Causes of the Current Crisis in the Financial Markets - Essay Example

CAUSES OF THE CURRENT CRISIS IN THE FINANCIAL MARKETS Introduction When one ponders over the events over the past several months, it is not clear if one has to cheer for the new era that America has stepped into with its first African American president at the helm of world affairs or whether one has to worry whether the current financial turmoil that is causing havoc across global financial markets is one that is just the beginning of a long crisis or one that will surpass quickly without a trail. The extent of damage that has been caused by market participants on Wall Street and in the government will only become clear in the months and years to come as new scenes unfold revealing the follies and misgivings of those involved. However, if such a financial meltdown is to be curtailed in the future and if such a phenomenon is to be prevented from happening again, the onus is on the emerging generation of financial planners and economists to understand the intricacies of the crisis and the contributing factors that have been brewing the mould of crisis over the past few years. As such, it is deemed essential to unearth the root causes of the current financial crisis. There is an enormous storm that has been raised over the past few months that have seen the giants of Wall Street crumble only to see bigwigs such as Lehman Brothers and Merrill Lynch to enter the books of history from the glories of the present. However, before we proceed to study how this was even allowed to happen, it is essential to understand how the world economy has ended up in this mess. This research paper will look into four major factors which caused the current financial crisis and as such this essay will attempt to analyze and explore how the correlation between the different factors culminated into an environment which encouraged financial institutions to overstep their logical responsibilities. Primary reasons for the crisis There are different reasons for the current crisis as there is multitude of factors behind the apparently complex phenomenon being witnessed by the financial markets of developed world. First, financial institutions made lending decisions which may not be termed as prudent because due to different factors such as low interest rates, less stringent monetary regulations as well as general increase in economic well being of households, forced financial institutions to lend to subprime borrowers. Subprime borrowers include those borrowers with relatively poor credit ratings as well as impaired repayment capacity. Due to higher return offered by such borrowers as financial institutions made a tradeoff between high risk and high reward and started to lend excessively to such borrowers. What is, however, also critical to note that due to excessive lending against real estate- in mortgage loans, real estate serves as collateral, and the overall prices of real estate skyrocketed? This increase in price further encouraged financial institutions to lend against their mortgage portfolio as banks felt safer against higher home prices. (Rutterford & Davidson, 2007). What is, however also tricky is the fact that financial institutions, in a bid to recapture the liquidity drained due to excessive lending made to subprime borrowers, started to securitize their mortgage portfolio. This securitization was made against the pools of real estate pieces held as collateral in such loans and was done with the purpose of utilizing the large pools of otherwise idle assets kept as collaterals. The real problem began when subprime borrowers started to default on their repayments as economic conditions started to tighten up. Such large scale failure to repay forced banks to divert other resources to pay off the Mortgage backed security holders and as such a credit crunch started to emerge. (Wood,2009) However, it is also imperative to note that there was an increase in the regulations which further eased up the use of land into US. There has been a change in the overall attitude of Governments of developed countries specially UK and US as more emphasis was placed in devising policies which allowed free market forces to work on their own. The significant influence of Milton Friedman on Margret Thatcher’s government as well as on the respective governments of US ensured that the regulatory framework was to be designed in a way which ensured lesser government interference into the functioning of the market. This shift towards employing free market policies was also encouraged due to the prolonged economic slowdown of UK and US. Therefore, it was debated that the government entities shall be privatized besides offering the existing enterprises a free hand to regulate themselves so that better allocation of resources can be achieved.(Williamson,2008). Such de-regulation efforts also resulted into de-regulation of institutions such as Fannie Mae. The prime task of Fannie Mae was to create a framework and administer it to ensure the commitment to housing thereby acting as an alternative against private moneylenders who were unwilling or unable to lend money without absolute credibility. After the 1968 charter act, the organization became a government sponsored enterprise that was authorized to issue Mortgage backed securities (MBS) (Lahart, 2007). Since 1993, the business of Fannie Mae was categorized into three sections based on income (Gordon, Robert 2008). Qualified/high income/affordable. Moderate and low income/partially qualified. Unqualified/unaffordable. The primary purpose of this segregation was to enhance the percentage of home ownership in the country. The major reasons for the current financial crisis are very complex and diverse in nature and are mainly concentrated within the housing and credit markets, where a number of colluding factors led to an intertwining state of affairs that accumulated over time to result in the present turmoil (Seidman, 2008). Apart from the inability of many homeowners and borrowers to pay for their mortgages, the lenders who conceded to sanction the loan without a proper evaluation of the repaying capacity of the borrower are also to blame for the present crisis. Investment bankers went berserk in their quest to rake in quick and huge profits and In doing, so they based most of their investments on false and ill prepared assumptions and convictions. Several mortgage products had turned risky and the level of debt at the personal and firm level had accumulated to unimaginable proportion. Financial products that served as masks meant to hide away the risks involved in mortgage default and faulty calculation of risks combined with a lack of proper monitoring and regulation on the part of the key people in the Wall Street and those in the administration are also reasons that led to this collective failure of the system (Brown,2008). The Run up to the Crisis Regulatory Failure It has been argued that the financial system seems to embarrass free market economics only when times are good. However; it turns out to be a strong supporter of government intervention when things aren’t good for it. (Kane & Marcus, 2003). Such situation reappeared once again when during the year 2007, Federal Reserve Board of US decided to intervene into the financial markets in a bid to support already dwindling giants of Wall Street. Similarly, in UK, Bank of England as well as FSA started to take measures which were indicating the potentially decreasing role of government regulators into the affairs of the financial markets. What caused such a shift into the policies is a debate which needs to be well initiated and understood in order to learn lessons out of it. (Mcllroy, 2008). The failure of financial institutions such as Northern Rock& Lehman Brothers very strongly indicate towards the fact that regulatory bodies of US and UK have completely failed to take notice of what is going on under their very nose. It also indicates the severity of regulatory risk run by the financial markets as a whole and how it can lead to the overall decline of the financial system. (Mcllroy, 2008). According to IMF, the response from the regulatory authorities towards the so called innovation into financial markets brought through the introduction of various derivative transactions was basically slow and non-existent. This lack of interest or capacity of the financial regulators either in US or UK allowed financial institutions to take extended risks which proved beyond their capabilities. Most of the financial institutions went to a level where the leveraged exposure reached to a level where it was not only unmanageable but was also beyond the capacity of the financial institutions to absorb such huge losses. This trend had been written off in the positive and in the interest of the market by way of the complex financial techniques that were used by the banks. However, little did the regulators and the bosses within these banks to realize that borrowing results in more depends on additional borrowing that fuels an artificial price increase of the financial assets that have been invested in. These include almost all the financial instruments that are used by banks such as equity, property, infrastructure and debt (Liebowitz, Stan 2008). Further, it has also been argued that the credit crunch is not the only reason for the failure of financial institutions as lax regulatory standards are also considered as responsible for the collective failure of the market. It is important to note that Alan Greenspan has remained at the top of regulatory setup in US. However, what is critical is the fact that he was considered as a strong believer of de-regulating the financial markets as time and again he boasted that financial markets know how to regulate themselves. Therefore, there is no need for regulatory interference into them. However, he has been proving wrong with the mass scale failure of the financial institutions paved the way for the debate again that financial markets need to be regulated due to their specialized nature.(Lanman & Matthews,2008) The response from the UK’s regulators has also been the same too as FSA, the premier regulatory body in UK adopted an attitude of facilitating investors into the country. Therefore, the overall regulatory standards were lowered in order to facilitate the banks and other financial institutions. The higher profitability of banking institutions was often cited as an example of how the de-regulated environment into the country contributing towards the overall profitability of the sector and as such regulatory responsibilities were overshadowed with the intent of being more profitable. (Brummer, 2008). BASEL accords were introduced as set of best practices. However, both accords were ignored specially by the banks in UK and US either through regulatory environment or banks simply did not pay much attention to them as most of such practices were already implemented into those banks. (Pomerleano, 2009) Overall, while recounting the run up to the current crisis, the role of financial regulators is one of the most controversial as they subsequently failed to take notice of the overtly ambitious behavior of financial institutions. (Pomerleano, 2009) HIGH RISK LOANS As discussed earlier that there was a general shift in the attitude of the governments of developed world towards allowing financial markets to work on their own. Therefore, all subsequent policy initiatives either fiscal or monetary were taken with an aim of reducing the role of Government into the affairs of the markets. The liberal monetary policy and the drive to issue more mortgage based loans encouraged lenders to offer increasing loans to borrowers who had been identified as belonging to the unqualified or high-risk borrowers as stated above. What’s even more surprising is the fact the loans had even been extended to illegal immigrants. The volume of sub-prime mortgages (as it is called for mortgages to high risk and low income borrowers) had increased 20 fold during a 12 year period and had grown to a mammoth $600 billion. The eligibility for a mortgage is determined based on a points system wherein an applicant has to clear a certain threshold and is the difference of the interest rates between a prime and sub-prime mortgage. Since 2000, this difference had shrunk by more than half to 130 basis points that also indicates that the risk premium that was necessary to be fulfilled by lenders had been brought down in a bid to facilitate more borrowing (Blackburn, 2008). What surprises most market analysts are the fact that all this were allowed to happen quietly even though the credit eligibility of unqualified borrowers had declined sharply during the same period thereby pushing them farther into the high risk region. This would have meant that banks would have refrained from issuing loans in the event of collision between these two key mortgage determinants (Lumby and Jones, 2003). However, due to the effect of the credit cycle, the financial market had been experiencing an inflation of asset prices around that time that encouraged lenders to offer riskier incentives. For example, there was surprisingly no need for a down payment when buying a house in the United States during the past few years. This down payment, which projects the future potential of repayment, was seldom taken into consideration thereby prompting almost 45% of buyers during that period to purchase with no down payments. As against this, the down payments for housing related mortgages are 20% and 33% in China and India respectively (DiLorenzo, 2007). Globalized Markets Advances in technology made it possible for the financial institutions to make investments at more rapid speed and across the border. This characterization of the financial markets not only increased their depth and flexibility but also increased their overall risk because of the unique risks being faced by each investment made into respective geographical areas. The so called globalization of the financial markets not only weakened the grip of regulators over the financial institutions, but it also brought fundamental changes into the business models being used by the financial institutions over the period of time.(Mishkin,2007) Globalization thus provided more opportunities to the financial institutions by advocating the culture of equity i.e. the basic thrust of managers was to improve upon the share price of the stocks rather than managing risks. (Wignall et.al, 2008). This fundamental shift into the perspectives of the financial institutions therefore caused a new phenomenon of booms and busts into overall industry cycles. Such increased volatility. Therefore, this resulted into more risk into the overall financial system of the developed world. (Wignall et.al, 2008). Investment Process and Efficient Markets What is also important to discuss here is the fact that the very nature of the investment process is faulty. The failure of securitization process as described above clearly indicates that the derivatives, as investment vehicles as they are not only highly leveraged transactions but also require a certain degree of expertise over complexities of mathematics behind them. The inherent risk of various investment models i.e. most of the investment models are based on assumptions which tend to ignore reality, to a certain. Therefore, therefore such inherent risks do not allow investment managers to clearly see through the potential risks behind such investment models and theories. (Panzner, 2007). Similarly, markets are not perfect too as they continuously offer arbitrage opportunities which were exploited to the extent where they resulted into losses for most of the investors. This is also evident from the fact that credit rating agencies failed to predict the investment value of most of the borrowers on whom banks started to take risks. Credit rating agencies continue to offer credit ratings reports which were not reflective of the true credit ratings of the borrowers and banks continue to take on bets on such borrowers which were technically otherwise not eligible to get the funding from the banks.(Rosner,2007). Further, the innovations into the financial markets helped developed such products which were sometimes too complex for ordinary investors to understand. As such they preferred for such products which resultantly increased their overall monthly payments therefore, forcing them to default. (Coheo, 2007). This also indicates the fact that markets were not perfect in nature as prevalence of information asymmetries allowed banks to exploit consumers to the extent where they were naturally given the incentive to default because of unsustainable level of debts taken without assessing their potential risks. (Coheo, 2007). Recommendations Considering the above analysis, following recommendations may be considered: Regulatory Role As discussed earlier that the role of regulators was one of the main reasons behind the culmination of crisis. The subsequent policies of different governments allowed de-regulation by limiting the role of financial regulatory authorities. However, current crisis warrant that the role and interference of financial market supervisors such as central banks shall not only be limited to the regulation of monetary policy only. Regulators must have a far greater role in regulating the market by developing risk based prudential regulation compliance as well as implementation of best practices such as BASEL II accord. (Mcllroy, 2008). Improving existing regulatory infrastructure It is of great importance that laws such as Sarbanes Oxley shall also be extended to financial institutions to increase their accountability as well as further streamlining the financial disclosures made by the banks. The existing regulatory environment was lax. Therefore, it helped culminating at the present crisis. Therefore, situation warrant that the existing regulatory infrastructure shall be completely revamped by aligning it with the overall purpose of financial institutions i.e. value creation as well as safeguarding the deposit holders money.(Goodhart,2008) Conclusion Apparently, it seems that the prima facie reason for the current financial crisis is the bad loans extended to subprime borrowers however, further exploration of the issue would indicate an intertwined link of different factors which allowed financial institutions to reach to a level where they were simply helpless in controlling the consequences of decisions made by them. Increased risk appetite fueled by deregulation allowed financial institutions to take riskier bets out of greed of earning more. However, such temptation brought them to no return point because most of the institutions took exposures to the level where any adverse movements could wipe out the whole equity of the organizations. 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