Global Financial Crisis 2007-2009 - Essay Example

Global Financial Crisis 2007-2009 Introduction The world has become a global village where all the entities of the world are interconnected. No entity can claim to survive alone in the technological age and succeed. The positive aspects of this amalgamation are the numerous opportunities that can be availed by organizations and individuals, equally. However, the downside of the system is the ripple effect of changes that is almost inevitable in the modern world. If the economy of one important country or region fluctuates, its tremors are bound to be felt by multiple regions. Similar conditions were witnessed in the global financial crisis of 2007 which is termed to be the biggest one since the Great Depression in 1929. The financial crisis of 2007-2009 caused disastrous effects in the US economy as well as numerous other countries of the world. The effects have been so severe that the world still struggles to return to normalcy. 2. Causes of the Financial Crisis of 2007 2.1 Overview of the Crisis The crisis is considered to have planted its roots since as early as 2001. This is the time when United States of America recovered from a minor recession due to the terrorist attacks and the dotcom bubble. Dotcom bubble was a stock market recession that took place due to the heavy investments in the dotcom companies. Many investments were made in the technological companies with the expectancy of gaining even greater profits. The US economy survived this setback in their economy but their minds feared the probability of an actual recession. Singh (2007) stated that the Federal Reserve decided to decrease the interest rate to 1.75% from a rate of 6.5% to avoid any occurrence of a recession. This lowering of the rate proved to be an attractive package for the people as many more individuals could finally make their dreams come true and make desired investments. What the concerned authorities did not predict were the consequences of such an increase of loans and mortgages. 2.2 Beginning of the Crisis Due to the decrease in the interest rates, the people became restless buyers and started applying for more mortgages and loans. The demand for houses appreciated the property prices to a great extent and lowered rate for rented properties. A greater element of encouragement was introduced in the market when Federal Reserve lowered the interest rate even lower to only 1% in the mid of 2003. This was done with the aim of keeping the economy strong. Singh (2007) stated that this rate was the lowest one that was witnessed in the past 45 years. This gave an even bigger push for the people to invest as much as they possible could. Then, another factor was introduced in the market to escalate the investments in the market- CDO. Collateralized Debt Obligations (CDO) can be defined as the financial tools that are responsible for repackaging of loans so that they can be sold to other bodies in the market. These loans might include individual loans, credit card debt or house mortgage (Amadeo n.d.). CDOs provide more liquidity in the market since banks are able to transfer the debt to other bodies. This creates more leverage for the first bank to invest more or lend more. The concept of CDO resulted in even more investors and subprime mortgages, where subprime mortgage is defined as the mortgage that is lent to an individual with bad financial history. The applicant of a subprime mortgage is an individual, who would conventionally be rejected for any loans or mortgages due to his prior bankruptcy, non-payments for a previously owned loan etc (Google n.d.). These risky borrowers are granted loans on a comparatively higher interest rate as compared to the individuals who prove a good credit history. Even though such borrowers are considered to be very risky and have a higher probability of defaulting on loans, Federal Reserve and financial institutions did not realize the forthcoming circumstances that were waiting as a result of reckless grants of loans. High Beam Research (2005) stated the fact that homeownership rate rose to a great level of around 70%. Stock Market Investors.com (2008) provided the fact that around 5 million people in the US became homeowners due to the low interest rates. Then came the time when trouble started and homeowners realized what they had gotten themselves into as a result of hasty decision making and attractive packages from the banks. Federal Reserve realized that the country had fully recovered from the probability of a recession therefore they started increasing the interest rate. They increased it gradually but to such an extent that it rose from 1% to 5.25% by the mid of 2006. The demand for houses stopped once the interest rates were revealed to the people and thus the appreciation of properties ceased. The new interest rates made it difficult for the homeowners, especially the subprime loan borrowers to make their payments in accordance with the increased interest rates. The most common approach that was adapted by such homeowners was to declare bankruptcy to get rid of their debt. The rate of bankruptcy rose to its highest (during this crisis) in the mid of 2007. Singh (2007) explained that around $ 1 trillion were estimated to be owned by the financial organizations in the form of these failed subprime mortgages that resulted in liquidity problems. This was not enough of an awakening call for the Federal Reserve as they thought that the situation would soon return to norm. Due to which not enough timely mitigation actions were taken to handle the subprime mortgage sector of the country. The increasingly hopeless situation in the subprime mortgage sector started leaving its mark on other institutions as well for example stock market. The instability in the banking sector caused their shares to come down drastically in the mid of 2007. Stock Market Investors.com (2008) provided another fact that by the start of year 2008, major banks and financial institutions had lost around one third of their worth. The uncertainty in the market caused a freeze in the interbank market since banks feared the profile of the participating bodies; where interbank market refers to the borrowing of temporary funds from a bank that possesses greater liquidity. This also proved to severely affect the financial system of the United States of America. Figure 1: Causes of the Crisis BBC News (7 August 2009) Figure 1 gives a graphical representation of the facts that acted in the creation of the worst global financial crisis in decades; the increase in mortgage defaults caused a stop of flow of money in the market. The increase in defaulters indirectly affected the trust between the banks and thus they ceased interbank lending. It would not be wrong to state that it was the greed of the individuals and the financial institutions that aggravated the credit crisis and approved sub-prime mortgages in a great number. The major acting elements in the financial crisis have been risky decision making by financial institutions and an incompetent system that was incapable to manage risks. 3. Effects of the Financial Crisis of 2007 The scale of disaster called out for intervention by US Federal Bank and EU Central bank that provided some funds to the banks to encourage interbank market and reduce the uncertainty and insecurity in the market, it is graphically represented in figure 2. Figure 2: US Fed Bank and EU Central Bank provided US banks with funds BBC News (7 August 2009) The Federal Reserve also decreased the interest rates to encourage the actions of borrowing. Singh (2007) pointed out that the rate was lowered to 1% in October, 2008. These efforts could not prove to save the economy from the scale of crisis that was waiting for it. It could not help to solve the liquidity crisis in the market and banks remained insecure about lending cash to each other. The non-availability of credit brought about recession, layoffs in organizations, increase of prices to maintain a normal lifestyle and bankruptcies. The effect of the crisis was obviously the greatest in US where major financial institutions were forced to declare bankruptcy. Some of the major companies who got out of business and increased the level of uncertainty in the world are as follows: Lehman Brothers Holdings Inc. One of the oldest investment banks in the US initiated a major tremor in the global economy when it declared bankruptcy in September, 2008. Hasan (2005) described this as the biggest bankruptcy in the recorded history of US as there was $638 billion worth of assets filed. The reason for their failure was bad debts and record lowering of their share value. This declaration created havoc in the global market and effected many countries (which shall be discussed further in detail). Washington Mutual It was considered to be one of the biggest loan and savings institution. It severely got affected by the financial crisis of 2007-2009. Hasan (2005) stated that the declaration of bankruptcy revealed that the company had around $307 billion making it the 6th biggest bank in the country. The impact of this crisis could be felt in even far off countries around the world. Some of the major ones were UK, Netherlands, China, Australia etc. All of these countries started being cautious about lending loans and decreased the interest rate like Federal Reserve. 3.1 Impact on UAE The impact was felt even in the strong and blooming economies of the United Arab Emirates. They were affected from both aspects of financial as well as trade. The US and other countries were not in the state to buy too much oil due to which the finances of these countries were majorly affected. The decreasing demand in oil and thus declining prices of it made their whole economy stumble. Figure 3: Decrease in oil prices (World Bank 2010) It can be seen from figure 3 that oil prices were at a raging high till July of 2008. After this time, the global financial crisis started showing its effects globally and caused a great decrease in prices which was caused by the lowering of its demand in the global markets. The uncertainty in the market made the investor’s freeze their money and avoided any further investments. Khamis and Senhadji (2010) explained that the investors felt the urge even more to cease any further investments in the region after the declaration of bankruptcy by Lehman Brothers Holdings Inc in the US. The UAE including states like Dubai, Bahrain, Kuwait etc have had linkages with the credit markets of the US therefore the effect was greatly felt there. World Bank (2010) explained that the tightened liquidity conditions and freeze on investments caused the property prices to be decreased by a great degree. The projects that were underway also faced many losses and some could not even be finished that created havoc among the homeowners. This took place around the time when the property prices in UAE especially Dubai were at its greatest peak. Figure 4: Bank credit growth from 2008 to May 2010 (Khamis and Senhadji, 2010) Figure 4 highlights the effect of the financial crisis on the Gulf Cooperation Council (GCC) countries with respect to the bank credit growth. It can be seen that the bank credit growth had been severely affected and still struggling to return to its normal status. 3.2 Impact on South Asia South Asia accumulates India, Bangladesh, Pakistan, Sri Lanka, Nepal etc. This region was already recovering from a prior setback in their economies when the global financial crisis hit them. World Bank (2008) termed the prior setback as ‘Terms of Trade shock’ that took place during the years of 2003 to 2008. The major roles that played in this setback were the global rise in the petroleum and oil prices that affected the GDPs of the countries. The global financial crisis of 2007 caused a decrease in the foreign capital flow due to the lesser number of exports. World Bank (2008) pointed out the fact that exports make up 20% of the GDP of the South Asian countries therefore the decrease in this area caused a considerable blow to their economy. The economies also got affected due to the decreasing income from remittances. Layoffs were also witnessed in this region however much lesser than the US. India Today.in (13 August 2010) stated that India was able to withstand the pressures of the global financial crisis and recovered from the setback very quickly. India was among the few countries who survived the financial crisis to a great extent. Other countries in the list included Australia, China and Brazil. The effects of the global financial crisis that initiated in 2007 still prevail in the markets and economies of the world. The US economy continues to launch one program after the other to overcome recession and provide jobs to the unemployed people since the unemployment rate had reached record low in the times of the crisis. Figure 5: Unemployment rate of US since the financial crisis (Trade Economics 2010) It can be seen from figure 5 that unemployment rate slashed down to a very low percentage of 4.8 in the first quarter of 2008 but has improved by the introduction of several programs by the government. Improvement is being witnessed in the economy of different countries; some countries show slow progress while some are proving to find solutions quicker than the rest. 4. Lessons Learned from the Crisis When the causes of the financial crisis are analyzed, it can be found that different schools of thought seem to give different reasons. Some give more importance to the risky decision making by the financial institutions whereas some consider the flaws in the regulations to be the major factor. Due to the lack of agreement on the causes, there are differing lessons learnt by different individuals. When the crisis took place, one of the most common questions was about the effectiveness of the risk management plans that were implemented in the organization. The researchers wondered why the risk management processes failed and could not control the global crisis. Some lessons have been learned from a crisis of such a great degree that are discussed below: Lesson 1 Marinella and Wander (2009) addressed the matter of increasing number of organizations making use of highly efficient quantitative risk analysis models. These models provide a basis for effective decision making as it is able to simulate and weigh all the factors that might be involved in a certain scenario. As much as these models facilitate the portfolio managers to make effective decision making about their investments, they have some severe drawbacks. The realization of these drawbacks has increased after the global financial crisis and an important lesson has been learnt. One of the major drawbacks of the quantitative risk models is that they rely on historical data for their analysis. Since the world had not seen such a severe global financial crisis before, the models did not provide any relevant basis for decision making. An important lesson can be learnt from this that models should not become the sole basis of decision making and common sense should also be put into practice by the portfolio managers. The risk managers should be able to judge when the models analysis and decision making is not suited for the situation at hand. Lesson 2 Another important lesson learnt from the crisis is that greed and emotions should not come into play in the midst of investments and business decisions. Greed of the financial institutions led the approval of such a great number of subprime borrowers even though there is always a high chance of such borrowers to default their loans. It should also be remembered by portfolio risk managers that every high has a severe fall as nothing remains constant for too long. If a certain market has lived its peak time for too long then it is safer not to invest in it since its low point might be very close. Therefore greed should not be allowed to become a part of the portfolio decision making. Lesson 3 Bartholomew (2010) stated that the global financial crisis revealed the importance of liquidity for all organizations. It is vital for any organization or institution to be able to fulfill their immediate cash requirements. The company might come at a point where it would start struggling for its existence if it is not able to meet such requirements. Liquidity evaporated from the market in the times of the recent financial crisis due to the lack of planning from the organizations therefore corrective and systematic measures need to be taken to promote extensive planning regarding the perseverance of liquidity. 5. Conclusion The entire world suffered one of the greatest financial disasters in the recorded history that began in 2007. The crisis initiated after the housing boom in the US market where interest rates slashed to very low figures. The introduction of CDOs gave way to more applicants for mortgages and loans. The financial institutions did not make good decisions and started authorizing subprime mortgages. The subprime borrowers started defaulting on their loans after some time and created havoc for the financial institutions. Many large organizations were forced to shut down and declare bankruptcy. The financial crisis caused a global tremor and caused major layoffs in US as well as many countries around the world. The crisis caused a major decline in the oil prices that caused a decline in the revenues of the Gulf region. South Asian countries also suffered loss in their revenues due to the declining demand of their export products. The crisis took place due to lack of centralized governance of the financial institutions, greed and incompetent risk management processes. Portfolio risk management processes have been analyzed by organizations around the world to make them efficient enough to handle such severe setbacks. References Amadeo, K n.d., CDOs (Collateralized Debt Obligations), About.com Guide, viewed 8th September, Bartholomew, D 2010, ‘Risk management 2010: Lessons from the Credit Crisis’, BlackRock BBC News 2009, ‘Timeline: Credit crunch to downturn’, 7 August Google n.d., Subprime Mortgages, viewed 9th September, High Beam Research 2005, ‘U.S. homeownership rate climbs toward 70 percent’, Qualified Remodeler Hasan 2005, ‘Some Major U.S. Companies That Went Bankrupt!’, Directory Journal India Today.in, 2010, Brazil, India & China fared well during the financial crisis, 13 August Khamis, M., Senhadji, A 2010, ‘Impact of the Global Financial Crisis on the Gulf Cooperation Council Countries and Challenges Ahead: An Update’, International Monetary Fund Marinella, M., Wander, B. 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