Causes of the Financial Crisis Leading to World Recession - Essay Example

Research Proposal Table of Contents Research Proposal Table of Contents 2 Introduction 3 Literature Review 5 Research Methodology 10 Sources of Facts and Figures 11 Data Analysis 13 Time Schedule 15 Reference 17 Bibliography 19 Introduction Like many other economic upheavals, global credit crisis was originated for a number of factors. This paper investigates into the factors leading the financial crisis to result in an awful global recession. In the year of 2007, the series of undesirable events starts in Unites States. US faced the worst financial credit crunch since 1930s (Hull, 2009). The crisis widened swiftly from US to the other countries, leading to a global recession. Some financial systems just collapsed. A number of financial systems had been bailed out by the respective governments. No doubt that the set of adverse situations in the financial systems led to the deep downturn in the national economies. This paper investigates into the origination of the credit crisis, the series of events leading the crisis to the one of the worst world recessions, till now. In such a course, observation of some similar cases will be helpful to gather information on the influential factors behind this global recession. Certain matters would be included in the research area to investigate the responsibility of each of them in the origination of the disastrous recession in recent times. These factors would include US housing market, Securitization, Asset backed securities, ABS CDOs, Rating Agencies and existing regulations. In the month of July, 2008, a story was published on the “Economist’ edition. A professor was giving a lecture to the public on the solar system. An elderly lady interpreted the fact that that the whole world is moving on the back of a giant turtle. The professor was wondering “But what is supporting the turtle?” A prompt reply from the lady “You can’t trick me; they are turtles all the way down” (Economist, 2008). Apparently, the US financial systems seemed to be as logical as “turtles all the way down” (Economist, 2008). Deeper down the line the same old story of the faulty system of housing finance. The politicians just started counting on two of the country’s mortgage giants, Fannie Mae and Freddie Mac to reinforce the housing market by absorbing more mortgages (Economist, 2008). At the starting of 2008, these two gigantic pillars of US financial systems got collapsed; the deemed rescuers themselves were now in need of salvage. As a consequence, US housing market went deeper down the mud and the economy trembled. The trembling situation expanded to the other economies on the globe and the world experienced one of the worst recessions, ever. Looking back to the housing industry, starting from the year 2000 till 2005, US has seen a boom in its housing prices. One of the crucial factors, giving rise to the housing market boom, was the low interest rate level between the years 2002 and 2005. However, the increase was mostly fuelled up for the mortgage loan practices. Mortgage lenders relaxed their lending standards. As a consequence, the amount of subprime mortgage lending increased drastically. Subprime mortgages are precisely those mortgages which are considered to be considerably riskier than the average mortgages. With the default of these mortgages, the US housing market almost collapsed. The number of events and factors after that just accelerated the collapsing, escorting it to a disastrous recession, worldwide. Literature Review Reduction in general availability of loan is known as ‘Credit Crisis’. Studies have suggested few models to derive the financial crisis; however there are debates on the sufficiency of model attributes. The existing theoretical models of financial crisis comprises of four categories, fundamental based models, multiple equilibrium models, moral hazard models and expectation based models. As the approaches, taken here, is not much related to these types of models, a brief discussion would be provided on each of them. The first one, Fundamental based models consider the fundamental changes to derive the financial crisis (Chari, Christiano & Kehoe, 2008). As per some economists it is quite difficult to derive the financial crisis from the fundamental variable of the economy. However there have been some recent researches to use the composite variability in stead of the base ones. Expectation based models consider models which incorporates the expectations of the future values. This has been quite similar to the models of bubbles, introduced by Allen and Gale in the year of 1998. The model aims to fetch its derivation of the financial crisis from the other agent’s expectations (Chari, Christiano & Kehoe, 2008). Multiple equilibrium models take into account the economic functions in the economic environment. Hence it is able to explain the noticeable changes in the economic conditions during a crisis, after shifting from one equilibrium state to the other (Chari, Christiano & Kehoe, 2008). One limitation of this model is that the model does not offer any explanation on either of the reason or the processes of shifting from one equilibrium economy state to other. Moral hazard models have taken into account government guarantees while studying the US savings and loan crisis, back in 1992. As per the critics the moral hazard problems arise from the explicit and implicit respective government aids to implicit guarantees to the depositors in any country. There are certain limitations for each of the models. As each of them considers some crucial factors over time; accumulating all the factors can offer a better representation and idea of the credit crisis (Chari, Christiano & Kehoe, 2008). After 9/11, American economy has seen a downturn. With the rising political tensions, the economy has seen a rise in the premiums for credit risky assets. In the aftermath situation of 9/11, the banking industry was badly affected due to the ongoing weakness pertaining in the stock market. As a consequence the economy has seen falling down of some of the iconic organizations. In such a situation, the governments and the banking industry changed the lending standards. In 2001-2002, the situation deteriorated due to the investing and lending behavior of the banking industry (Felsenheimer & Gisdakis, 2008). The real economy got severely affected by various consequences after the bubble burst. The bubble came to existence with some new companies coming up with a higher market cap than the profitable old companies. This happened as the new companies promised to give a higher growth to the investors than the older ones. However, when these new companies went down, all the bubbles exploded. Analysts argued that the financial environment, that time, had fundamental as well as technical issues. The technical side of the market, mostly the innovation of complex new products, had a significant impact to intensify the credit crisis. The 2001- 2002 has showed a much dreadful alliance of both the failing fundamentals and fragile technicalities (Felsenheimer & Gisdakis, 2008). Moral hazards, self fulfilling processes and panic over the financial conditions have been observed during the tech bubble burst (Felsenheimer & Gisdakis, 2008). The default probabilities amplified significantly in that period, which is quite an obvious scenario in the credits crisis. Investors demand more risk premium on their investments, as they expect more to take the default risk on heir portfolios. As a consequence, the credit spread has gone wider, which has been enough compensating for the current default risk, but not for the future one. At this point of time, even the companies needed to fund themselves at a much higher level, which was really not possible for most of the low rated companies (Felsenheimer & Gisdakis, 2008). Hence the whole scenario led to a liquidity squeeze, eventually increasing the default rates of the companies. In the micro environment of the credit crunch, the moral hazard had been existed in the internal systems of the companies (Felsenheimer & Gisdakis, 2008). Many organizations had been accused to overlook the fraudulent activities, they had in their companies. At this time ‘Enron’ happened, which triggered the panic within the investors and they denied having any exposure to any of the companies, independent of their bad and good characteristics (Felsenheimer & Gisdakis, 2008).. Overall, 2001-02 was one of the most intensified credit crunch in the new millennium. A wider crisis in the credit derivatives was first recognized in the month of May, 2005. In that time, the crisis happened in the standardized tranches, iTaxx universe and that caused considerable distortions on the underlying credit market, making the spread much wider (Felsenheimer & Gisdakis, 2008). The widening of the credit spread was technically driven; there was certainly no fundamental factor influencing the crisis. Credit Crunch 2007 has it all. The fundamental as well as technical influential factors led to a credit crunch. At the time of US housing boom, most of the lending banks and financial institutions had made their lending standards flexible. In such a course, the financial institutions provided subprime loans, keeping the house as mortgages. Subprime loans were at the centre of the mortgage breakdown. However, as the housing price went down, more and more people felt default at their loan repayment. The investment bankers and the mortgage brokers re-engineered those defaulted mortgages into complex derivatives. However those mortgages were backed by non performing loans (Financial Times, 2009). So when these loans started defaulting, gradually the investment banks, mortgage traders and other financial institution all started collapsing. As a matter of fact the US financial system seemed to be in a trembled situation. Soon the shivering spread to other economies. Globalization of trading activities had its effect to make the US credit crisis to a global recession (Brookings, 2007). In this case there were fundamental factors like faulty mortgage loan system behind the financial downturn. On the other hand technical factors like innovation of complex financial instruments were there to intensify the intensity of the credit crisis and let it result into an awful recession. A number of factors are assumed to be responsible for the credit crisis. As per some analysts, the credit crunch has been the result of over regulation. As per some of them, ‘The Community Reinvestment Act’ (CRA) was an encouragement to provide subprime housing loans economy (Debate wise, 2009). The regulation has been evolved from the worry of US regarding the exclusion of the poor people to get access to the homes available. As this was done to encourage the poor, more and more loans were allocated to let them avail the homes available. However as a matter of fact, in such a course the no of sub prime loans increased giving raise to the default probability. On the other hands some people argued that the law has made it clear that the loan activities must be carried out with in a safe and secured manner economy (Debate wise, 2009). They argued that CRA had been into existence for the last thirty years and possessed no responsibility to cause the credit crisis economy (Debate wise, 2009). As per them the law did not make the financial institutions to lend a loan, instead their own profit motives drove them to do so economy (Debate wise, 2009). Another debate prevailing in the economy is regarding the responsibilities of credit rating agencies, the respective governments and many more. A part of the economy think that many institutions like Government National Mortgage Association (Ginnie Mae) had repackaged and sold securitized mortgages through the name of asset backed securities economy (Debate wise, 2009). The ratings were not reflecting in the true sense, as the organization was backed by the government itself. They argued that the government, itself was responsible for such downturn in economy (Debate wise, 2009). Credit Rating agencies are mostly driven by the fees paid by the issuers of bonds and other securities, so surely the organizations would expect the rating to be high, which happens in most of the times (Debate wise, 2009). The regulations and monitoring needs to be changed to make the rating agencies work in a more ethical way. Research Methodology Most of the research would be based on the secondary research. There are a number of new articles, journals, and books on the recent credit crisis to help in the research procedure. Apart from all those, the online articles, mainly the articles provided by the governments of different nations can be of much help to have more how the US credit crisis taken back their respective economies. The research would start giving a background to the US credit crisis, leading to the global recession. The main areas would include the affect of various factors on the credit crisis and the global recession. A literature review on the credit crisis events of the millennium would be helpful to get more insight into the credit crisis scenarios. It would help to understand the fundamental and technical factors behind the credit crunch events. At the same time, it would help to acquire the knowledge about trends in the factor, influential to the credit crisis events. The credit crisis of 2001 has taken a major part of this discussion. This had mostly the fundamental factors prevailing behind the financial downturn. The credit crunch in 2007 had it all. The fundamental and the technical influential factors worked together to originate and intensify the credit crisis to result into the global recession. This literature review would help to understand the transformation from the crisis, driven by the fundamental factors to the crisis driven by both fundamental and technical factors. The literature would also take care of some of the recent debates going on regarding the origination and implication of the credit crisis. The objective is to look into the causes and factors of the credit crisis leading to the devastating recession. As the research would be based a number of facts and figures, it is very much crucial to collect proper facts and information, related to the research paper. The whole research would be based on secondary research procedures. The choice of data is quite important as this should not contain any individual predisposition. Data analysis is the most important part of the whole research. It would investigate into the events which took place in the crisis period. Investigation of those incidents one after another would give a better idea of the factors, driving the credit crisis to the recent recession. The data analysis must not include the personal opinion of the researcher. The analysis should direct towards the conclusion. It is very much necessary to put forward the recommendations about the preventive measures of a credit crisis event. Discussion about the measures taken by different economies to recover from this recession is crucial to have an up to date knowledge to wither the economic and financial downturn. After deciding on each of the activities, time schedule for the implementation of each of them needs to be created. The time schedule would be an expected one, but attempt should be put forward to make the estimation as real as possible. Enough care should be taken to make the research fact and figures oriented. Critical analysis of the data and information would be carried out, leading to a logical interpretation of the same. Sources of Facts and Figures Collection of the project related data and information is one of the most significant activities in a research project. The collection of the facts and figures must be inclined to the research at a balanced, unbiased conclusion after carrying out the research activities. Books are always been critical resource for research projects. Referring to a number of books would lead to the attainment of more facts and figures regarding the current credit crisis and global recession. The recent crisis has its epicenter at the mortgage loans and the complex re engineering of the financial products. Books would help one to get more idea about the pricing and the underlying assets of any complex financial assets like derivatives. Before getting an idea about the various reasons which have led the credit crisis to result in one of the disastrous downturns of the millennium, it is necessary to know about the financial instruments. Articles about the US housing market would be of great importance as the whole story began from this mortgage market. This financial downturn has attracted many new papers to publish a number of news on different economies, different companies. This information would be very much helpful while doing the research. Financial Times, Bloomberg, Financial Express, BBC are the names of some of such sources. Various journals from well built databases can be crucial data sources for the research. These journals would provide a detailed explanation on the credit crisis and the spread of the same to lead towards the global recession. The online journal like ‘Wall Street Journal’ can be such source of journal articles. The online reports and articles can contain various up to date news on the credit crisis. The research and the analytical reports are of great importance as they accumulate many of the information in between them selves. However, the analysis drawn in them should not influence the conclusion of this research paper. The ideas can be taken from these reports, but predisposition is strictly avoided. To look into the causes those led the credit crisis to evolve as the global recession, it is crucial to investigate into few economies to have a micro idea how these economies experienced recession from the period of credit crisis. There are certain questions which need to be investigated like what went wrong in those economies or how US credit crisis became so powerful to put a devastating impact on the other economies, worldwide. Looking into the reports of the respective economies would help in this regard. Most of these reports would be generated by the respective government organization. Most of the economies, which had been badly effected by the recent downturn, have been those economies which had more export and import trading relations with US. Certain macro and micro economic databases would help to go in more depth of the analysis with more of certain factors. For an instance the company related micro information would be available on the company annual reports or at the company websites. So there are a number of sources which can be used and referred while carrying out the research process. Articles and reports chosen out from books, journals, government generated reports and online articles must be based on true information and with out the predisposition of individual conclusions. Data Analysis This part is the most significant part of any research projects. Analysis of data must be done in a proper logical way. This must be carried out without any prejudice of the researcher. The analysis would consist of both qualitative and quantitative data. However the analysis would be mostly based on the qualitative data. Quantitative data like export and import figures, the mortgage loan amount, default rate etc would be taken into account while doing the analysis. The objective of the analysis is to look for the causing factors or the reasons which made the credit crisis to evolve as the global economic downturn spiral. The analysis would start with an investigation into the factors affecting the credit crunch. For an obvious reason the discussion would start with the analysis of US housing market. In the pre crisis period the pertaining environment in the US housing market, which led to such mortgage crisis, hence the financial crisis, must be analyzed in details to get more insight about the epicenter of the crisis. To discus about the credit crisis it is crucial to analyze the role of certain products and institutions to make the crisis bigger. Some of these factors are complex financial instruments like Mortgage backed securities (MBS), Asset backed securities (ABS), Credit Default Swaps (CDS) and other complicated ands reengineered financial instruments. The role of each of them is important to understand the complicated facts of the financial crisis. Apart from these, there are certain institutions which were responsible for the origination of the credit crunch and had intensified the same. All those intermediaries were connected to each other and that was the reason when one fell down, other just followed the row. This interrelationship or the correlation between these institutions is of great significance in the credit crisis scenario. This is why the fall down of certain financial institution took the form of devastating global recession. The loopholes of the financial system would be investigated to find out the blind spots in it and at the same time to reach at the enhance measures for the same. A few economies would be randomly chosen to see how much correlation it used to possess with United States and how did it go against the respective economic and financial conditions. This would need the analysis of the macro and micro economic data of the respective countries. Investing into the correlation factors of those randomly chosen countries and the US economies is a vital instrument to comment if the higher correlation has resulted in more intensified economic and financial downturn. Liquidity factor of the companies, presiding in the economies would be other areas of investigation. Liquidity is a crucial factor in the financial system. In absence of it, the whole system is bound to crash. The companies, those have collapsed in this recession, would be analyzed from their micro and macro point of views. In the macro environment analysis the whole economy would be taken into account; while in the micro analysis, the internal financial condition would be considered. The objective of this investigation is to see the amount to which collapsing of any company can be attributed to its macro and micro economic factors. There can be instances where the economy has somewhat prevented the financial downturn; however any company in it has fallen apart due to its internal financial state. Data like the export, import with other countries, specifically with United States would be analyzed to find out if any correlation exists between the trade relationships with the foreign countries, specifically United States. Apart from all these, evidences would be looked upon to see the effect of globalization on the faster spread of credit crisis and result in a devastating global recession. Time Schedule A time schedule is necessary in any research proposal. An appropriate well formatted time schedule is of great significance as to keep a track of the times taken by each of the research activities; so that necessary adjustments can be done in the estimated time period in case of any requirement of the same. The table shows an approximation of the time period taken by each of the research activities. Date Time Period Activities 29/03/2010 4 days To accomplish the review of literature related to the credit crisis and the recent recession. This would also include the review of certain models to derive the credit crisis and the factors, considered. 02/04/2010 10 days To collect the facts and figures available on the reports, books, journals and various news articles. Collect the economic data specific to few economies. Looking for the specific companies’ micro economic data. 12/04/2010 8 days To apprehend the data collected, analyze the same and infer the conclusion. 20/04/2010 `10 days To articulate the research report with an apposite approach. The above mentioned activities would take around 32 days to complete the respective research report. Care would be taken to ensure that the activities should not exceed the stipulated time periods. However as the time schedule is created on certain underlying assumptions, it is natural to change as per the project requirements. Still, it can be ensured that the aim would be not o exceed the time limits stipulated for each of the activities. Reference Brookings. October, 2007. Credit Crisis: The Sky is not Falling. [Online]. Available at: http://www.brookings.edu/papers/2007/10_mortgage_industry_downs.aspx [Accessed on March 28, 2010]. Chari, V., Christiano, L. & Kehoe, P. October, 2008. Facts and Myths about the Financial Crisis of 2008. [Pdf]. Available at: http://www.minneapolisfed.org/research/WP/WP666.pdf [Accessed on March 28, 2010]. Debate Wise. June 4, 2009. The Credit Crunch Was Caused by Over-regulation of the Financial Sector. [Online]. Available at: http://debatewise.org/debates/870-the-credit-crunch-was-caused-by-over-regulation-of-the-financial-sector [Accessed on March 28, 2010]. Economist. July 17, 2008. End of Illusions. Available at: http://www.economist.com/business-finance/displaystory.cfm?story_id=E1_TTSVTTPJ [Accessed on March 28, 2010]. Felsenheimer,J. & Gisdakis, P. Credit crises: from tainted loans to a global economic meltdown. UK: Wiley-VCH, 2008., pp 220-230. Financial Times. Auguest 4, 2009. US prime borrowers fall behind on payments. [Online]. Available at: http://www.ft.com/cms/s/0/bd76dbca-8128-11de-92e7-00144feabdc0,dwp_uuid=d355f29c-d238-11db-a7c0-000b5df10621.html [Accessed on March 28, 2010]. Hull, C., J. May, 2009. The Credit Crunch of 2007: What Went Wrong? Why? What Lessons Can Be Learned? [Pdf]. Available at: http://www.rotman.utoronto.ca/~hull/downloadablepublications/CreditCrunch.pdf [Accessed on March 28, 2010]. Bibliography Bernman. Global Financial Stability Report. Washington: International Monetary Fund, October, 2008. CNN Money. December 4, 2007. Credit crisis: Long road to recovery. [Online]. Available at: http://money.cnn.com/2007/12/04/markets/credit_outlook/index.htm [Accessed on March 28, 2010]. International Monetary Fund. World Economic Outlook, October 2008. Washnigton: International Moneary Fund, 2008. Gilbert, M. November 13, 2009. Credit-Crunch Villains Pass the Buck, Party On. [Online]. Available at: http://www.bloomberg.com/apps/news?pid=20601039&refer=columnist_gilbert&sid=a1fW2P6H4W5U [Accessed on March 28, 2010]. Goldberg, R. The Battle for Wall Street. New Jersey: John Wiley & Sons, 2009. Muolo, P. & Padilla, M. Chain of Blame: How Wall Street Caused the Mortgage and Credit Crisis. New Jersey: John Wiley & Sons, 2010. United Nations. World Economic Situation and Prospects 2008. United Nations Publications, 2008. Read More