Capital Markets and the New Economy Bubble and the Banking Crisis - Essay Example

Analysis of how Capital Markets Helped in Creating the Conditions that led to the “New Economy” Bubble and the Banking Crisis : Tutor: Date: Analysis of how Capital Markets Helped in Creating the Conditions that led to the “New Economy” Bubble and the Banking Crisis Introduction The collapse of the Lehman Brothers in September 2008 is considered to have singularly triggered a financial crisis that nearly brought down the world’s financial system. Lehman Brothers was one of the largest banking organizations with branches spread out across the world. In attempts to try and shore up the industry, governments across the world were forced to inject huge amounts of taxpayer-financed bailouts (Hemerijck 2009). Despite all these measures, the eventual ensuing credit crunch morphed was already a very nasty economic downtown into the worse recession the world had seen for 80 years. While the bailouts were seen to greatly help in preventing the financial depression from spiraling out of hand, the economic recovery is seen to be quite feeble as compared to the other previous post-war upturns. By using different concepts and theories, this paper will show how the capital markets were responsible for creating both the conditions that led to the “new economy” bubble and the banking crisis. A record is seen to have been set by the Dow Jones when it closed at 14,047 on October 9, 2007, however, just one year later, the Dow Jones was seen to be just above 8,000, after it happened to drop by a staggering 21% in the first nine day of October 2008. Across the world, most major stock companies had also experienced huge plunges alongside the Dow Jones. Numerous companies began to start laying off their workers in droves as they were force to put off any capital investments that they might have had. Credit markets became nearly paralyzed as individual consumers in the United States were systematically denied loans for college tuition and mortgages. The effects of this crisis are still being felt in most rich countries and especially so in those located in Europe, where the financial crisis eventually evolved into the euro crisis. The 2007-09 global financial crisis is viewed to have been a very powerful reminder of the fact that crises can often have a multifaceted nature. The recent global financial crisis is perceived to have been triggered as a result of a combination of various complex factors that included relatively easy credit conditions seen in the period ranging between 2002 through to 2008. These conditions are seen to have encouraged a large number of high risk borrowing and lending practices without the capital markets first assessing factors such as international trade imbalances, default risk, government revenues and expenses fiscal policies and real-estate bubbles among other factors. Capital Market’s Contribution to the New Economy Bubble New Economy is a term that is used to describe the numerous new and extremely high-growth industries that are seen to be on the main cutting edge of technology and are perceived to be prime driving force for economic growth. The new economy is believed to essentially have stated during the late 1990s as various high tech tools, such as increasingly powerful computers and the internet began to quickly penetrate the business and consumer marketplace. However, the capital market eventually contributed to causing the new economy to morph into a bubble when without attempting to try and consider the various macroeconomic factors, financial institutions and investors such as capital markets began to bid up the stock prices to extreme and unprecedented heights. While the tech bubble is seen to have since burst, the firms that managed to survive this burst have since then emerged to remain at the technological forefront by being highly innovative. These companies are seen to be rather heavily involved in both the biotech and internet industries, however the ripple effects of new technologies are seen to have spread out to some of the other industries as well. The Creation of the Housing and Credit Bubbles by Capital Markets: According to Roberts (2008), it can be argued that structured finances by capital markets help in creating efficiency in our financial system because other objectives can be pursued with freed capital. This view can however be challenged by that held by Warren Buffet that the products of structured finance are essentially financial weapons of mass destruction. In a fractional reserve banking system, loans are seen to be created out of nothing by the originating lender as a result of the loan becoming part of the collateralized debt obligation (CDO). As long as there happens to exist sufficient cashflow, debt creation in this system is seen to be normal. However, in the event that excessive debt is created and the existing available cashflow is found to be unable to service this debt, it is then seen that the system experiences the rather extremely serious problem of insolvency which can in turn result in monetary deflation which in this case is basically the disappearance of lender-created money back into the ether from which it was created. The effects of this practice by capital markets and other financial institutions is seen to be exemplified by the fact that credit bubbles in both Europe and the United States experienced massive growth before the crisis. While the Euro zone indebtedness grew to a staggering 304 percent of GDP by the end of 2008, with the United Kingdom borrowing being seen to be considerably higher at 320 percent, the United States, credit outstanding is seen to have rose from about 221 percent of GDP in the year 2000 to a significantly higher percentage of 291 by the end of 2008 when it reached $42 trillion (Roxburgh 2009). If an individual investor wanted to obtain a mortgage loan, the initial purchase would be facilitated by using equity as opposed to using lender-created money. However once the loan has been packaged into a collateralized debt obligation, this is often purchased by capital market investors or any other lenders, a system that is seen to create money from nothing. Since the system’s equity tranche essentially raises no capital, the mezzanine tranche is seen to be the only money in the structure not created by the lender out of the ether. As a result of there being so little “real’ money in this deal, there is seen to be extremely very little buffer between what would potentially be a loss of invested capital and an eventual banking loss of created capital. When the debt service exceeding the cashflow tipping point in this system is reached, the entire debt structure is seen to easily collapse in a deflationary spiral. Marx’s Theory of the Law of the Tendency for the Rate of Profit to Fall: Structured financial products such CDO’s and their various derivatives are found to be highly leveraged instruments having very sensitive tipping points. They are highly sensitive to short term lending rates and credit availability. The long-term CDO’s that were financed by capital markets were often seen to be financed by rollover over short term debt. While the rising cost of purchasing short-term debt can generally take a while before it can cause problems, a sudden withdrawal of credit availability as was witnessed during the credit resulted in a sudden and desperate sale for those individuals that happened to be owning these instruments. This is seen to be in line with Marx’s theory of the law of the tendency for the rate of profit to fall. According to this theory, capitalist systems are generally characterized by their returning of less money to their workers by paying them salaries and wages are compared to the total value of the goods that have been produced by these workers. The workers are thus unable to buy all the goods that they are producing. The profits obtained in capitalistic systems first go towards covering the business enterprise’s initial investment. As these business enterprises grow, they start to heavily compete as is seen by the stiff competition between financial institutions attempting to try and provide loans to new customers, the abundance of the loans in the market causes their prices to fall and lenders start offering these loans to individuals and firms that might have difficulties in repaying them, in a cycle that is seen to affirm the theory of tendency for the rate of profit to fall. The analysis of collateralized debt obligations, credit ratings and the proper analysis of all the structurized financial obligations are aspects seen to be important to the smooth function of the secondary market for mortgage loans. Credit ratings are seen to be widely used by numerous investors as they help in providing a convenient tool that is sued in the comparison of the potential credit risk among the various investment alternatives. When the rating agencies perform their job as required, there is generally greater efficiency in the capital markets as investors are able to effectively minimize their risk and securities syndicators are able to obtain maximum market values. However, in the housing bubble that resulted in the 2007-09 global financial crisis, rating agencies were seen not to provide accurate or credible ratings for most CDO tranches. Minsky’s Theory as Applied to Capital Markets and the Global Financial Crisis While the Hyman Minsky theory of financial crises is seen to have been developed for use in the context of a primarily domestic economy, the recent financial instability seen to be experienced in the international economy is seen to however suggest that it would be quite useful to try and examine this theory in a more global environment. In the context of an expanding economy, Minsky’s theory suggests that as expansion continues to rapidly develop, there is a corresponding increase in optimism and the set conventions pertaining to risk and proper level of debt begin to change. The general level of speculation gradually increases as the prices of various financial assets continue to rise. Speculation as applied to this scenario is perceived to be attempts to try and accurately bet on the overall psychology and future direction of the concerned market, this is also in addition to its being perceived as the more general process of financing assets whose eventual value is seen to depend on future developments. Capital markets speculated that the loans will eventually be repaid without much trouble and that their profits will continue to rise. The economy grows further as the capital markets provide more loans for investment. The lenders eventually start believing the misconception that they will be able to successfully get back all the money that they lend and as a result of this, they become increasingly willing to lend to firms without having any full guarantees of successful loan repayments (Wolfson 2002). Ponzi financing is seen to occur as lenders continue to provide loans to firms that they know will have problems in repaying the loans. In this manner the money channeled into the system by capital markets is seen to have caused economies to take on increasing amounts of risky credit. The unrestrained availability of credit as a result of there being excessive liquidity in the financial systems is seen to have led to the creation of a bubble in nearly each and every asset market across the world starting with the United States housing market. While the eventual bursting of these asset bubbles is seen to have been the main trigger of global financial crisis, it should be noted that the capital markets helped to facilitate the relatively unrestrained availability of credit (Kolb 2010). Conclusion From the analysis provided in this paper, it can comprehensively be shown that the problems that emerged in the subprime mortgage market in the United states were instrumental in triggering the global financial crisis, the deep causes of the financial crisis can be attributed to the practices of the current financial regime as well as flawed institutions such as capital markets. As the actions of institutions such as capital markets caused the financial markets to grow increasingly larger as compared to the nonfinancial economy, the more important financial product were seen to become illiquid, opaque, complex and system-wide leverage exploded. The resulting financial crisis that resulted from this process is seen to have been responsible for eventually pushing the global economy to almost undergoing a depression (Crotty 2009). The unprecedented government efforts have largely managed to try and end the crisis and economic collapse that initially resulted from the actions of the capital market, however, these efforts have had mixed results in different countries. It can thus be seen that the capital markets were responsible for creating both the conditions that led to the “new economy” bubble and the banking crisis. Bibliography Crotty James. 2009. Structural causes of the global financialcrisis: a critical assessment of the ‘new financial architecture’. Cambridge Journal of Economics. 2009, 33, 563–580 Hemerijck, A. et al. 2009. Aftershocks: economic crisis and institutional choice. Amsterdam: Amsterdam University Press. Kolb Robert. Lessons from the financial crisis : causes, consequences, and our economic future. Hoboken, N.J.: Wiley. Roberts Lawrence, 2008. The great housing bubble: why did house prices fall?. [S. l.] : Monterey Cypress Pub. Roxburgh Charles et al. 2009. Global capital markets: Entering a new era. Available at Wolfson Martin. 2002. Minskys Theory of Financial Crises in a Global Context. Journal of Economic Issues. Vol. XXXVI No. 2 June 2002 Read More