Why Did the Financial Crisis Spread So Quickly - Essay Example

Why did the 2007 financial crisis spread so quickly and so far? Why did the 2007 financial crisis spread so quickly and so far? The financial crisis in 2007 occurred for two years and is commonly referred to as the Global Financial Crisis. It was the most catastrophic financial stress as it affected many financial institutions including banks, which had to be bailed out through monetary policy expansion by the national governments. However, the efforts were not strong enough to save stock markets, which continued to deteriorate all over the world. The financial crisis left many people homeless globally due to evictions catalyzed by the lack of jobs and foreclosures in the housing sector. The crisis also led to the global recession in 2008 following its effects on international trade (Acharya & Matthew, 2009). The financial crisis is believed to be as a result of increased values of securities related to the United States of Americas in the stock market. The increase on the securities was as a result of the housing bubble which reached its optimum in 2006, affecting many financial institutions worldwide. Therefore, the crisis was a result of a complicated interplay between policies that enabled home ownership through the provision of cheaper loans to potential home buyers. Subprime mortgages were hence overvalued based on the presumption that real estate prices would continue to escalate. The global stock markets suffered heavily when real estate securities suffered large losses as a result of declining credit availability and dented investor confidence. Most economies globally slowed down during this period as a result of credit unavailability and a decline in international trade (Caballero, Pierre-Olivier & Emmanuel, 2008). The financial crisis was primarily an internal problem in the United States of America. The crisis began as a subprime crisis in the country in 2007 and spread over to other advanced countries. The crisis commenced with an enormous real estate asset bubble. Housing prices dramatically escalated in the United States with mortgage rates lower than normal mainly because of the Federal Reserve lowering the federal funds. Federal funds are the rate at which financial institutions lend each other overnight (Ely, 2009). In order to avoid losses, mortgage lenders have traditionally been very strict in scrutinizing the eligibility of a citizen in terms of repaying the loan. However, this did not happen in the United States of America when there was widespread securitization. Securitization allowed banks to lend mortgage loans to many jobless individuals with no income or assets at all. Loan regulators also authorized mortgage securitization companies such as Fannie Mae, a company whose debt was correctly guaranteed by the government, to take excessive risks by participating in the process. The regulators also gave a green light to credit rating agencies to go ahead and give investment ratings to mortgage-linked securities, which were of dubious quality. As credit and housing bubbles were building, several other factors facilitated the expansion of the financial system making it even more fragile. This process of the financial system expansion is known as financialisation. The United States Government policy encouraged deregulation in a move to encourage business. As a result, a shadow banking system evolved when there were financial institutions giving less information on their new activities (Haldane, Vasileios & Simon, 2010). There have been disagreements among policymakers and economists on what exactly caused the crisis. Many of these parties agree that the slack supervision and regulation of the monetary policy in the United States’ financial institutions activities. Others believe that the increasing global imbalances and related capital flows were the primary sources of the financial crisis across countries with advanced economies (Acharya & Matthew, 2009). The housing demand in the United States has been identified to be sensitive to money market interest rates. Therefore, the accommodative Federal Reserve monetary policy encouraged the increase in housing demand and asset prices (White, 2009). The monetary policy contributed to the development of financial imbalances in a number of channels. Loose monetary policies which are low short-term rates reduced the expense of wholesale funding for banks. According to information obtained from Ely (2009), the banks and other financial systems opted to create a leverage out of the situation. Banks on the other hand ended up taking more liquidity and credit risks. Loose monetary policies also increased the demand and supply for mortgage loans causing house (asset) prices to escalate. A worldwide moral hazard and ineffective supervision played a role in the global financial crisis. This theory has been proved by the work done to assess the variations in the supervisory regimes. The study identified that the balance sheet expansion caused by wholesale funding markets was minimal where there existed strong supervisory powers. Moral hazard and ineffective supervision reduce capital flow effects thus setting up financial imbalances (Haldane, Vasileios & Simon, 2010). Global imbalances are also considered as one of the causes of the global financial crisis. The increasing worldwide imbalances are often associated with a wider dispersion of current accounts positions. On top of this, larger net capital flows occur between countries. At the level of a single country, net capital inflows, which arise from the increased entry of foreign investors in a domestic economy, match the country’s current account deficit (Ely, 2009). The resulting high capital inflows have the potential to reduce the cost incurred by domestic banks in terms of wholesale funding in international markets (Ostry et al., 2010). Capital inflows also compress spreads by reducing long–term interest rates. The reduction in interest rates causes banks and other financial institutions to create leverage as the investors look for cheaper and easier loans. Finally, global imbalances may lead to an increase in the availability of credit to citizens which is harmful to the domestic economy by raising the prices of local assets such as the house pricing witnessed in the United States of America (Reinhart & Carmen, 2008). Before the global financial crisis, the imbalances experienced in many advanced economies had already been linked to the reduction in long-term interest rates. The enormous capital flows into financial markets influenced risk-taking measures on an extraordinary scale. Many financial institutions therefore opted to expand their balance sheet and design new instruments in order to satisfy the overwhelming search for yield by investors (Ely, 2009). According to information gathered from previous financial crises cases, the monetary stress is passed on and on between countries. The transmission takes only about two months to affect every other region of the globe. However, there is a significant variation of the crisis amongst economies. The financial crisis is felt with a stronger intensity by developing economies, which tend to have close financial ties in terms of foreign direct investment and banking systems with the more advanced economies. The key tools for crisis transmission during the 2007 global financial crisis were the linkages in the bank lending activities. Western European banks, for instance, have been known to dominate bank lending flows to developing countries since the mid-1990s. By the end of the first crisis year, their total assets in developing economies made up 10 percent of advanced-economy GDP (Brunnermeier, 2009). This figure was 7.5 percent more compared to a total 2.5 percent Canadian, Japanese, and United States banks’ GDP. Since emerging economies in Europe stand out as the primary recipients of bank lending flows, the intensity of such links clearly explains why the worldwide financial crisis, which revolves around banks, had such a penetrating impact on most emerging European economies (Borio & Haibin, 2008). Many banks in other countries bought collateralized United States debt when the subprime mortgage loans were bundled and sold to financial institutions worldwide. From the crisis spread, the links between banking systems were visualised. This is because banks ceased from lending each other, which made it hard for consumers and firms to obtain loans from banks all over the world. The role played by the banking system globally in the financial crisis point to a drawn-out reduction in capital flows directed towards developing economies. From this information, we can deduce that there is a high state of dependency between countries globally (Haldane, Vasileios & Simon, 2010). In terms of budgetary and monetary policies formulation, the 2007 global financial crisis was just a recurrent of previous financial crises. The only differences between the 1920s and 2007 financial crises are just in the mode of occurrence where the 2007 crisis started off in the housing sector and spread over the economy. The 1929 crisis occurred as a result of a stock market crash which was followed by market contractions and disruptions of global proportions. In the 1920s, where the monetary supply could not be expanded as easily as nowadays, credit expansion rose to high proportions as a result of leveraged stock buying. The same mistake was repeated in the 2007 crisis when a real estate bubble occurred due to increased cheap mortgage loans. The 2007 financial crisis was not any different from the 1920 crisis since, in both scenarios, assets were acquired with forever increasing amounts of credit. The loans were borrowed under the assumption that assets acquired would generate money at a faster rate than the compounded interest and principal. This shows that the same mistake is bound to happen in the near future if the activities of the financial institutions go unregulated (Stephan, Ravi, Selim, & Irina, 2009). References Acharya, V., &Matthew, R. (2009). Restoring Financial Stability: How to Repair a Failed System. Wiley. Borio, C., & Haibin, Z. (2008). Capital Regulation, risk-taking: a missing link in the transmission mechanism? BIS , Working Paper, No 268. Brunnermeier, M. (2009). Deciphering the Liquidity and Credit Crunch 2007-2009. Journal of Economic Perspectives, 77-100. Caballero, R. J., Pierre-Olivier G., & Emmanuel, F. (2008). An Equilibrium Model of Global Imbalances and Low Interest Rates. American Economic Review, 358-393. Ely, B. (2009). Bad Rules Produce Bad Outcomes: Underlying Pubic-Policy Causes of the U.S. Financial Crisis. CATO Journal, 93-114. Haldane, A., Vasileios, M., & Simon, B. (2010). "What is the contribution of the financial sector: Miracle or mirage?”. The Future of Finance, the LSE Report. Ostry, J. D, Atish, R., Ghosh, Karl Habermeier, Marcos Chamon, Mahvash S. Qureshi, and Dennis B.S. Reinhardt. (2010). Capital inflows: the role of controls. IMF Staff Position Note, 20. Reinhart, Vincent R. Reinhart and Carmen M. . (2008). Capital Flow Bonanzas: An Encompassing View of the Past and Present. NBER, Working Paper 14321. Stephan, D., Ravi, B., Selim E., & Irina T.. (2009, April 16). Rapid Spread of Crisis Reflects Close Global Economic Ties. IMFSurvey Magazine. White, W. R. (2009). Should Monetary Policy “Lean or Clean". Federal Reserve Bank of Dallas Globalization and Monetary Policy Institute , Working Paper No. 3. Read More