View that Capital Markets Created the Conditions that Led to the New Economy Bubble and Banking Crisis - Coursework Example

Critically discuss the view that capital markets created the conditions that led to the ‘new economy’ bubble and the banking crisis Contents Critically discuss the view that capital markets created the conditions that led to the ‘new economy’ bubble and the banking crisis 1 Contents 2 Introduction 3 A. Discussion 3 a. New Economy Vs Old Economy 4 b. Banking Crisis 6 Conclusion 8 References 9 Introduction Capital markets refer to the market where the transactions relating to selling and buying of debt and equity instruments take place. Capital markets are considered as vital for the functioning of any economy because capital is considered as an important component to generate economic output. It includes primary markets as well as secondary markets. Primary market is that market where new bond and stock issues take place and are sold to investors. Secondary markets refer to the market where the selling and buying of existing securities take place between investors. Capital market is concerned with the issue of bonds and stocks for the medium to long term. In this regard, it can be differentiated from the money market because money market is concerned with those financial instruments which have a maturity of less than one year. There are numerous participants in the capital market such as institutional investors, individual investors, governments and municipalities, banks, financial institutions and organizations. Institutional investors comprise mutual funds and pension funds. The size of the capital market of any country is directly proportional to its economy size. The United States of America is considered to be the largest economy in the world. Consequently it has a capital market which is also considered to be very big. A. Discussion In the globalised economy of today, it is considered that capital markets are interconnected in a large way and so any ripples in capital markets in one corner can have major implications elsewhere. This can be considered as a drawback and this is best illustrated when the credit crisis of 2007-09 had global implications. The global credit crisis resulted due to the collapse in mortgage backed securities of US. Capital markets of countries transmitted the effects of the crisis globally since there are a large number of institutions and banks in Asia and Europe which held a large amount of these securities. The institutions and banks in Asia and Europe held these securities amounting to trillions of dollars. a. New Economy Vs Old Economy The development and growth prospects in the old economy attracted manufacturing organizations with a sound plant capacity. The definition of companies was mainly based on their ability to acquire old capital such as equipment, plant, lending capacity, and land. It also had a significant bearing on their infrastructure related to manufacturing (Cuthbertson and Nitzsche, 2008, pp. 55-58). The cost that is associated with doing business is usually kept low in the old economy as a strategy because low wages and low taxes were considered to be very competitive. The oversight of organizations, communities, and people was mainly dependent on the notion of control and management. Labour markets, competition between communities were considered as regional in the old economy (Bodie, Kane and Marcus, 2008, pp. 72-77). The talent pool in the old economy adjusted to the needs of people in the region and so it was also considered as regional. But the evolution of new economy has a totally different view. It replaced manufacturing plants with talent as an indicator of economic prosperity and growth. It considers talent as something that is fungible which means it can be exchanged like currencies (Elton, Gruber, Brown and Goetzmann, 2007, pp. 33-37). The talented people are driven by factors such as quality of life, healthy communities, recreational opportunities, and access to basic amenities. In the new economy, it is considered that talented people try to create jobs rather focusing only on job search. The lifestyles that the talented people follow put reduced pressure on the environment and also actively promote justice which can be considered as social (Burton and Lombra, 2003, pp. 61-63). The economic development in the new economy is not achieved by compromising on social inequity and depleted resources but is promoted by sustainable culture. The recognition of the fact that economic success and also competition are largely determined on a global scale in today’s world led to the basic foundation for the new economy. In this regard it should be noted that all elements of the economy cannot be termed as global but the ones that has the ability to make a difference in future can be considered as global (Cecchetti, 2006, pp. 85-88). The dependence of the industry on new technology led to the use of the term “New Economy” in the late 1990s. The dependence of industries on new technology such as computer and internet has largely increased in recent times. Internet can be considered as the most important event in the economy of US since the Industrial Revolutions (Kidwell, Peterson, Blackwell and Whidbee, 2003, pp. 33-37). This can be considered as the main reason for capital markets creating a double standard in 1990s. In the old economy, a post tax return on capital employed of 12% to 15% can be considered as satisfactory. But in the new economy, organizations have the ability to raise huge amounts of capital from the market. In this regard it can be said that double standards encouraged new technology start-ups to recover their excess costs through the Initial Public Offering route of capital collection (Ahlstrom and Bruton, 2009, pp. 56-59). Digital companies that are new at that point in time have grown at a rapid pace with the help of venture capital. Statistics show that there is a huge growth in venture capital between the years 1995 to 1999. In the US, venture capital grew from 803 in the year 1995 to 3080 in the year 1999 (Barrington, 2012, pp. 26-29). This ultimately resulted into the tech crash in the year 2000. It must be noted that the concept of new economy has found enormous support in the minds of speculators and investors. It has been discussed earlier that the new economy focuses on the use of new technology and it forms the basis of new economy. The old economy involved very little of the aspect of technology. This is so because organizations operating in the old economy are not that efficient in learning new tricks and they use to focus more on their organizational approach (Blackburn, 2008, p. 15). The stocks of companies operating in the old economy typically tend to be of low volatility and they usually pay dividend that is considered as consistent over time. Organizations operating in the new economy, in contrast, are able to grow at an intense pace. Companies like eBay, Google, Yahoo, and Cisco are all technology based companies and have shown how they operate under different business models when compared with the companies of old economy. New economy companies tend to retain back a part of their earnings known as retained earnings to grow at rapid pace. Capital markets also tend to over value new economy companies as they have the potential to grow at a very high rate (Demyanyk and Hemert, 2008, p. 18). The P/E ratio of such companies also tends to be higher as compared to old economy companies. b. Banking Crisis The one significant crisis that is said to have happened in the 20th century is the subprime mortgage crisis in the US. Housing market can be considered as that market where buyers and sellers meet to enter into a transaction of buying and selling properties between themselves or through any intermediary. It has been only a few years when there was a near collapse of the housing market and the financial system (Kregel, 2008, p. 16). We are again moving in that direction where the prices of houses are moving towards their old prices due to the creation of a bubble relating to stock (Samson, 2010, p. 28). In an effort to prop up the prices of assets, the Fed is pumping dollars into the system and so it can be said that we are heading towards a territory of the unknown. The Fed has tried to create a bubble by taking about the tapering factor in the month of May, 2013. The news of tapering by the Fed spiked up mortgage rates and also led to the decrease in the stock prices (Reinhart and Rogoff, 2008, p. 19). It is a fact that Fed is not going to begin its tapering program in the immediate future. But if such an incident occurs, it will mark the end of the low mortgage interest rates. There is also a big gap of monthly $ 85 billion. Mortgage REITS fell as the news of tapering by the Fed hit the market. Mortgage REITS make profits by the act of lending long term mortgages and borrowing short term. The fall in mortgage REITS endangered the $ 40 billion industry (Cassola, Horta and Kast, 2012, p. 16). So if the act of tapering is started by the Fed in the immediate future, the rates of mortgage REITS have to be raised to survive in the long term. If they don’t follow such an act, their business will be at a risk of getting liquidated (Kojucharov, Martin, Martin and Xu, 2008, p. 21). This in turn will hit the housing market in a big way. The rise in mortgage rates will have major implications for the housing market. The May, 2013 episode has already led to home buyers stop paying for their mortgages and the owners of houses has also stopped refinancing (Tiller, 2009, p. 21). There are clear signs of slowdown in the housing market since May, 2013. There are also no signs of regaining the past momentum by the housing market. Subprime borrowing was considered as the major factor which led to an increase in the ownership rates of houses. It also fuelled an increase in the demand for houses during the bubble tears (Hattori, and Shin, 2008, p. 19). The ownership rate in the US increased from 64% in the year 1994 to 69.2% in the year 2004. The demand for housing increased the values of houses to a considerable level. There was an increase of 124% in home values between the years 1997 and 2006. There are also numerous homeowners who exploited this situation to their advantage (Ee and Xiong, 2008, p. 13). The increase in the values of property gave them the opportunity to refinance their house with an interest rate that is much lower and also took out a second mortgage against the added value which was used for consumer spending (Bhagat, 2009, p. 18). The housing bubble collapse led to a high default on subprime rate. The subprime mortgages rose from 9% in the year 1996 to 20% in the year 2006. The total of subprime mortgages was $ 600 billion in the year 2006 which accounted for approximately one fifth of the home loan market in the US (Shirai, 2009, p. 11). It is estimated that $ 1.3 trillion of subprime loans are still outstanding (Crouhy, Jarrow and Turnbull, 2008, p. 18). The rise in the values of real estate resulted in more subprime loans as lenders started to take more risks. It is also believed by some experts that this type of behaviour is mainly encouraged by Wall Street which bundled the loans into securities and sold them to institutional investors and pension funds who generally seek higher returns (Ravier and Peter Lewin, 2012, p. 18). Conclusion It can be concluded that new economy is better when it is compared to the old economy. In the new economy, the focus is on the technology aspect and it forms the basis of new economy. The new economy replaced “manufacturing plants” of old economy with “talent” as an indicator of economic prosperity and growth. In the new economy, talent is considered as something which can be exchanged like currencies. It considers that talented person tend to create jobs rather than searching for jobs. It also recognizes the fact that economic success and competition are largely determined on a global scale. Organizations that are operating in the new economy have the ability to grow at a rapid pace. Analysts and economists have to understand the implications as well as the causes of the subprime crisis. The mortgage crisis and its resulting fallout are already well documented. Regulators, legislators, and industry outsiders have witnessed the devastating impacts of the mortgage crisis on global economies and the US in particular. But the main question in this regard is still unanswered regarding the steps that are to be taken to fix the issues that created the mortgage crisis in the first place. References Ahlstrom, D. And Bruton, G., 2009. International management. Stamford: Cengage Learning. Barrington, L., 2012. Comparative Politics. Stamford: Cengage Learning. Bhagat, S. 2009. Causes of Subprime Credit Crisis. Available at: http://leeds-faculty.colorado.edu/bhagat/CausesSubprimeCrisis.pdf. [Accessed on: 27 Feb. 2014] Bianco, K.M. 2008. The Subprime Lending Crisis: Causes and Effects of the Mortgage Meltdown. Available at: http://www.consejomexicano.org/Emails/subwprev.pdf. 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