20 07_244.pdf Read More