Causes and Effects on Global Economy - Research Paper Example

Causes and Effects on Global Economy Introduction The recent financial crisis is considered to be the worst by economists since “the Great Depression”. This led to the closure of reputed financial institutions like Lehmann Brothers; while the others were either rescued by the government stimulus packages or were sold forcefully. The main reason for this can be traced to the bursting of the housing bubble that had gained momentum in US over the years on account of low interest rates. This resulted in a steep fall in the value of the securities, with real estate as underlying. There was a decline in the level of economic activity that gradually spread across the globe. The spate of events undermined the confidence of the investors impacting the global financial markets. With the tightening of the credit norms there was a slowdown in the economies worldwide. It is argued that the government and Federal banks could have avoided this situation had they acted on time. Critics put the blame on the regulatory practices of the government and credit rating agencies. The latter failed to assess the risk associated with the mortgage based financial products. As a result of the high ratings given to these securities they were passed on to the investors easily. A hike in the interest rate led to widespread delinquency on the home loans and early foreclosures. This increased the supply of houses thereby putting a downward pressure on their prices. The rise in the rates of delinquencies due to the steep housing installments eroded the value of the mortgage based securities. Financial crisis: Causes Surplus liquidity and low rates of interest created conditions of easy credit and contributed to housing boom. There was a considerable increase in the home ownership rates in the country most of which was comprised of the subprime mortgage. During this time credit was extended to the borrowers with a bad credit history. The installments on these loans were low initially but with the re-set of the interest rates the monthly installments of the borrowers also increased substantially. Meanwhile the steep rise in the house price and credit created a building boom. The rise in the rate of foreclosure together with the surplus unsold houses caused a steep fall in the housing prices in US. Another reason that contributed to the rise in the home loan delinquency was the quality of credit. Enticed by earning higher transaction fees the lenders failed to check the credit worthiness of the borrower and in the process extended credit to the high risk segment. The size of the down payment for the first time borrowers in the country was scaled down considerably to nearly 2 percent as compared to nearly 20 percent in other countries. The underwriting standards of mortgage deteriorated considerably during this time. Besides this the automated procedure of loan approval failed to review the credentials of the borrower. This system of subprime credit coupled with the securitization of traditional mortgage dealt a final blow to this aggravating crisis. Securitization- The process of securitization enabled the banks to free the tied up funds and pass on the credit risk to the investors in the form of mortgage backed securities. The sale of the mortgages to the investors replenished the funds of the banks enabling them to issue new loans and earn transaction fees. The reason that the subprime crisis reached such magnitude is due to the complex financial instruments created through securitization. By way of this the banks pooled their mortgage loans into sellable instruments thus offloading the credit risk associated with these loans to others. Securitization released the tied-up funds of the banks by converting long-dated loans into securities. These securities were rated by the credit rating agencies as safe that encouraged people to invest in them. With the soaring profits the banks were tempted to create even more loans as they could easily convert them as securities. As the credit risk was passed on to the investors the banks did not bother about the credit record of the borrower. The boom in the housing market attracted the investors to the mortgage backed securities thus increasing the profits on the securitized instruments. There was an increase in the loan portfolio of the banks just for the purpose of the securitizing the mortgage. Collateralized Debt Obligations (CDOs) increased the risk by covering up the risk of the bad loans (Shah, 2009). Faulty credit ratings- There was a conflict of interest with the credit rating agencies as these agencies were paid by the sellers of the structured securities like the investment banks and other firms. The agencies gave a safe rating to the securities with the subprime mortgage as underlying. This facilitated the sale of securities based on the risky assets to the investors thus contributing to the housing boom. Initially the ratings were considered justified as it reduced the risk in the form of credit default swaps. However, the flaws in the rating system were highlighted by the fall in the value of the securities. An investigation by the Securities an Exchange Commission (SEC) revealed the important weaknesses in the rating process. Eventually the agencies downgraded the ratings of the mortgage backed securities. This lowered the value of these securities with the financial institutions and created the demand for additional capital to meet the norms of capital ratios. This was followed by a fall in the value of floating shares. The agencies undermined the risk inherent in the structured derivative products. This hurt the confidence of the participants about the authenticity of the ratings. The report prepared by the Financial Stability Forum (FSF) stated that the faulty rating of the agencies was to an extent on account of methodological shortcomings. It highlighted that the rating agencies had failed to make a note of the falling lending standards. The report criticized the agencies for failing to monitor the securitized product’s quality. These agencies assigned AAA ratings to the “senior tranches” of the CDOs, the rating assigned to the corporate and government bonds with low return yield (Utzig, 2010). Regulatory practices- Some economists are of the view that the government policy supported the subprime meltdown due to legislations like Community Reinvestment Act as per which the banks are forced to extend credit to borrowers with poor credit record. With the aim of increasing home ownership in the year 1982 the Congress passed the Alternative Mortgage Transactions Parity Act (AMTPA) allowing the non-federally contracted creditors to give adjustable rate mortgages. This gave rise to new loan types like option-adjustable rate, interest-only mortgage, adjustable rate etc. But the government failed to frame regulations to avoid any exploitation resulting from these loans. This led to the misuse of the lending practices with the adjustable rate mortgage accounting for the highest percent of the subprime mortgage. The Glass-Steagall Act separated the activities of the commercial and investment banks to avoid the conflict of interest arising from the lending and rating functions. Its cancellation was highly criticized by the economist Joseph Stiglitz. The cancellation of this Act is said to contribute to the crisis because of the investment bank’s inherent culture of risk taking. The laidback policy of the central banks is one of the reasons that magnified the impact of the crisis. With the charge of managing the monetary policy and inflation rates the central banks tended to react only after the aftermath of a crisis to minimize the damage to the economy. However they did not play a role in preventing the crisis. One of the key factors that contributed to the sharp rise in the housing prices was the low interest rates. Between 2000 and 2003 the rates on federal funds were reduced to 1 percent. This was done with view of softening the impact of the burst of dot-com bubble, terrorist attack and risks of deflation. As the inflation rate was low the Fed lowered the rate of interest ignoring the other crucial factors. The interest rate was then significantly raised between 2004 and 2006. This added to the miseries of the subprime borrowers. The adjustable rate mortgage was reset to the market rates increasing the monthly burden. This is also said to be one of the factors that led to a fall in the asset prices. With a boom in house building there was an increase in the supply of houses but this did not match with the demand as the rates moved up. This led to a fall in the price of the assets. Impact of the crisis The financial turmoil that originated towards the middle of 2007 has largely subsided. Even though the financial system has improved but it is yet to get back to normalcy. The effect of the crisis is apparent from the difference in the LIBOR- the rate of interest charged on inter-bank lending and borrowing- and Treasury yields. This difference between the 3 month LIBOR and 3 month treasury widened during the summer of 2007 as a result of the failure of Bear Stearns. It widened with the takeover of Freddie Mac and Fannie Mae, and the bankruptcy of the Lehman Brothers. This reached a stage of financial panic when the spread between the LIBOR and Treasury reached 450 basis points, signaling the fear of the largest banks in the world to extend loans to each other. A string of actions by the FDIC, Federal Reserve, Congress and Treasury Department controlled this panic by the year 2009. The gap between the LIBOR and Treasury narrowed and has reached the stage where the banks freely borrow and lend each other. Though there has been an improvement in the financial system it is not yet normal. Depository institutions continue to fall at a rapid rate. This trend is likely to continue for many years to come. Nearly 135 institutions have been closed by the FDIC in 2009, which is the highest since 1992, and around 550 institutions are on its “troubled list”. The securitization markets remain weak on account of higher loan loss anticipations. There is also an uncertainty about the coming changes in accounting and legal rules as well as regulatory reforms. While the private bond issuances reached to the highs of $2 trillion in 2006, this figure was less than $15 billion and most of it was backed by TALF program of Federal Reserve. The issuance relating to commercial and residence mortgage backed securities along with the CDOs has become dormant. The small businesses and the consumers have to face a credit crunch as the lenders have raised the standards extraordinarily. As per the survey of the senior loan officials by Federal Reserve the lenders have been drifting away from the segment of consumer market since the closing of 2007 and small businesses from the onset of 2007. The statistics of lending reflects the credit contraction. The circulation of credit card issued by the banks has gone down by approximately 100 million after peaking in the year 2008. The total debt relating to household has contracted by approximately $600 billion. There is a fall in all the segments relating to consumer finance, auto, mortgage debt and credit card. The outstanding on industrial and consumer loans have also fallen significantly. As per Federal Reserve, there has been a decline of nearly $165 billion or 20 percent in C & I loan after reaching the highest levels in 2008. All this shows the desire of the businesses and households in reducing the debt loads. Besides this it also reflects the unwillingness of the lenders to extend credit. The immediate impact of this financial turmoil on the economy was recession. This will go into records as the most severe and longest downturn after the Great Depression. It did not leave any industry or region in the country unscathed. The impact of this turmoil in terms of job loss, rising unemployment and reduction in the real GDP has been more than ever seen before (Zandi, 2010). Effects on US- Rising Unemployment There has been a steady rise in the level of unemployment in the country, which has increased the vulnerability of the unemployed to bankruptcy and foreclosure. The people in US are burdened with debt as the amount owed has more than trebled as compared to 1982. However this rise has not been accompanied by a corresponding increase in the savings, which has reduced to half over the same period. The rate of unemployment reached 10.2 percent towards the last quarter of 2009. This put the estimate of American people who were jobless at 15.7 million. The majority of the jobs today are in the service sector that offers lesser pay and benefits. Sectors like manufacturing offer the higher benefits but these account for merely 9 percent of current payroll. The amount of per capita debt has risen from $14000 in 1982 to $46000. Along with this there has been a sharp fall in the amount of savings from 10.9 percent of the post-tax income in 1982 to nearly 2.7 percent in present times. This partly explains the reason for the rising amount of foreclosures as the people do not have any cushion during tough economic times (Recession. ORG-a, 2009). Widening of income gap As a result of the recession the middle income group and poor families have been the worst affected, and the gap between the rich and poor has widened even further. There has been a decline in the household income across all the income groups but the fall is sharper in the case of middle-income group and poor families. The average income dropped from $52163 to $50303 in 2008. Poverty level jumped to 13.2 percent, the highest in the last 11 years. According to the analysts the reason for the widening gap can be attributed to the series of layoffs in the crisis period, which lowered the household budgets after the official start of the recession in December 2007. While the rich Americans are coping with pay-cuts, those at the lower rung of the income ladder are either jobless or are struggling (Recession.ORG-b, 2009). The unemployment report sent the stock market tumbling across the globe. An impact of the recession was also felt on the sale of homes, with the “pending sale index” dropping to 87.6 percent. The phone connections and broadband of a number of Americans was disconnected by AT &T for their failure to make payments (BBC News, 2008). Impact on trade The countries that rely on US exports are the worst hit due to the economic downturn. Countries like Mexico, Central America, and Canada are the most affected due to the downturn in the US imports (Weisbrot, et al., 2008). These countries benefitted when there was a growth in US economy but due to the downturn in the US economy the impact of the slow growth was also felt on its trading partners. Effects on Michigan State- The job losses in the state have continued for six consecutive years, making this the longest shrinkage accounted by Michigan since the Great Depression. A large number of people have been laid off by the automakers. Shops are being closed in Ann Arbor and Kalamazoo, by the pharmaceutical giant, Pfizer. Michigan ranks among the top three states in the country in terms of mortgage delinquencies and home foreclosures. In the view of an analyst, the state is trapped in a “one state recession”. Its political leaders are under continuous pressure to reduce the impact of the economic crisis but the present economic crisis has also impacted the state government’s reserves. The Governor and Republican legislators are indecisive as to how to turnaround the economic condition in the state. While the Governor wants to emphasis on training and education to develop a skilled workforce, the leaders are advising tax cuts to attract business. The credit rating of the state has lowered on the Wall Street. A cut in fund allocation for education, healthcare and public safety can make the investors wary of spending money in the state. According to Comerica’s chief economist Dana Johnson, the sluggish economy in the state is due to the losing ground of big automakers like Ford, General Motors and DaimlerChrysler in the US market. The indigenous automakers reported a market share of 53.7 percent in 2006 recording a fall from 73.7 percent in the year 1993. Over the last few years the vehicle production in the state fell 27 percent, accounting for a job loss of nearly 120000. Previously the impact of downturn in the automobile sector raised the unemployment levels but the impact of it was not as severe as at present (Vock, 2007). The employment rate in most sectors in Michigan has reduced since 2007. There was a slowdown in the R & D expenditure between the years 2005 and 2007 due to a fall in the local and state funding of URC universities. States like Michigan, Ohio, Indiana and Wisconsin have the largest concentration of employment in the manufacturing sector in the country (Federal Deposit Insurance Corporation, n.d.). Irresponsible acts of global financial decision-making- The main factor leading to the financial crisis was the unhealthy lending practices of the financial institutions in US. To generate higher amount of fees the lenders ignored the credentials of the borrowers and granted credit to people with poor credit history. This was compounded with the securitization of the mortgage into securities that was passed onto the investors across the globe. Usually the loans of the banks have longer maturities, so to free the additional funds the banks securitized the loans, thus passing on the credit risk of the bad loans to the buyers of the securities. The market for the CDOs and Credit default swap was largely unregulated and hid the risk from the investors. A rise in the interest rates burst the housing bubble that started the downfall in the economy. The rise in delinquencies eroded the value of the financial instruments underlying the mortgage. With this the jittery investors contributed to a fall in the worldwide financial markets. Responsibility of the crisis The deregulation and unregulated free markets are responsible for the economic woes. But the real culprit of the economic fiasco lies with Washington. The lapses in the regulation enabled the subprime borrowers to obtain home loans. Questions have also been raised about the Laisseze Faire attitude of the government. To sustain growth rates the economy and the financial system must be properly regulated. Some are of the view that the administration in the country was dominated by big business groups, which is the main cause of the debacle as the interests of the state were compromised for the personal or business interests. Noted economist James D. Hamilton is of the view that the rise in the price of oil between the period 2007 and 2008 is the root cause of the present recession. Based on an evaluation of the affect of the oil price movements on economy it can be concluded that in the absence of an increase in the oil prices, the US economy would not have been affected by the recession. Alan Greenspan the longest serving chairman of Fed has also been accused of the recession. He is said to have contributed to the crisis as he allowed the housing bubble to grow by keeping the interest rates low and loosely regulating the mortgage lending. The subprime borrowing was supported by him that created a financial burden on the borrowers when the interest rates were revived to higher levels. The boom in derivative market was also backed by Greenspan, which increased five times from $100tn to $500tn over a five year period. Even though the derivatives did not find support from noted individuals like Warren Buffet and George Soros, Greenspan continued to defend the derivative markets from regulations. Derivatives actually function as an instrument of transferring risk from the risk averse individuals to the people who are capable of bearing the risk. Using these complex products for enticing the investors goes against the aim of its creation. Former Senator Phil Gramm also encouraged the growth of the derivatives like credit default swaps. The blame for the crisis has also been put on Clinton administration. During his regime the mortgage lending rules were relaxed forcing the mortgage lenders to lend to the subprime borrowers. Clinton repealed the “Glass-Steagall Act” in 1999 that demarcated between the investment banks and commercial banks. The proportion of subprime borrowings prior to the repeal was merely 5 percent but this rose to 30 percent when the credit crisis blew up. The role of the British Prime Minister Gordon Brown in the crisis cannot be overlooked. His practices of limited regulations, low taxes for the non-domiciled foreign banks operating in London, including the private equity businesses added to the financial miseries. The credit rating agency Standard & Poor’s played a crucial role in the onset of the crisis as the complex products were assigned the AAA rating, thus concealing the inherent risk from the investors. They betrayed the trust of the investors by highly rating the incomprehensible mortgage based securities that eventually turned toxic (Finch, et al., 2009). Conclusion The misuse of the lending practices coupled with the wrong usage of the derivatives contributed to the financial crisis. This situation could have been avoided had the government and the central banks assumed a pro-active role in the regulation of the financial institutions. But instead the administration encouraged the institutions to take part in subprime lending by the cancellation of the “Glass Steagall Act” that removed the separation line between the investment banks and commercial banks. Taken over by greed the investment banks contributed to the sharp rise in the subprime lending. Complex derivative products were developed with the risky mortgage as the underlying and the risk was transferred to the investors. As the structured products were assigned high ratings by the credit rating agencies, the investors had little to doubt about the quality of the investment. With the rise in the delinquency rates there was a fall in the valuation of these securities. This triggered panic in the worldwide financial markets. The loss of investor confidence lowered the worldwide stock market indices and there was a slowdown in the level of economic activity. Reference BBC News. (2008). Recession in the US 'has arrived'. Retrieved April 16, 2010 from http://news.bbc.co.uk/2/hi/7176255.stm Federal Deposit Insurance Corporation. No date. The Industrial Midwest Has Not Recovered from the Last Recession. The 2009 Economic Landscape. Retrieved April 16, 2010 from http://www.fdic.gov/bank/analytical/quarterly/2009_vol3_1/vol3_1_industrial_midwest.pdf Finch, J. Clarl, A. Teather, D. (2009). Twenty-five people at the heart of the meltdown. Guardian News and Media Limited. Retrieved April 16, 2010 from http://www.guardian.co.uk/business/2009/jan/26/road-ruin-recession-individuals-economy Recession.ORG-a. (2009). Unemployment Packs A Bigger Punch. Retrieved April 16, 2010 from http://recession.org/news/unemployment-packs-bigger-punch Recession.ORG-b. (2009). Recession Widens US Income Gap. Retrieved April 16, 2010 from http://recession.org/news/us-income-gap-widens Shah, A. (2009). Securitization and the subprime crisis. Global Financial Crisis. Retrieved April 16, 2010 from http://www.globalissues.org/article/768/global-financial-crisis#Securitizationandthesubprimecrisis Utzig, S. (2010). The Financial Crisis and the Regulation of Credit Rating Agencies: A European Banking Perspective. Retrieved April 16, 2010 from http://www.eaber.org/intranet/documents/23/2172/ADBI_Utzig_2010.pdf Vock, C.D. (2007). One-state recession’ hampers Michigan. Retrieved April 16, 2010 from http://www.stateline.org/live/details/story?contentId=197521 Weisbrot, M. Schmitt, J. Dandoval, L. (2008). The Economic Impact of a U.S. Slowdown on the Americas. Center for Economic and Policy Research. Retrieved April 16, 2010 from http://www.policyarchive.org/handle/10207/bitstreams/20454.pdf Zandi, M. (2010). Financial Crisis. The Causes and current state of the Financial crisis. Retrieved April 16, 2010 fromhttp://www.fcic.gov/hearings/pdfs/2010-0113-Zandi.pdf Read More