Global Financial Crisis - Failure in Risk Management - Case Study Example

Executive Summary

The collapse of the sub-prime mortgage lending and the domination of the mortgage-backed securities in the United States securitization markets apparently led to financial instability which later spread to global financial systems resulting in the global financial crisis (GFC) of 2008. The decline of the sub-prime mortgages was as a result of the decisions of financial institutions in the United States to relieve housing credit requirements, to allow the low-income individuals to become homeowners; a decision that was quite normal and rational but had high risks. The resultant financial crisis in the country led to the massive collapse of the major financial institutions such as the Fannie Mae Corp. and the Lehman Brothers. This raised concerns over what went wrong since majority of the large banking institutions had sophisticate risk management systems in place that had been tried and tested over the years. The paper finds out how and why the risk management system failed so catastrophically; it seeks to understand how banking systems’ extensive adoption of the over the counter derivatives trading on securities, left the institutions highly leveraged and thus could not absorb the economic shocks.

Banking institutions trade derivatives based on the value of the essential assets, although any unusual changes in the essential assets might lead to crisis. In addition, derivative trading markets are often unregulated and thus it is not easy to track down any discrepancies in the assets. This makes it possible for fraudulent activity to be carried out without any way of knowing. Attempts to abolish the domination of the uncontrolled derivative trading markets remain unsuccessful, however. The players within the industry remain adamant that the derivatives are an essential global financial tool and as such their abolition will adversely affect the market. Moreover, there is no legal framework to motivate the regulators to take actions to do away with the high-risk derivative trading markets.

Introduction

Attempts to make loans easily available to the low-income earners so that they can become homeowners greatly contributed to the sharp decline in the United States sub-prime mortgage loans. In the early 1990s, the Clinton government put a lot of pressure on the financial systems to assist poor people to become homeowners. The Justice Department also threatened to fine the banks for discrimination had they failed to make the loans easily available to anyone ready and willing to take up the option to borrow in order to purchase a home. There was also pressure from the community-based organizations like the ACORN. On top of that, the industry recognized the potential to make money from such mortgage offering with perceived low risk. A combination of the pressure alongside the greed to make more money prompted a change in tact when it can to offering of loans to individuals. Consequently, the Fannie Mae Corp. along with other major institutions in the industry, relieved credit requirements on loans that it bought from financial institutions and other creditors, an idea, which was quite noble but very risky (Wallison, 2015).

Besides the change in lending policy, the early 2000s were plagued by mini financial crises that the federal government worked hard to curb by changing the fiscal and monetary policies. In doing so, the government flooded the market with money, to maintain a high level of liquidity. This meant that the amount of money in the hands of the public was high and thus they could invest more in real estate. By 2004, the housing boom had reached its peak and the bubble about to burst (Wallison, 2015). Coupled with the rapid rate at which the people took mortgage loan, there was an increased risk of collapsing is not checked. Majority of those that took the loans could not pay back the loans. The number of defaulted mortgages in the country drastically rose to 6 percent compared to the historical figures of between 0.2 and 2 percent defaults. Unfortunately, most of the defaulted loans were sub-prime loans, which were availed to borrowers who exhibited low credit ratings. The risks associated with the loan were quite high since they involved no down payment on the mortgage financed and/or no authentication of income or assets. Approximately 25 percent of sub-prime mortgage loan borrowers defaulted as of the year 2008 (Wallison, 2015). As a result the lending institutions had been left with worthless properties that they had no way of liquidate without making significant loses. The collateral had essentially become a risky proposition under current market conditions.

The sharp decline in sub-prime mortgage loan contributed to the financial instability in the United States. However, it soon rapidly spread to global financial systems and the entire world was engulfed in a financial crisis. There was a widespread increase in uncertainty because of the dwindling financial systems. A majority of the large financial institutions including Lehman Brothers, Freddie Mac, Fannie Mae, and AIG among other banks had collapsed due to inadequate risk management measures. This led to increased precautionary savings, suspension of scheduled projects and debilitation of inventories. Subsequently, there was a reduction in aggregate demand that augmented the crisis and extended it more around the globe. By mid-2008, most developed nations were experiencing financial recession, and approaching the end of the year the world economy had significantly declined. There was reduction in long-term interest rates, company losses, and fallen international trade (Wallison, 2015).

The credit derivative market has tremendously grown over the last decade. The credit default swaps (CDS), which is the basic form of credit derivative first materialized in the United States at the beginning of the 1990s. The financial institutions mainly utilized the CDS as security instruments to cover for risks in their loans. The most commonly used credit derivatives are the CDS and the collateralized debt obligation (Joint Technical Committee OB- 007, Risk Management, 2009). In 2007, the ISDA recounted that the worlds’ defaulted credit derivative summed up to 35.1 trillion. During the global financial crisis (GFC), the financial institutions that had established a proper balance between the security instruments thrived through the crisis while those firms that were highly leveraged ended up collapsing (Wallison, 2015).

Role of financial engineering in the global financial crisis

The decline of the United States sub-prime housing loans, as well as the mortgage, backed securities (MBS), like the collateralized debt obligations that were highly considered harmful, are the main factors accredited with the severe global economic shocks experienced in 2008. The use of derivative trading has been used since the sixteenth century but on a conservative level due to their risky nature. Derivatives can be traded depending on the worth of the essential assets. However, any disparate reduction in the value of the fundamental assets can contribute to a boom in the derivatives. The inverse is also true (Joint Technical Committee OB- 007, Risk Management, 2009). The securitization of loans in the United States mainly established on plain vanilla mortgages combined with the high risks taken by the large financial institutions such as Meryl Lynch through derivative trading, contributed to the financial instability in the United States that later spread worldwide. Many large financial institutions such as Lehman brothers, Meryl Lynch, and JP Morgan were highly leveraged meaning that the worth of their liabilities greatly surpassed the worth of their real assets on their balance sheets. As a result, when the assets declined, the banks remained with the harmful derivatives that required write-downs and bailouts from the government to deal with the situation (Wallison, 2015).

While it is true that the root cause of the GFC was the increased defaults in mortgage loans, the irrational move by the governments in attempts to save the declining large corporations at any cost, also played a major role in exacerbating the situation.As well as the underlying risks, the principal cause of the crisis is deeply grounded on the over the counter (OTC) derivatives. In 2009, the United States government postponed the mark-market regulation, which greatly sustained the mortgage portfolios. However, what was most significant was the idea that it barred the state from recalling large numbers of OTC derivatives contracts, for instance, currency exchange rates swaps, credit default swaps and forwards, which could have potentially led to the collapse of nearly all the large banks around the globe (Joint Technical Committee OB- 007, Risk Management, 2009).

The use of the over the counter derivatives as a hedging strategy in financial institutions is quite a common practice whereby a venture capitalist who is exposed to various interest rates has the ability to transfer the risks to a counter-investor through a swap in the interest rates. In this case, if the interest rates shoot up, the second investor pays for the variation as the first investor pays for the original amounts along with the price of the swap to the second investor (Joint Technical Committee OB- 007, Risk Management, 2009). Again, should the second investor encounter bankruptcy, the first investor remains accountable to the creditor. This means that the venture capitalist would experience losses from the risks offered by the counter- investor including all the net prices paid to the counterpart investor. Looking at the investors separately, there is little risks from both sides. Although, the counter-investor might balance the risk by introducing a third party and so on hence, leading to a network of intersected risks (Joint Technical Committee OB- 007, Risk Management, 2009).

Over the counter (OTC) derivatives are used for speculative purposes but the derivatives are similar to bets. For instance, an individual might bet that a particular firm would default on its bond responsibility. Betting in OTC derivatives has no link to any essential asset or actual trade risk although the risk and liability created by such bets are real. The speculative utilization of the OTC derivatives including the naked credit default swaps as well as CDOs was prohibited in the United States until 2000 when the gaming laws were deterred the Commodity Futures Modernization Act (Wallison, 2015). The OTC are quite risky given the uncertainty involved when trading in them.

Derivative trading on the essential assets are often exchanged in free markets hence little is known about such derivatives like those of the credit default swaps. In the over the counter markets, defaults made by the second investor often create a network of connectivity amid the market players and encourage risk unpredictability (Joint Technical Committee OB- 007, Risk Management, 2009). This resulted in systematic risks, which transpired when the Lehman Brothers financial institution failed. The collapse of the Lehman Brothers holdings led to increased uncertainties among investors around the globe hence led to the further extension of the financial shocks to the rest of the global financial systems especially due to reduced probability of lending among banks and reduced savings (Wallison, 2015).

The intrinsic inadequate transparency in the over the counter market usually hinder price discovery and that is not in accordance with the efficient market hypothesis that states that financial instruments are not to the latter but are always priced appropriately. There is more than ten times the global gross domestic product derivative contracts swaying around the international financial market. However, to the common investors, the rumble of the derivative is invisible. It was the unforeseeable and the improper pricing of the credit default swaps that greatly contributed to the collapse of the American International Groups (Wallison, 2015).

Governance and non-regulatory compliance

The regulatory foundation for the OTC derivative arises from the utilization of the derivatives to evade the regulations and tax policies that are in place. A majority of investors banned from capitalizing in particular banking instruments often presumed practically similar positions in the uncontrolled OTC derivative market segments. The only thing, which they needed to do, was to change the type, source or duration of their earnings. OTC derivative often has varied tax outcomes compared to capitalizations in financial instruments. In addition, the derivatives can establish ethical dangers as well as obstinate incentives. Ethical risks often result when companies undertake higher risks because at the back of their minds they know the government would bail them out should the banks become bankrupt (Wallison, 2015).

Following the 1930 Great depression, the United State government passed the Glass-Steagall Act regulation that provided for securities against excessive leverages and high risks, however, the law was repealed towards the end of the 1990s. The enactment of the Glass-Steagall law was a high achievement in the policy arena that ensured the protection of investors’ money against from losses resulting from the bad decision of the financial systems. However, the moment the law was abolished, the Wall Street financial institutions begun merging and this was the origin of the present notion of “too big to fail”. Case in point, the Citicorp, Travelers Group together with the Salmon Smith Barley merged and demonstrated the success of large corporations compared to other financial institutions (Wallison, 2015).

In addition, governments enabled derivative trading to spread through the financial systems which eventually led to the utilization of the over the counter derivatives that were typically carried out in free markets (Joint Technical Committee OB- 007, Risk Management, 2009). As a result, the regulators could not track down and reduce cynical practices. There were no centralized mechanisms such as the stock market, which provided the regulators with the power to realize faster that there were imminent risks. Therefore, when the value of the underlying assets disproportionately declined at the beginning of 2007, many people did not have an idea on the specific size of the derivative trading market. Consequently, there were consecutive rounds of the governments bailing out of the financial systems and each bailout round was characterized by certain derivative market segments (Wallison, 2015).

Moreover, the inherent ignorance received from the policy community significantly contributed to the global financial stability. In spite of the warning from the Orange County insolvency and the failure of the Long-Term Capital Management, the regulators remained adamant that the derivatives were quite instrumental in the financing arena providing a wide variety of products to both the financial systems and investor. For instance, in 2000, the many companies including Rubin, summer and Greenspan strongly supported the abolishment of the Over the counter derivatives, however, there cries fell on deaf years and derivative trading continued to reign in the banking systems (Wallison, 2015).

Role of ISO: 31000: 2009 in providing resilience in the global economy

There have been several efforts made to help clear-out the mess as well as to establish regulations to help restore confidence in the financial institutions. However, much of the efforts have not dealt will the fundamental problem that led to the global economic crisis, which is the use of the high-risk derivative trading as well as unreliable lending of money. Partnoy and Eisinger in their article, “What’s Inside America’s Bank” refers to the situation as a failure. Banking reforms have failed and currently, the financial institutions have grown bigger and become increasingly opaque than time in history. The banks also continue to engage in the risky derivatives the same manner as they did prior to the global economic crisis. Ignorance of alarming signs has become a culture in the financial systems. Hence, there is a high probability that the world would experience another great kind of global economic crisis (Wallison, 2015).

Implementation of regulations that take into consideration the problems the derivatives caused is the best course of action. Perhaps the adoption of the new ISO: 31000: 2009 would help provide adequate financial resilience in the global economy. The International Organization Standard provide basic principles and guidelines on how organizations whether private or public can manage risks (Joint Technical Committee OB- 007, Risk Management, 2009). Improving organizational resilience is one of the principles that the ISO advocates for in an attempt to curb the risk exposure that they may suffer. In addition, combined with other principles such as improved governance, improved stakeholder confidence, and trust, minimization of losses, as well as improved operational and efficiency, can guide particularly financial institutions to adopt best practices exhibiting low financial risks (Joint Technical Committee OB- 007, Risk Management, 2009). The ISO acts as an appropriate guide for institutions as well as the governments on the best practices in order to avoid catastrophic mistakes.

However, the extensive use of the high risk over the counter derivatives coupled with high ignorance and resistance from the policy arena, as well as the conservative nature of the financial institutions significantly contributed to the global economic crisis. Although, the ISO: 3100: 2009 provides fundamental principles to help adopt best practices and clearly identifies the organizations and policymakers as key stakeholders in risk management, the inability to eradicate the organizational inherent cultures and the political ignorance might deter the possibility of the standard to provide sufficient resilience in the global economy. Hence, with proper regulations in place together with more adaptable financial institutions, the adoption of the ISO: 31000: 2009 will help protect the global economy from imminent global crisis (Joint Technical Committee OB- 007, Risk Management, 2009). The policy makers as well as the implementers of the policies are thus interlinked with failure to adhere by either proving to be catastrophic.

Conclusion

The cycle of events, which led to the global financial crisis, was as a result of bad decisions since the root causes of the event including irrational lending, high risk taking and poor policies could be avoided with better policies and financial risk management instruments. The majority of the larger financial institutions, for instance, the Lehman Brothers holding failed because of excessive risk taking by venturing into the unregulated derivative trading markets. Although many attempts had been made to transform the financial institutions, many failed because the efforts barely focused on the real cause if the crisis. The ISO: 31000:2009 provides fundamental principles and guidelines for risk management. However, its ability to provide resilience to the global economy will depend on the transformation of the conservative cultures of the banking systems together with proper policies. Perhaps the banking systems should adopt the ISO: 3100:2009 standard to help guide on the management of risk to prevent future global crisis.