The Global Financial Crisis Essay
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To this day, many still debates as to what exactly caused the Global Financial Crisis. Most people believe that it was the US subprime housing market, but we know this was only the trigger not the cause. There is a number of contributing factors that led the world economy to where it is at today including both macro and micro factors. The macro context is characterized by a prolonged period of excess global liquidity partially induced by low rate of interests set by the Federal Reserve Bank and other Central banks following the US recession in 2001 after 9/11.
The excess liquidity is often viewed as a global pool of funds mainly from developing countries such China, India and Saudi Arabia. These countries had been growing rapidly in recent decades after loosening on trade restrictions and embracing the globalization change. Traditionally, this global surplus of funds would seek investment in ‘old fashioned’ government treasury bonds, but this massive excess in liquidity was posed unwelcoming by the US federal reserve when Alan Greenspan announced that the Federal Funds rate will be at 1%.
This proposed a challenge for all the investment managers and institutions as to where to invest all this money? With the US housing market booming ever so rapidly, the global excess surplus of funds fuelled domestic demand especially in residential investment. This triggered a dramatic increase in housing prices which more than doubled between 2000 and mid 2006. During this period of housing boom, housing prices were forever increasing, but consumers were saving less and both borrowing and spending more.
Household debt grew from $705 billion in 1974 (60% of disposable personal income) to $7. 4 trillion by end 2000, and a massive $14. 5 trillion in 2008 (134% of disposable personal income). _51. The micro context is related to the lack of regulation and supervision and changing industry practices by financial institutions which contributed to the build up of vulnerabilities in the financial market. The “originate-to-distribute” lending model, which was used by many financial institutions during this period, seems to have aggravated the problem further.
Under this model, banks did not make loans and then hold the mortgage for the term of the loan, but more so to write loans primarily to sell them on to other financial institutions that then in turn would pool them together and issue asset backed securities. The logic behind these loan sales was to transfer the risk associated to the ultimate buyer of the security which are backed by the underlying mortgage loans.
These securities would then be pooled together again and named collateralized debt obligation (CDOs) which are rated in tranches in regards to its risk levels, thus creating new instruments in which the same transfer of risk continues so on and so forth. Another factor was the mispricing of risk by credit rating agencies such as Moody’s and S&P who used modern technologies, but historical data. New innovations in financial instruments combined with the never seen before massive emergence of subprime borrowers meant that historical data can not be counted on.
This mispricing of mortgage backed securities linked to subprime loans led the market to believe that there was an arbitrage opportunity. Such market perception gave more demand for these instruments and contributed to erosion in mortgage underwriting standards in attempt to increase the supply of loans to meed the global appetite for mortgage securitized assets. Lax of regulation on the account that risks were being transferred to the unregulated segment of the market meant that the heavily regulated banks would only be the originators and the ultimate holders of securities were over and beyond the boundaries of regulation and supervision.
It seems at first glance, that it was the subprime mortgage market that started all this turmoil as house prices started to fall in 2007. This had serious consequences for banks which had organized increasing off-balance sheet activities through special purpose vehicles (SIVs) which held mortgage backed securities (MBS). The importance of SIVs was that it held large positions of asset backed securities (ABS) which represented loan portfolios that had been sold in national and international capital markets.
The originate-to-distribute model assumed that banks could easily sell loan portfolios in the capital market; this is to some degree why banks created SIVs to unload asset backed securities and to encourage off-balance sheet activities. SIVs relied on short term commercial papers or bonds in order to finance themselves, the collapse of the US bonds market in 2007 forced banks to take the mortgage portfolios from their SIVs back into their own balance sheets. Falling house prices which resulted from default and foreclosures especially in the subprime market explained the increased supply of houses.
The unexpected decline in prices meant that peoples’ homes were less worthy than their mortgages and homeowner’s equity dropped sharply some even with negative equity. This in turn meant that refinancing options were limited and very difficult. The drop in housing prices in the US had eroded investors confidence into mortgage-based securities (MBS) held by SIVs, in particular, problems with refinancing MBS evidenced significant problems in the asset backed securities market (ABS). The price of MBS and its respective portfolios fell rapidly in 2007 as a result of the decrease in prices of the US subprime mortgage market.
But the crisis was not just confined to the US. One of the largest mortgage banks in the UK, Northern Rock, had the government coming to its rescue for a bail out. The UK government decided to nationalize the bank in early 2008 and this started a long and heavy government involvement in the UK banking crisis. The US subprime crisis which evolved into a banking crisis and ultimately turned into a Global financial crisis has uprooted the stability of the financial system at an international level.
While the Federal Reserve cut interest rates sharply and the government implementing emergency stimulus packages to boost the economy, there is no evidence that governments have undertaken appropriate structural reforms in order to prevent a re-living of history. Although still under investigation, it has been widely accepted that the financial crisis started in 2007 when US housing prices dropped sharply and increased doubts in investor confidence in mortgage based securities spread.
This made refinancing of special purpose vehicles increasingly difficult. However, innate problems lie with the lax of regulation and supervision in the financial system. In the late 1990s, unregulated hedge funds with sky rocketing rates about 20% put enormous pressure on banks to match with similar rates of return on equity. A leading global financial services firm in America UBS has created its own hedge funds along with many other banks creating off-balance sheet activities and special purpose vehicles in order to uplift the rate of return.
These SIVs invested in collateralized debt obligation (CDOs) which are repacked bundles of asset backed securities with specific tranches in terms of risk profiles, and relied on short term commercial paper (bonds) for refinancing. As mentioned previously, this method failed as house prices started falling in 2007 and investor doubts emerging quickly and banks had to take the portfolios of mortgage based securities back from their SPVs onto their own balance sheet.
A key problem here is that the unregulated hedge funds and their indirect roles in the financial system were not only of its high levels of leverage, but also its role in driving rates of return so high that created massive pressures on banks to come up with similar offerings. The increase of off-balance sheet activities meant that traditionally effective banking operations and governance could no longer be supervised through balance sheets.
Banks wanted to maintain the loans on their books but wanted to get rid off the risk associated with the loans, to achieve this, banks bought Credit Default Swaps (CDS) from special service providers and insurance companies. The way CDSs were traded lacked transparency for the market as well as the prudential authorities. Regulators allowed CDSs to be traded globally, but the lack of prudential supervision meant that no one kept track of these transactions and created a global facade of ignorance as to the allocation of CDS.
Currency and bond markets are faced with the challenge of assessing the market value of loan portfolios as it makes a big difference whether there is credible insurance for the loan or not, hence the efficiency of financial market pricing remains low. Another problem in regulation was that of the rating agencies. These agencies often came up with ratings which were often unrealistic. The faultiness of these agencies can be seen in the example of Lehman, where it had been given almost top ratings even two days before it went bankrupt. Many mortgage backed assets had AA and AAA ratings although common sense would tell you otherwise.
Flawed ratings can have significant consequences leading to misjudgement of risks for investors and other stakeholders. The USSEC was the prudential supervisor for investment banks and was mainly interested in investor risk and did not take much interest in other associated issues such as systemic risk. The Fed, who was in charge of traditional banks, took a laisser-faire approach under chairman Greenspan. Banks in the US and EU could adopt higher risk without regulators requiring enhanced risk management. Such an approach in prudential regulation is common among OECD countries prior to the pitfall of the crisis.
A final factor that lacked regulation and supervision in the financial system was that of inadequate incentives in the current framework for long term investments in banks. Managers and traders took interest mainly in short term investments that generated high bonuses and commissions. This meant that long term investments that promote steady economic growth are often overlooked. Many would argue that the crisis we see today is not something of the unexpected. One has to blame both banks and the prudential regulatory authorities to have allowed such turmoil to emerge in financial markets.
The reforms and changes necessary to help fix existing gaps in regulation and supervision are obvious. They must respond to the problems identified. A more strict and comprehensive regulation of hedge funds must be sort after. Trading of CDS could be restricted and hedge funds who do not comply should not be permitted to trade. Banks should also establish more comprehensive and consolidated balance sheets which includes all off-balance sheet activities. Review in domestic accounting standards as well as global accounting measure may also need to be looked at.
CDSs should have a central register where transactions can be recorded. And complex innovations of financial products should be standardized in order to avoid pricing complexities. Rating agencies should undergo frequent review by other individual bodies as well as be required to obtain a license as proposed by the European Commission. Additionally, there should be random checks and fines for poor rating accuracy. Finally, a new tax revolution may be necessary for financial companies and institutions to encourage more long term healthy investments that promote steady economic growth, rather than short term monetary incentives.
The financial turmoil of 2007-08 saw a long chain of financial intermediaries that starts with investors who has a massive excess in funding to top companies and institutions throughout Wall Street and ended up with people who stand to lose their houses. Every player in the chain wanted to seek for a quick fix of short term benefits and deluded themselves thinking the risk associated was transferred to someone else. The lost in value of ABSs triggered by securities back with subprime mortgages widely held by financial firms, resulted in large decline in capital of many banks, tightening the availability of credit around the world.
This banking crisis soon turned into a global financial crisis with governments of all countries stepping in to play a role. Just as the Chief of IMF stated “that regulation and supervision were not strict enough…” one might as well ask, could all this ciaos been preventable had adequate regulations were in place? Or personal greed being at corporate or individual levels would have inevitably driven the world to where we are now?