Causes and Effects of the Global Financial Crisis - Research Paper Example

Running Head: Causes and Effects of the Global Financial Crisis Causes and Effects of the Global Financial Crisis Introduction Recent global financial crisis was inevitable after the crash of the real estate markets, as this paved the way for subprime loans to reveal their negative impacts. As subprime mortgages turned into nonprofit loans and the mortgage, backed securities went into default the loss of confidence in the banking system led to the liquidity crisis. Lack of liquidity in the financial markets caused the bankruptcy of many leading banks throughout the United States and governments rescued others. “A financial crisis is a disruption to financial markets in which adverse selection and moral hazard problems become much worse, so that financial markets are unable to channel funds to those who have the most productive investment opportunities” (Mishkin, pp. 7, 1992). The Triggering Event: Liquidity Shortfall The recent financial crisis or more specifically the recent global financial crisis derives its roots primarily from the triggering event in the US economy that is a short fall of liquidity in its financial system, which led to the bankruptcy of its major financial institutions. The US economy was heavily reliant on its financial institutions and investment banks. As investment banks, had grown to be very large the bankruptcy of one major bank could lead to a direct hit on the overall market. Federal Bank closely watched any moves by major financial institutions and attempted to avoid intervention into the market-based system. In August 2008, Lehman Brothers that was then one of the leading investment banks in the US came under the net of the liquidity crisis. The crisis was the result of rumors in the market by some newspapers that certain banks were unable to honor their commitments. This rumor had critical impact on the functioning of the financial markets and led to a possibility of a run on the banks. In such an instance, depositors end up in queues at bank counters to withdraw their currency in anticipation of bankruptcy by the bank. As banks only maintain the expected withdrawals as liquid cash in their reserves there is a possibility of major banks going bankrupt in such a situation. In an attempt to save the financial system from instantaneous cash withdrawals, the Federal Bank immediately announced its guarantee for withdrawals up to a hundred thousand dollars. This guarantee was sufficient for most individuals to restore their confidence in the daily banking system. Another positive side was that banks were able to offer withdrawals under limit and did not default on individual payments. However, this episode created a panic situation in the country and the interbank lending came to a standstill. Any bank with excess liquidity aimed at maintaining extra funds to cope with an imminent financial crisis and the banks with a shortage of liquidity were unable to borrow funds to meet the shortfall. Interbank borrowing is common as no bank can predict the amount of withdrawals with a hundred percent certainty (Amel, pp. 2493-2519, 2004). A situation where banks will not lend to each other was not what the financial sector had expected to happen. Their counterparts viewed banks willing to borrow funds with suspicion and market began to signal trouble. This situation became worse and many major banks began to feel the effect of the liquidity crunch. This is a situation where banks with excess liquidity could benefit at the expense of those with liquidity shortages (Taylor, pp.42-45, 1999). In a matter of three days, Lehman Brothers declared its bankruptcy as it was unable to meet certain payments to its large clients. The federal bank decided not to rescue Lehman Brothers from its liquidity crunch, as it wanted to set an example for the financial industry. The federal bank was conveying a message that it would not rescue financial institutions and corporations should take corrective measures in order to survive on their own. Truly, the federal bank officials had not anticipated the situation to be this worse. They failed to understand that the network associated with Lehman Brothers would suffer at large from its bankruptcy. The lack of support by the federal bank also raises questions on its ability to protect the financial system from a collapse (Brain, pp. 321-327, 1999). The sentiments were ambiguous and no right answers were available for what action should have been helpful to the overall economy. An institution as large as Lehman Brother’s is interlinked to thousands of businesses and several other major financial institutions. The losses suffered by the connected institutions due to the bankruptcy of Lehman Brothers were substantial and drove many businesses into major losses and even bankruptcy. Deeper roots in the real-estate crash and subprime mortgages The larger picture behind the recent financial crises is primarily the bursting of the real-estate bubble in the US economy. The optimism of financial experts and the Wall Street led to the development of various innovative financial products offered by these financial institutions in an attempt to ease out the masses financially and extend easy credit to individuals. The government was equally involved in permitting these financial institutions to extend credit without any true credibility. This marked the beginning of the subprime crisis. Heavy investments by the financial institutions, individual investors, and foreign investors into the mortgage-backed securities resulted in a wave of unjustified optimism. Mortgages in general are an illiquid investment and due to their long-term nature, only the life insurance sector was interested in buying mortgage pools to improve their expected returns based on their long-term investment horizons (Altman, pp. 589-609, 1968). However, financial experts introduced mortgage-backed securities that would result in converting the illiquid mortgages into liquid debt instruments such as bonds tradable in the secondary markets. Since, these bonds were backed by the illiquid mortgages the return provided on the bonds were higher than those available in the short-term market. The higher returns accompanied by the liquidity provided by these securities appeared attractive to investors and the demand for mortgage backed securities increased exponentially. The increase in demand of mortgage securities was met by an increase in supply through subprime lending (Zhang, pp.121-123, 1995). In this case, subprime mortgages were those that lacked adequate capital and sold to individuals demonstrating little if any ability to pay back the loan. Therefore, the financial experts were busy earning their fees by creating mortgage-back securities that were very risky. To make things worse, a pool of mortgages included both the good and the subprime mortgages, in order to be better able to disguise their existence. Stakeholders were very optimistic about the real estate sector; and expected that mortgagees will generate adequate returns from an increase in price of the property and even if they are unable to meet the mortgage obligations through their personal income, they can always sell the property to pay the mortgage back and still make a certain profit from the transaction. However, the prices of the real estate sector did not rise up to their expectation levels and the financial institutions, which had made huge indirect investments in real-estate portfolio, suffered from losses which caused the financial crisis to become worse (Berger, pp. 541-600, 1992). As financial institutions and banks cannot to make direct investments in the real estate, they found it viable to sell sub-prime mortgages. On the other side, the mortgagee had an option where he could take a mortgage on a zero-percent down payment and the worst-case scenario was to default on the mortgage. The mortgagee had no personal funds invested in such a mortgage and was only paying the interest rate on the mortgage, which can be considered similar to an option premium payment (Sen, pp. 34-37, 2008). If the property price increases, the mortgagee can exercise his call option and sell the property making a profit. While if the prices decrease considerably they can default on the payment and end up losing, only the premium they had paid for the mortgage option. The use of such intuitively counteractive product reflects on the careless attitude of the financial institutions and the government agencies that should have been the saviors of the financial systems. Increase in market uncertainty and the change in asset correlations To understand the global financial crisis one needs to consider the prevalence of high stakes and uncertainty in financial markets (Altman, pp. 12-17, 1993). “In such situations, the risks involved in holding financial assets are often disproportionately high when compared to those to the realized returns.” (Sen, pp. 1-9, 2008). Therefore, many financial institutions were unable to measure the appropriate risks related to their investments as the considered asset correlations when measuring the level of risk associated. Later, it was seen that in case of such financial crisis’s the asset having otherwise low correlations might tend to have high and positive correlations. By introducing complex derivative instruments such as the credit default swaps, which aim to protect asset values in uncertain markets, these instruments also, make it possible to invest and acquire financial assets much more easily (Viney, pp. 42-46, 2009). Most derivative instruments came to being for purposes of hedging risks, but they have made leveraging a company much easier. Due to the use of derivative products, a bank can now increase its financial advantage by as much as it intends to rise. This is possible because no banks can take large positions in the derivative markets without placing any substantial amount in the margin accounts. “The current crisis is widely considered distinctive in several respects, it appears to be exerting a much greater impact on commodity prices, financial markets, and economic activity throughout the world including the industrialized countries” (Kamin, pp. 1-19, 1999). Managers expected to increase the diversification of their portfolios through investment in emerging economies; the idea was that the correlation in the movement between the developed and emerging economies is considerably low. However, during the recent financial crisis the global economy became more correlated than it had ever been before. It is understandable that in worse scenarios we can expect the benefits of international diversification to be almost non-existent. It is also important to note that the global economy is converging and is more interlinked than it was ever before. Global imbalances are visible through a substantial and increasing current account deficit of the US and increasing current account surpluses in Asia, particularly in China, and in oil exporting countries in the Middle East (Goddard, pp. 1911-1935, 2007). This owes to the consumption-based economy of the US where the saving rates have been consistently low over many decades. Individuals tend to consume their future expected income before it is realized and this sort of behavior is critical in defining the financial crisis today. Consumption based economies As individuals have already consumed their future income that they do not essentially expect in the aftermath of the crisis, a large number remain indebted. Stricter borrowing rules after the financial crisis and lost jobs can only result in an increase in the indebtedness of these individuals bringing a blow to the consumption driven US economy. As consumer confidence and purchasing power is considerably low, the financial crisis and its impact on the overall economy continues to be significant. Moreover, global macroeconomic imbalances were another underlying cause of the crisis (Wheelock, pp. 127-138, 2000). Huge cross-border financial flows due to low interest rates in the western economies added stress on the financial stability of the banking institutions in these economies. The global imbalances interact with the market flaws to generate an even wider crisis. Excessive use of financial advantage Another important cause of crises is the excessive use of financial leverage not only at the micro-level but also at the macro level (Amel, pp. 17-27, 1989). The environment of very low interest rates has failed to induce the desired level of investment in the economy due to low levels of confidence in the business community. In addition, since the macro financial and economic environments were stable at that time, this led to the optimistic point of view on the inherent risks. However, this trend of obtaining easy money had to end and so it did with the federal bank tightening its monetary policy. This led to an increase in mortgage pre-payments by the borrowers since the decreased interest rates in the economy allowed them to exercise their option of early payment through refining their mortgages (Lungu, pp. 32-37, 2008). This essentially led to further problems for the banks as now they not only had to suffer from defaults but also from lower expected returns on healthy mortgages. Advances or loans extended by the financial institutions to the many borrowers against in-sufficient collateral base, started to become non-performing loans (Kolari, pp. 361-387, 2002). It is very interesting to note this fact that there were many stress tests conducted by various financial institutions just before the crisis hit them, and they came out perfectly fine in a way that they showed that the institution is securitized well and will be able to absorb any shocks in the forth coming times. However, in reality, the perceived value of that collateral led to a disaster since assets that lost their value those securities. So in fact, the financial institutions had a heavy perceived net-worth base on which they conducted their business but it was not real and this fact had to unveil one day, which marked the beginning of the recent financial crisis (Ports, pp.14-21, 2009). Ethical dilemma and financial crisis The financial markets themselves became more complex hence giving rise to the crisis. Moreover, the extensive utilization of non-banking financial institutions in the financial intermediation process led to the complexity of financial sector. Many small-scale investors had no idea of choosing the right fund for investing their savings. As hedge funds are largely unregulated, they took risks that the investors did not perceive and lost their money. Moreover, lack of transparency for the financial reporting in the hedge funds also revealed major frauds where investors lost billions. In addition, the derivative instruments caused a decline in transparency on the financial scenario (Ohlson, pp. 109-131, 1980). The use of credit default swaps became so widespread that every institution and insurance company had passed their perceived risks to another institution. Many institutions sold credit default swaps in excess of their ability to pay for them in case of a default and went into bankruptcy during the crisis. Initially, these institutions were selling large amounts of credit default swaps based on the idea that the chance of default of those institutions was minimal. Another very important point to note here is that we cannot deny the tradeoff between efficient financial intermediation and a stable financial system by using an extensive de-regulated environment and operating with financial products that reduce the financial environment’s transparency. Globalization or global village had its own impact. The cross border transactions that were carried out in huge numbers and volumes with an optimistic approach, lacked due diligence which trickled down to the recent crisis pond and kept on accumulating. Excessive financial innovation The financial innovation techniques developed at a much faster pace than the counter risk-mitigating models and techniques. The policy makers did not account for the real risks inherent in the extensive usage of so-called financially sound and safe products but in actuality, they were far more complex and lethal. The market participants, however, had almost the same share of market information, yet there were certain conflicts amongst them, which also caused uncertainty on the financial scene. When institutions realized that they might suffer potentially huge financial losses and go bankrupt, they attempted to gamble in the derivatives market. The risk-takers idea was to take more risk in order to avoid bankruptcy, as a turn of events could save them. The larger bets in the derivatives sector did not make their outcome worse as they already expected bankruptcy, but it did affect the overall stability of the financial system largely. The misconception of US being the wealthiest nation, because then it should be showing the highest domestic saving but in fact, the foreign capital inflows finance a huge current account deficit. As financial risk mitigation models did not develop at a pace equivalent to the pace of financial innovation, similar is the case with regulatory framework, which did not evolve as an effective tool in combating and unforeseen circumstances. Conclusion It is clear that the recent financial crises was a result of a failure of the financial institutions and the regulatory bodies to assess the risk involved in their actions and their failure to function according to expectations. It also presents us with a situation where individual investors need to be more aware and actively involved in the formation of their portfolios. 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