Monday, January 6, 2020
The Factors That Triggered The Financial Crisis Finance Essay - Free Essay Example
Sample details Pages: 15 Words: 4552 Downloads: 5 Date added: 2017/06/26 Category Finance Essay Type Cause and effect essay Did you like this example? The current financial crisis originated from global asset scarcity. A large capital flows towards the USA that causes an asset bubble, eventually burst .Anticipation of capital gains on housing property led to a bubble in asset prices. This trend has started in late 90s and not affected by dot com bubble. DonÃ¢â¬â¢t waste time! Our writers will create an original "The Factors That Triggered The Financial Crisis Finance Essay" essay for you Create order Persistent global imbalances, subprime crisis, and volatile oil and asset prices are heavily correlated for recent dooms in world economy. The crisis started in July 2007 with the collapse of two Bear Stearns hedge funds, the Bear Stearns High-Grade Structured Credit Fund, and the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund. With this collapse, the so-called subprime mortgage crisis became apparent with a substantial increase in mortgage delinquencies and foreclosures in the United States. As credit markets froze, the Treasury bill-Eurodollar spread known as the TED spread (difference between the3-month US Treasury bill yield and LIBOR) started to increase dramatically (Kenc Dibooglu, 2010). 1. FACTORS TRIGGERED THE FINANCIAL CRISIS: 1.1) Global imbalances: The crisis exacerbated the shortage of assets in world economy, which triggered a partial recreation of bubble in commodities. Rising oil price, led to an increase in petrodollar investing in us financial market. One of the underlying reasons for USA asset appreciation was current account deficit. Starting in 1991 us current account deficit becoming worse day by day, reaching 6.4% of us GDP in fourth quarter of 2005, and then falling back to 5% of GDP by early 2008. The counterpart of deficit were Japan , Europe and emerging Asia.(IMF, 2009 ) The rapid growth in china and other East Asian economies, and rise in associated commodity prices has a capital flow in US, which has been thought a feasible place .How do the macro economic imbalances sustained? The trade surplus countries kept their exchange rate low relative to US$, which helped sustain the deficit configurations. The rise in asset prices led to an increase in consumer wealth, which further stimulated US consumption, spendi ng and imports, helped sustain the trade deficit ( Kenc Dibooglu, 2010). The global saving glut hypothesis also views the global imbalances as direct results of increased savings and current account surpluses in developing and emerging economies. In these economies, export driven growth has led to higher incomes (Kenc Dibooglu, 2010). 1.2) Interest rate: The reallocation of capital flows subsequently decline the USA and world real rate of interest and a boom in market. In the context of low real interest rate US households were encouraged to take more housing risk then they could afford. Also fed decreased the interest rate to make US current account deficit, which has caused dollar to depreciate. The collapse of dot com bubble in2001, US economy slowed down and entered in to depression in 2001.At that time US FED reduced its interest rate .Lower target interest rates made by FED contribute to the global flow of funds in making mortgages more affordable and house prices rose sharply as the demand for houses exploded (Kenc Dibooglu, 2010). 1.3) Securitization: Mortgage securitizations entail pooling of mortgages and issuing assets backed by the cash flow of the mortgage. It plays a vital role in relation of housing bubble. MBS(Mortgage based securities) are created when mortgage holders form a portfolio of mortgages and sell shares .Then , the cash flow from the portfolio of assets are passed to investor. Normally, this investment is more liquid than any individual mortgages since bundles of assets reduce risk. When considering mortgages, instead of creditworthiness, more emphasise has given to make money by selling it to third party, e.g. ABS CDOs (Hull, 2009). 1.4) Lending standard: Since US government has been trying to improve to expand home ownership and pressuring to mortgage lenders to increase loan to low and moderate income people. Lenders made it easier for less creditworthy families who made increased demand for real estates and price increased. Also the lender knew there risk is covered by underlying high asset price. Some of the terms known as , liar loans , NINJA(no income, no job, no assets).With low interest rate , mortgage lenders follows lax standards in approving mortgages and optimism fueled speculation in housing market ( Kenc Dibooglu, 2010). 1.5) Agency problem: Credit rating agencies are now under scrutiny for given investment-grade ratings to MBSÃâÃ based on risky subprime mortgage loans. These high ratings enabled these MBS to be sold to investors, thereby financing the housing boom. These ratings were believed justified because of risk reducing practices, such as credit default insurance and equity investors willing to bear the first losses. However, there are also indications that some involved in rating subprime-related securities knew at the time that the rating process was faulty. (US House of Representatives committee, 2008). According to Buttonwood (2007) the rating agencies suffered from conflicts of interest, as they were paid by investment banks and other firms that organize and sell structured securities to investors. On 11th June, 2008, theÃâÃ SECÃâÃ proposed rules designed to mitigate perceived conflicts of interest between rating agencies and issuers of structured securities. On 3rd December, 2008, the SEC a pproved measures to strengthen oversight of credit rating agencies, following a ten-month investigation that found significant weaknesses in ratings practices, including conflicts of interest practices, 1.6) Subprime mortgage default: Around 80% of U.S. mortgages issued in recent years to subprime borrowers were adjustable-rate mortgages. After U.S. house prices peaked in mid-2006 and began their steep decline thereafter, refinancing became more difficult. As adjustable-rate mortgages began to reset at higher rates, mortgage delinquencies soared. Securities backed with subprime mortgages, widely held by financial firms, lost most of their value. The result has been a large decline in the capital of many banks and U.S. government sponsored enterprises, tightening credit around the world. 1.7) Shadow banking: The shadow banking system has been implicated as significantly contributing to theÃâÃ financial crisis of 2007. In a June 2008 speech, U.S. Treasury SecretaryÃâÃ Timothy Geithner (speech Reducing systematic risk in a dynamic financial system), placed significant blame for the freezing of credit markets on a run on the entities in the shadow banking system by their counterparties. The rapid increase of the dependency of bank and non-bank financial institutions on the use of these off-balance sheet entities to fund investment strategies had made them critical to the credit markets underpinning the financial system as a whole, despite their existence in the shadows, outside of the regulatory controls governing commercial banking activity. Furthermore, these entities were vulnerable because they borrowed short-term in liquid markets to purchase long-term, illiquid and risky assets. This meant that disruptions in credit markets would make them subject to rapid deleveraging, se lling their long-term assets at depressed prices. Nobel laureateÃâÃ Paul KrugmanÃâÃ described the run on the shadow banking system as the core of what happened to cause the crisis. As the shadow banking system expanded to rival or even surpass conventional banking in importance, politicians and government officials should have realized that they were re-creating the kind of financial vulnerability that made the Great Depression possibleand they should have responded by extending regulations and the financial safety net to cover these new institutions. Influential figures should have proclaimed a simple rule: anything that does what a bank does, anything that has to be rescued in crises the way banks are, should be regulated like a bank. He referred to this lack of controls as malign neglect (Krugman, 2009). 2. EFFECTS OF THE CRISIS ON FINANCIAL MARKETS: The rapid decline of US housing prices in 2007-2008 has significant impact on money market, bonds, stocks and derivatives. Asset Backed Securities (ABS) and Collateralized Debt Obligations (CDO) have been affected the most during that session. The fundamental of these securities is the availability of fund. Since the crisis started there was lack of cash flow which results into contaminate the mortgage backed securities (MBS) (Mayer, et al., 2009). Regulators allowed giant banks to measure their own risk and set their own capital requirements. Given perverse incentives, this inevitably led to excessive risk taking Deregulation allowed financial conglomerates to become so large and complex that neither insiders nor outsiders could accurately evaluate their risk. The Bank for International Settlement told national regulators to allow banks to evaluate their own risk-and thus set their own capital requirements-through a statistical exercise based on historical data called Value at Risk (VAR). VAR is an estimate of the highest possible loss in the value of a portfolio of securities over a fixed time interval with a specific statistical conÃâÃ ¬ÃâÃ dence level. The standard exercise calculates VAR under negative conditions likely to occur less than 5% of the time. There are four fundamental flaws in this mode of risk assessment. First, there is no time period in which historical data can be used to generate a reliable estimate of current risk. Second, VAR models assume that security prices are generated by a normal distribution. Third, the asset-price correlation matrix is a key determinant of measured VAR. The lower the correlation among security prices, the lower the portfolios risk. VAR models assume that future asset price correlations will be similar to those of the recent past. However, in crises the historical correlation matrix loses all relation to actual asset price dynamics. Most prices fall together as investors run for liquidity and saf ety, and correlations invariably head toward one, as they did in the recent crisis. Again, actual risk is much higher than risk estimates from VAR exercises. Fourth, the trillions of dollars in assets held off balance sheet were not included in VAR calculations (Blankfein, 2009).Reliance on VAR helped create the current crisis and left banks with woefully inadequate capital reserves when it broke out. A Financial Times editorial observed that risk management models . . . were catastrophic. The Financial Times Gillian Tett concluded that it was sheer madness for financiers ever to have relied so heavily on these VAR models during the first seven years of this decade (Tett, 2008). Following discussion is how the crisis affected the financial markets; 2.1) Derivatives Market effect: A financial security backed by a loan, lease or receivable against assets other than real estate and mortgage backed securities (Hull, 1997). Mortgage classes can be identified by tranche: senior tranche (AAA), mezzanine tranche (BBB) and equity tranche (no rating). Different mortgage classes associated with different risks and returns. The higher-ranking tranche receives higher priority return with minimised credit risk. A mezzanine tranche for example can be cut into different slices, separating prime and subprime mortgages and creating a new portfolio with AAA rated tranches, A rated tranches and unrated tranches. ABS/CDO portfolios started to experience increasing the due of the non payment debt and foreclosures and their values declined precipitously (International Labour Office, 2009). As AAA tranches associated with lower risk have suffered an intense increment in downgrades (Barnett-Hart, 2009). As initial risks have been miscalculated by rating agencies and financial in stitutions solely relied on credit ratings, repackaged BBB tranches were traded as AAA tranches in the market and therefore experienced default losses from the subprime mortgage segment. As result financial institution were no more able to raise funds through ABS and CDOs. The crisis has spread to other types of markets including credit default swaps, high-yield corporate bonds, the inter-bank market, commercial paper, money-market funds, hedge funds and the real economy. Defaulted mortgages and CDOs affected the Credit Default Swaps (CDS) as they required providing insurance against the default counterparty. The insurance holder has the right to sell the insured instruments (e.g. bonds) to the CDS seller at their initial face value or to claim the difference between the initial face value and the recovery rate if the reference entity defaulted. In 2007 and 2008 a large number of CDS sellers had to make payments to CDS holders. Moreover, CDS that were written on securities with AAA rating that actually deserved a credit rating of BBB, forced CDS holders to make payments that were higher than expected because of the miscalculation of default risk and underestimation of positive correlation among sub prime tranches. 2.2) Stock market affect: In December 2007 (Homan and Matthews, 2007) US stock market acted declining sharply as reaction to immense losses related to sub prime mortgages. The US stock market further declined by the bankruptcy of Lehman Brothers in September. In between 0ctober 2007 and 2009 the Dow Jones industrial average lost 53% value of their stock (Yahoo finance). The stock market had been observed extremely volatile which results in to 7.87% losses and profits up to 10.88 during the month of December 2007. 2.3) Bond market: Fears of a recession in the United States and interest rate cuts by the Federal Reserve have pushed the yield on the 10-year Treasury below the rate of inflation. In the wake of the collapsing housing market and credit market turmoil in the late 2007 and early 2008, the findings from the Federal Reserves survey certainly come as no surprise. Over the past few months, credit spreads have surged. The spread between Moodys Baa bond yield and the 10-year Treasury yield has doubled in the past year to over 300 basis points, a rise usually associated with recessions (The sceptical speculator, 2008). In 2007 CDS spreads increased for all securities which were not considered as risk less, especially for those which were rated with BBB, such as high-yield corporate bonds. Suppose such a bond pays 8%, but now has a CDS spread of 400bp (4%) rather than 200bp (2%). Assuming LIBOR/swap rates to be constant, investors return on insured high-yield bonds fell by 2%. To raise funds on the capital m arkets, such a company would now be forced to increase its bond yield by 2%, thus increasing its cost of financing. 3. RECOVERY FROM THE CRISIS: Recovery processes are different depending on different types of financial crisis. Historical evidence shows that, each and every financial crisis was followed by an economic expansion and those expansions are different in nature which includes credit booms involving upset labour markets, goods and services, booming real-estate business, equity prices and asset price bubbles as well. According to the IMF (2009); Recessions in the advanced economies over the past two decades have become less frequent and milder, whereas expansions have become longer, reflecting in part the Great Moderation of advanced economies business cycles. Recessions associated with financial crises have been more severe and longer lasting than recessions associated with other shocks. Recoveries from such recessions have been typically slower, associated with weak domestic demand and tight credit conditions. Recessions that are highly synchronized across countries have been longer and deeper than those confined to one region. Recoveries from these recessions have typically been weak, with exports playing a much more limited role than in less synchronized recessions. The current financial crisis was highly synchronized across the countries and this is why it was thought to be stayed long. The governments of different countries have taken different actions to stabilize their economy. 3.1) Introduction of Term Auction Facility: The first policy action to manage the financial crisis was the introduction of Term Auction Facility (TAF) in December 2007. The primary objective of this policy was to make the borrowing easier for other banks from the Fed and reduce the spreads in the money market and eventually increase the flow of money which would lead to a lower interest rate. By this new policy banks could borrow directly from the Fed avoiding the discount window with larger maturity dates in order to inject liquidity into the market. The fed was trying to lower the gap between the long term lending rates and the overnight rates (Taylor and Williams, 2008). Figure 1, shows the amount of funds taken up along with Libor and OIS spread. Figure 1 is showing that soon after the starting of the TAF, the spread came down for a while but after that rose again showing no respect for the TAF. 3.2) Interest rate adjustment: Interest rate change is the primary initiative for any central bank regarding monetary policy to handle with the financial crisis. Federal Reserve Bank has decreased their funds rate from 5.25% from the beginning of the crisis in August 2007 to 2% in April 2008 to minimize the crisis. However, that initiative did not work according to their expectation but, depreciated the Dollar sharply which influenced the dramatic increase of the oil price as well as other consumer goods price instead. From the beginning of the financial crisis in August 2007 to July 2008 the oil price has almost doubled. The relationship between oil prices and interest rates is proved by empirical studies. For instance, the First Deputy Managing Director of the International Monetary Fund John Lipsky (2008) said: Preliminary evidence suggests that low interest rates have a statistically significant impact on commodity prices, above and beyond the typical effect of increased demand. Exchange rate shifts also appear to influence commodity prices. For example, IMF estimates suggest that if the US dollar had remained at its 2002 peak through end-2007, oil prices would have been $25 a barrel lower and non-fuel commodity prices 12 percent lower. 3.3) Temporary Cash Infusions: Economic Stimulus Act of 2008 passed in February 2008 was another recovery policy action. Like a package, the aim of this stimulus was to boost up the family and individual consumption by providing cash totalling of over $100 billion in May, June, and July 2008. This was done by tax rebates to lower and middle income tax payers, incentives to encourage business and to increase the limits forced on mortgages that could be obtained by the government agencies. It was not completely a monetary policy because the rebate was financed by borrowing rather than money creation (Taylor, 2008). As shown in the figure 3 consumption was not increased as was expected whereas the personal disposable income increased sharply because of the rebate. 3.4) Fiscal support for the American International Group (AIG): In September 2008, after a sudden financial deterioration of American International Group, a big financial panic was developed and whose result was judged to have significant adverse effect in the economy. The Fed announced an 85 billion dollar financial support for AIG to backup its finance and to keep the money market mutual fund from breaking the buck (Goodfriend, 2009). The Feds financial support for AIG was criticized immediately by some important members of Congress as a questionable commitment of taxpayer funds, in effect, a bridge too far (Blackstone Yoest 2008). 3.5) Interest on reserves: The Financial Services Regulatory Relief Act, signed in 2006, gave the Fed the authority to pay interest on reserves starting in 2011 for the first time in its history. In May 2008, Fed Chairman Bernanke asked that Congress give the Fed immediate authority to pay interest on reserves. Using authority granted under the Emergency Economic Stabilization Act of 2008, the Fed announced that it would begin paying interest on required and excess reserve balances (Goodfriend, 2009). The payment of interest on reserves was intended to assist in maintaining the federal funds rate close to the target. Nevertheless, the Feds authority to pay interest on reserves is timely and valuable because, in principle, it gives the Fed the operational capacity to exit credibly from the zero bound without first drawing down the stock of bank reserves. Unfortunately, in practice, the fact that the federal funds rate has fallen somewhat below the rate of interest paid on reserves indicates that some financia l institutions holding balances at the Fed that trade in federal funds market are not authorized to receive interest on those balances. Although most of the central banks have lowered interest rates to tackle the global downturn, they were appropriately cautious in doing so in order to maintain incentives for capital inflows and to avoid disorderly exchange rate moves or a full-blown capital account crisis (IMF, 2009). In the context of a financial crisis, fiscal policy was particularly effective in shortening the duration of recessions, whereas the impact of monetary policy was reduced. However, room to provide such fiscal support would be limited if such efforts erode credibility in the absence of a medium-term framework. Thus, governments are faced with a difficult balancing act-delivering short-term expansionary policies but also providing reassurance for medium-term prospects. This task is becoming increasingly difficult as the downturn extends in depth and duration. Althoug h governments have acted to provide substantial stimulus in 2009, it is now apparent that the effort will need to be at least sustained, if not increased, in 2010, and countries with fiscal room should stand ready to introduce new stimulus measures as needed to support the recovery. 4. FINANCIAL REGULATORY REFORM: Banking supervisors, including the Federal Reserve, have broad powers to set binding rules limiting financial activities of the institutions they regulate and to issue guidance describing the standards they will consider in supervising and evaluating those firms. Rules, for example, set standards on the amount of capital that institutions must hold to engage in certain activities. Examples of guidance issued prior to the financial crisis include statements describing how examiners would evaluate firms exposures to commercial real estate lending and non-traditional mortgage products. The federal banking supervisors seek to work together and with state supervisors to introduce consistent rules or guidance where possible, either through informal channels or through the Federal Financial Institutions Examination Council, which was established for that purpose. However, where they cannot reach agreement, supervisors can and have introduced guidance independently to their respective inst itutions (Gramlich, 2007).The Federal Reserve also works with foreign supervisors to develop consistent standards. For example, the Federal Reserve played a key role in the international development of the first Basel capital standards in 1988 (Basel I) and in the revised Basel Capital Accord in 2004 (fcic.gov). Policy and regulatory reform: Stronger macroeconomic policy and macro prudential analysis to avoid too loose monetary policy and excess liquidity; assessment of asset bubble .tightening monetary policy when money or credit grow in an unsustainable way (IMF, 2009) Reforming expeditiously the Basle 2 capital requirement process for bank capital for banks and higher quality of capital; counter-cyclical approaches capital buffers; higher capital for trading books; measuring and limiting liquidity risk; stricter rules for off-balance sheet vehicles; common definition of own funds. Credit rating agencies (CRAs) To be supervised by new European Securities Authority; fundamental review of role of CRAs in the financial system; distinct new approach to rating of securitized products (OECD, 2009). Accounting Strengthened governance of the IASB; wide reflection of the role of mark to market accounting necessary; improved valuation techniques. Accounting standards should not bias business models, promote pro-cycli cal behaviour or discourage long-term investment (General Accounting Office, 2007). Insurance Essential to deliver Solvency before May this year. Appropriate safeguards to be defined to ensure an effective group support regime. within the EU, a strengthened CESR should be in charge of registering and supervising CRAs; A fundamental review of CRAs business model, its financing and of the scope for separating rating and advisory activities should be undertaken; Sanctions/supervisory powers to be strengthened throughout the EU so sanctions bite and are deterrent. Competent authorities in all Member States must have sufficient supervisory powers, including sanctions, to ensure the compliance of financial institutions with the applicable rules; competent authorities should also be equipped with strong, equivalent and deterrent sanction regimes to counter all types of financial crime. Parallel banking system (HPs, private equity) All parts of the financial system where they have a potentially systemic nature should be appropriately regulated and supervised; for hedge funds information requirements on hedge funds should become mandatory through regulation of hedge fund managers. Securitized products/derivative markets should be standardized and simplified; at least one well-capitalized clearing house for credit default swaps should be created in the EU. simplify and standardise over-the-counter derivatives; introduce and require the use of at least one well-capitalised central clearing house for credit default swaps in the EU; guarantee that issuers of securitised products retain on their books for the life of the instrument a meaningful amount of the underlying risk (non-hedged Investment funds Common EU rules should be strengthened -including tighter control over depositories and custodian. Most of the Economic specialists agree that governments failed to make a proper regulatory framework for the financial system which would be able to keep the financial market stable. It has been proved that supervision and regulation was inadequate as they were not able to tackle this big sized crisis. Main weaknesses of the regulations taken that time are measured as the followings: There should be sufficient government supervision for the banks. Hedge funds even operated completely outside of the supervisory framework. Systemic risk has been underestimated by the regulators in the financial system. Banks are interconnected and highly leveraged institutions can affect the entire financial system if they failed. Requirements for capital and liquidity were too low. Financial institutions were not required to hold sufficient capital to cover their assets. Moreover, regulators did not require firms to hold enough capital for scenarios such as a shortfall of liquidity or an abrupt increase of counterparty risk. As the responsibility for supervising financial institutions was split among various authorities, banks could decide wh ich authority to choose and therefore act in their own interest. Regulations fro the financial system should become more vigorous and reliable. Regulatory standards for financial institutions should not allow for excessive risk-taking and give banks no opportunities for arbitrage, gaps or loopholes. 5. NEW TRENDS ON THE FINANCIAL LANDSCAPE: Financial markets have recovered faster than expected, helped by strengthening activity. Nevertheless, financial conditions are likely to remain more difficult than before the crisis. Specifically: Money markets have stabilized, and the tightening of bank lending standards has moderated. Moreover, most banks in core markets are now less reliant on central bank emergency facilities and government guarantees. Nonetheless, bank lending is likely to remain sluggish, given the need to rebuild capital, the weakness of private securitization, and the possibility of further credit write-downs, notably related to commercial real estate. Equity markets have rebounded, and corporate bond issuance has reached record levels, amid a reopening of most high-yield markets. However, the surge in corporate bond issuance has not offset the reduction in bank credit growth to the private sector. Those sectors that have only limited access to capital markets, namely consumers and small and medium-s ize enterprises are likely to continue to face credit constraints. So far, public lending programs and guarantees have been critical in channelling credit to these sectors. Sovereign debt has come under pressure for some small countries, as they struggle with large government deficits and debt, and as investors increasingly differentiate across countries. Amid a relatively rapid return to healthy growth in many emerging economies, portfolio flows into these markets have picked up, easing financial conditions and prompting nascent concerns about asset price valuations. By contrast, cross-border bank financing is still contracting in most regions, as global banks continue to delever. This will limit domestic credit growth, especially in regions that had been most reliant on cross-border bank flows. CONCLUSION: Economic production and trade bounced back worldwide in the second half of 2009. Confidence increased strongly on both the financial and real fronts, as extraordinary policy support forestalled another Great Depression. In advanced economies, the beginning of a turn in the inventory cycle and the unexpected strength in U.S. consumption contributed to positive developments. Final domestic demand was very strong in key emerging and developing economies, although the turn in the inventory cycle and the normalization of global trade also played an important role. Driving the global rebound was the extraordinary amount of policy stimulus. Monetary policy has been highly expansionary, with interest rates down to record lows in most advanced and in many emerging economies, while central bank balance sheets expanded to unprecedented levels in key advanced economies. Fiscal policy has also provided major stimulus in response to the deep downturn.