Performance of the Housing Markets in the US - Essay Example

? Risk management Contents Contents 2 Global Financial crisis 3 Role of financial engineering: derivative products were a risk management device 4 Interconnectivity between operational risk, credit risk and systemic risk 7 Role of Governance and non-regulatory compliance 9 Role of ISO31000:2009: creating an environment of resilience in the global economy 11 References 14 Global Financial crisis The global financial crisis started with the deterioration in the performance of the housing markets in the US. The investments in housing, real estate and properties were lucrative in the initial days. The investors had the opportunity to multiply their amount of investment in a short period of time due to appreciation of prices of the land properties. In addition to that the US government also passed laws to ensure that all the citizens of US irrespective of their financial status should have land ownership rights. This created a bubble in the housing finance sector and mortgage properties. Investment banks and other financial institutions started to lend money to the mass of people as well as corporate houses for purchase of land or other business purposes. The land and housing properties were kept as mortgage serving as underlying securities for those loans. These loans were granted to the borrowers without looking at repayment feasibility of the loans or without carrying out adequate evaluation of the credit parameters. The credit parameters like income of the borrower, assets available to service the loan, existing liabilities, etc. were ignored by the financial institutions in the mortgage loans. This led to the inflation of the bubble in the housing sector which developed earlier. The bubble finally burst as the borrowers were unable to repay the loans and the defaulters in the mortgage loan market started to become heavy. This led to the devaluation of the mortgages which served as underlying securities. The fall in the prices of land resulted in increased number of bad loans by the investment banks and the financial institutions. The investment in assets and real estate properties were also devalued thereby creating a financial crisis in 2007 that resulted in a global financial meltdown. With the decrease in the valuation of assets, the flow of information to the market led to the erosion of investors’ confidence that reflected in the plunge of share prices of the company (Allen, 1999, p.24). Huge wealth of the investors was eroded in short time thereby causing a situation of liquidity crisis. Several companies like Lehmann Brothers, Bear Stearns, Meryl Lynch, etc. were affected due to fall in the valuation of the companies and inability to return the investment of the shareholders. The liquidity crisis created shortage of monetary supply in the economy which tightened the credit conditions in the economy. This created a global credit crisis which was fuelled by the implementation of revised regulatory standards, enforcement of strict credit parameters and revised policies of the companies to counter the global financial crisis. Role of financial engineering: derivative products were a risk management device Derivatives products are financial instruments that derive its value from the underlying assets such as stock, interest rates, currencies, commodities, etc. Derivative products involve two parties entering into a contract for payment of a certain amount on a certain date under the agreed terms and conditions. The derivative products may be of two types, namely “lock” and “option” derivatives. The lock derivatives enforce the parties entering into the contract to fulfil the payment obligations of the derivative product as per terms and conditions. The “option’ derivative provides the right to the buyer to enter into the contract but the buyer is not obligated to enter into the contract in “option” derivatives. The derivative products are used to hedge financial risks and also to speculate financial gains in the time of adverse financial situations. The derivative products were used a device for risk management by the companies during the time of heavy credit offerings to the US mortgage market (Chance and Brooks, 2009, p.35). The companies entered into credit default swaps and over the counter derivatives in order to gain protection to the loans granted to the borrowers. The time to the financial crisis in 2007 saw huge growth of over the counter trading of derivatives as compared to the exchange traded derivatives. A graphical representation of the sharp rise of over the counter derivatives till the financial crisis in 2007 is given below. The derivatives dipped in 2008 after the emergence of financial crisis. The Bank for International settlements reported that there had been an increase in trading of derivatives by 27% amounting to $681 trillion during the third quarter of 2007 as a result of the financial crisis. The increase in trading of derivatives happened as a result of speculation of investors where they bet on the financial losses due to the fall of the US mortgage market. Due to tightening of credit parameters after the financial crisis, the derivative trading finally dipped in 2008. Although derivatives were not responsible for the global financial crisis but the high use of derivatives by the companies fuelled the emergence of the financial crisis (Bodie, 2008, p.39). The use of derivatives meant that the money flowed from the pockets which had money to the pockets which needed those funds. Derivative acted as a protection for the investments. The investment banks and other financial institutions which lent trillions of dollars to the borrowers were able to reduce their risk exposure by entering into derivative contracts. Thus derivative contracts were used as a risk management device by the lending corporations. Another motive for the use of derivatives was the speculation by the asset managers to achieve maximum returns from their investments (Mayo, 2010, p.34). Most of the asset managers who were based in US and UK were guided by the laws and regulation of the fund which was based in some offshore countries. Thus the regulatory aspect was much relaxed for lending of funds which had underlying securities as mortgage of real properties. This is also a reason why the over the counter trading of derivatives rapidly increased as compared to the exchange traded derivatives. The notional value of the derivates increased exponentially in 2007. This is represented in the graphical representation as given above. The derivative markets grew by almost 50% in 2007. This meant that with apparent cover on the investments, there was boundless flow of money from the lenders to the borrowers with underlying mortgage as security for loans and interest rates, commodities, equities as underlying assets for the derivatives. The inherent risk associated with the credit default swaps and over the counter traded derivatives led to decrease in the valuation of the contracts as a result of the increase in the number of defaulters. Thus the derivative products which were used as a risk management device turned the situation of heavy investment and protection to a damaging global financial crisis (Madhumathi, 2012, p.36). The bankruptcy of Lehmann Brothers, near fall of Bear Stearns and bailout of AIG indicates that there are systemic implications of derivatives leading to the fall of financial markets. Interconnectivity between operational risk, credit risk and systemic risk The global financial crisis and the implications of the crisis resulting to changes in economic conditions all over the world establishes the interconnectivity between the three types of risk, namely the operational risk, credit risk and the systemic risk. The operational risk is the uncertainty of financial performance created as a result of the operations of the organisation. The credit risk is the uncertainty of repayment of debt or loans by the borrower resulting into default of loans granted by the creditor. The system risk of the financial system is the uncertainty of the entire financial system due to systemic changes and crisis created by the integrated effect of individual failures of several financial organizations. The global financial crisis started as a result of the ineffective policies of operation of the financial institutions. Lured by the huge return of investments available in the subprime market and fuelled by the government policies of land ownership, the investment banks and financial institutions started to grant loans to the borrowers without carrying out due diligence of their creditworthiness. The loans were granted by the financial institutions without sufficient assessment on the feasibility of repayments. The credit parameters like income of the borrower, existing liabilities of the borrower, asset base of the borrowers were all overlooked thereby exposing the organisations to operational risk. Moreover, lack of initiative on the part of the government and regulatory authorities paved the path for non-compliance of credit parameters. Moreover, the use of derivatives accelerated the flow of funds into the hands of the borrower who were not creditworthy. All these operational aspects of the financial institutions and investment banks exposed them to the risk of non-repayment of loans in future and increase in the number of defaulters and bad loans. The risk exposure on account of operational aspects led to the credit risk exposure of the financial entities. The underlying mystery is that the borrowers had no urge for availing loan facilities as the investments with underlying mortgage securities were very lucrative for the companies and offered huge returns in short period of time. The grant of loans to non-creditworthy borrowers led to default in repayment of loans for which the valuation of the assets of the company fell. As a result of the credit risk exposure, the valuation of the companies hit the bottom with the investor wealth and confidence getting eroded in quickest time. The implications of the operational and credit risk fell created the system risk for the economy at large. As a result of the fall in the share prices of individual companies in the financial market, the entire financial market found itself in a position of turmoil. The stock exchange movements plunges leading to a fall in the overall market indices. The devaluation of underlying securities and assets meant that the companies’ wealth was eroded due to the financial crisis. Non-repayment of loans meant that the investment banks also had shortage of fund to lend in the market which created tighter credit conditions due to shortage of liquidity in the system (Ruozi and Ferrari, 2013, p.28). This created the liquidity crisis which occurred as a result of the system risk. The shortage of liquidity in the economy led to the decrease in the demand for products. The income levels of individuals and per capita income also declined as a result of the financial crisis. The production unit had to decrease their capacities of production which led to job cuts and decline in purchasing power of the people. The interest rates were revised by the central banks in order to control the liquidity crisis. All these impacts on the international economy occurred as a result of the system risk. Thus the interconnection between the operational risk, credit risk and the system risk has been explained in the background of the global financial crisis. Role of Governance and non-regulatory compliance The role of governance and non-regulatory compliance is extremely crucial in the context of global financial crisis. Apart from the regulation and standards passed by the government and regulatory authorities, the companies also have an internal framework of governance and non-regulatory compliance in order to abide by the policies of the organisation and make necessary changes in corporate strategies through discussion taking into account the benchmarks of performance. The corporate governance of the organizations define a set of actions by the management and the shareholders of the company in order to achieve the desired goals taking into account the risks involved in the areas of operation and investment. Putting a strong system of governance in place would help the companies to monitor the actions of the internal stakeholders and the external stakeholders of the organization and take necessary steps in cases of deviation. An effective system of governance would help the companies to address the conflicting areas of interest of the stakeholders and affix more accountability of the stakeholders in the execution of the process. In the background of global financial crisis, strong governance of internal operations of the financial institutions helps the organisations to reduce the credit risk for lending to the borrowers (Handlechner, 2008, p.38). The employee in charge of processing the loans would be held accountable for the disbursements. Any deviation from the parameters of credit appraisal would be tracked and the rational for such deviations would be determined in order to prevent such deviations in the interest of the organization. Apart from tracking and monitoring of activities, a strong system of governance ensures discussion among the stakeholders in the areas of interests and areas of conflict for the stakeholders. The effective governance system holds the board of directors for their accountability to the shareholders and their progress of actions in order to safeguard the wealth of the shareholders. True financial disclosures of reports of the companies are the responsibilities of the board of the directors and the senior management. The actions are, however, directed and implemented by the executives who are in turn held responsible for their actions. Thus adhering to tight credit parameters and monitoring and tracking of the activities of employee to find possible deviation would lead to decrease in grant of bad loans and would also reduce the number of defaulter. This is important for controlling and mitigating the impacts of global financial crisis. At the same time, disclosure of the correct financial information which is ensured by effective governance would help to safeguard the interest of the market investors. The financial information published by the companies help the market investors to take decision on investments by evaluating their financial performance. Incorrect and inflated reports would aggravate system risk and would lead to a deeper financial crisis of the economy. Governance also ensures that the new regulatory standards of the market like the Sarbanes Oxley Act are fulfilled by the companies. Thus the role of governance in credit risk models is of extreme importance. The non-regulatory compliance followed by the organizations is also a key to mitigating the credit risk. The aspect of non-regulatory compliance includes active discussion among the principal stakeholders in order to identify the problems of a project and to address the key issues with possible solutions. The principal stakeholders in the scenario of global financial crisis are the government, the financial institutions, the housing property holders, the local people, etc. Through intense discussion and engagement in the field, the fair valuation of the properties is determined and according to that the valuation of the loans would need to be disbursed keeping in the mind the creditworthiness of the borrower (Conrow, 2003, p.24). Thus the non-regulatory compliance plays a crucial role in credit risk models and help to mitigate the risks involved in the models. Role of ISO31000:2009: creating an environment of resilience in the global economy The International Organisation for Standardization has passed a family of standard set of principals and general guideline for the companies all over the world to implement an effective system of risk management. The ISO31000:2009 presents a universal set of principles and guidelines for companies to replace their existing set of risk management policies. The guidelines for the standardization are universal irrespective of the industry of the companies. Thus a new global standard for risk management is proposed by ISO31000:2009 which is aimed at creating improved resilience in the international economy. The principles and guidelines provided by ISO31000:2009 for implementation of effective risk management policies and strategies by companies across the world is given below: The first principle guideline talks about avoidance of the risk. The companies would need to identify the risk associated with its activities and area of operation. After identification of the risk, the companies would need to avoid the activities that incur associated risk (Jolly, 2003, p.42). This could be done by not starting the starting the risk prone activity or stopping the activity at the point of identification of the risk. The second guideline talks about the opportunity associated with the identified risk. The companies have to undergo an analysis of opportunities available due to the risky proposition. With an analysis of risk-return, the companies could consider increase in the risk-prone activity to avail the opportunities in the business. The third guideline talks about removing the source of risk. Removal of the source of risk would eliminate the risk imposed on the business activities. The fourth guideline mentions changing the likelihood of risk. This reduces the probability of adverse impacts on the business of the organizations. The fifth guideline talks about changing the consequences of risk. By this principle, the companies could change the degree of impact of the risk exposures. The sixth guideline emphasizes hedging of risk by adopting various risk financing options and by entering into contracts like derivatives, etc. The last guideline of the standardization mentions about retaining the risk through correct information to the stakeholders. This also includes true financial disclosures to the investors in order to safeguard the interest of the investors. These are seven universal principles and guidelines of ISO31000:2009 that frames the system of risk management of the organizations. Thus ISO31000:2009 plays an important role in creating a resilient structure of the organizations in the global economy. The ISO31000:2009 could be used by the companies of any sector of the industry irrespective of their size and activity scale. The set of international standards provide a guideline to the companies for increasing the likelihood of achieving their objectives supported by the minimization of risk through the risk management systems (Khatta, 2008, p.42). Also the impacts of the risk could be mitigated by several strategies like avoidance, acceptance, risk financing procedures and entering into contracts by the organizations. The ISO31000:2009 provides a guideline for internal and external audit parameters to the organizations. Thus the companies across the world could evaluate their performance and compare the individual business performances with the benchmark standards set in the global platform. Thus the set of guideline for standardized risk management techniques puts the companies in a global platform and tracking of performance as per international benchmark helps to reduce the systemic risk and address the problems of global financial crisis. It is obvious that the implementation of standardized guidelines as per the ISO31000:2009 benchmark needs to be supported by a strong system of governance and non-regulatory compliance by the companies. Effective risk management as per the ISO31000:2009 not only sets new global standards fro risk management but also establishes an environment of resilience for the companies in the global economy. References Ruozi, R. and Ferrari, P. 2013. Liquidity Risk Management in Banks: Economic and Regulatory Issues. Springer; Germany. Allen, R. E. 1999. Financial Crises and Recession in the Global Economy. Edward Elgar Publishing; Great Britain. Bodie, Z. 2008. Financial Economics, 2/E. Pearson Education India; India. Khatta, R. S. 2008. Risk Management. Global India Publications; New Delhi. Handlechner, M. 2008. Risk Management. GRIN Verlag; Germany. Conrow, E. H. 2003. Effective Risk Management: Some Keys to Success. AIAA; America. Chance, D. M. and Brooks, R. E. 2009. Introduction to Derivatives and Risk Management. Cengage Learning; USA. Madhumathi, R. 2012. Derivatives and Risk Management. Pearson Education India; India. Jolly, A. 2003. Managing Business Risk. Kogan Page Publishers; USA. Mayo, H. B. 2010. Investments: An Introduction. Cengage Learning; USA. Read More