Recent Credit Problems in the Financial Markets - Essay Example

 Recent Credit Problems in the Financial Markets 0.1 Introduction 9 August 2007, it is the fateful date when the devastating credit constraints hit the financial markets (Larry, Teather & Treanar 2010). The magnitude of the crisis was such that it threatened to hit the very fundamentals of capitalism in the developed economies, portending to gradually seep into the still opening developing economies as well. Certainly since then, this crisis gave way to far reaching alterations in the Western economies. Still a wide range of questions remain unanswered. People still doubt as to the possible outcome of the integration of international economies and the potential limitations of the free market system in the times to come (Larry, Teather & Treanar 2010). During the beginning of the credit crunch in the financial markets, commoners and experts doubted as to the validity of the capitalism in a highly globalized and interdependent world (Larry, Teather & Treanar 2010). The effigies of bankers were put to flame in mass protests (Larry, Teather & Treanar 2010). The skyrocketing interest rates in the United States pushed many middle class home owners affiliated to sub-prime mortgages to default on their financial commitments towards their lenders. The news eventually spread like a raging and uncontrollable wild fire as the banks and financial institutions desperately cringed from extending further loans. The statutory bodies and organizations started to pump massive funds into their economies to breach the fast widening crisis of trust in the financial markets. The small investors begin queuing before the local bank branches to withdraw their savings and investments at the earliest. The situation was marked by a sense of chaos, right from the domestic kitchens to the plush offices of the top notch banks. The ramifications of the drying up of credit sources were immense. Banks and financial institutions collapsed like packs of cards. The international stock markets drastically plummeted, never to recover for a long time. The housing and real estate markets in the United States were left devastated and rudderless. Barring the infamous Great Depression of the 30s, the world had never come across such dire circumstances (Soros 2008). Businesses simply failed and the owners came on roads, overnight. In a matter of days, the collective consumer wealth of the world, shrunk by billions of dollars (Soros 2008). Governments found themselves faced with the dilemma of owing up to gargantuan financial commitments (Soros 2008). Economic activity simply lost its earlier vigour and gradually crashed to a crawling pace, if not a total collapse. The credit crisis left no nook or corner of the world economy, untouched or uninfluenced. It was much later that the experts and organizations endeavoured to come out with a possible evaluation and explanation of this credit crisis. Yet, these analyses only facilitated future guidelines and possible precautions, without coming out with a sure shot cure for the rot that had already shattered the international financial system (Soros 2008). Still, an attempt to understand the causes and ramifications of the credit crisis was a step in the right direction. In fact, one primary responsibility of the academic institutions, business schools and research efforts around the world should be to grapple with, evaluate and understand this financial crisis, so that never again the economy watchdogs and those in the position of responsibility may ever fail to step in and blow the whistle, when financial markets start getting unreasonable and driven by greed (Muolo & Padilla 2010). If nothing else, at least every such effort sends a clear and precise message to the financial leaders and institutions that financial management is as much about ethics, responsibility and accountability, as about growth, initiative and risk taking. This review is one such small yet meaningful step in that direction. The purpose of this review is to try to understand and explain the causes behind the recent credit problems in the financial markets. This review intends to delve into and understand the reasons and causes behind the credit problem under consideration. It also tries to touch upon the considerations which made the financial watchdogs, banks and financial organizations fail to foresee, predict and halt this credit debacle, just in time. The given review also elaborates on the impact of this credit crisis on the developed and developing economies. To achieve this objective, this review has resorted to a thorough study and critical analysis of the available textual and online sources. 0.2 Main Body 0.2.1 Causes behind the Recent Credit Crisis The credit issues being faced by the financial institutions are of quiet complex and complicated origins. A wide range of economic, financial, social and statutory factors acted and reacted in tandem to give way to this credit crunch. Some of the salient causes behind this credit scarcity are: 0.2.1.1 Housing Bubble The US housing bubble was a phenomenon that originated and grew in the ten year period 1995-2000. Right from the start of the late 90s, the social and financial life in the US begin to come across many changes and influences (Brownell 2008). The digital revolution and the digitization of the world economy and international markets eventually gave way to the Dotcom frenzy in the national and global markets (Munroe 2004). Adventure, innovation and risk taking were the buzz words that defined the sentiment and mood of the lay investors and financial markets (Brownell 2008). Such innovations and a calculated risk taking in the stock markets, bolstered and aided by information technology, saw many people ending up getting rich and affluent (Brownell 2008). Conclusively, everything looked fine and propitious and almost everybody, including the ordinary people and big financial institutions and banks felt that the US economy was just on the right track (Brownell 2008). Nobody expected anything to go wrong and haywire in the times to come. The investor sentiment was upbeat, buoyant and positive. However, it was not to be so for a long time. First there was the Dotcom bubble bust. Came 2000 and the US economy begin to exhibit symptoms of recession. In fact, beginning from the third quarter of 2000, the US economy showed a recessionary growth over the consecutive three quarters (Bernstein & Mishel 2008). Everything suggested that it was the time to get cautious and somewhat restraining the existing mood of adventure and risk taking in the public and national finances (Allen 2000). Yet, though the economy was discernibly showing a downturn, still it failed to deprive the ordinary investors and financial institutions of their positive sentiments and aspirations. When the Dotcom frenzy was nose-diving and the stock markets were slowing down, surprisingly, the real estate prices in the urban and commercial hubs in the US, like Florida, Phoenix, California, Washington and Boston started to rise like never before (Shiller & Case 2003). The people and financial institutions, which were by now shying away from the stock markets, found a new ray of hope and opportunity in the real estate sector (Shiller & Case 2003). Suddenly, houses no more stood to be a social and personal need, but an instrument for reaping massive profits and getting rich fast. The spirit of the times was such that almost everybody in the US wanted to buy as many houses as possible. Even, if it amounted to soliciting exorbitantly costly loans, which were beyond one’s assets and finances. The regular man in the street disheartened by the Dotcom bust and falling stock markets, begin to envisage real estate as one’s ultimate saviour (Morse 2006). This led to an unreasonable and unrestrained speculation in the real estate markets in the US (Morse 2006). Both the buyers and bankers threw the caution to wind. Both were quiet confident that the existing soaring of the real estate prices will continue and more than compensate for their risky investments (Morse 2006). Nobody bothered to stop and revise the economic and financial fundamentals and the cautious forewarnings of the saner experts and organizations were laughed at and ignored. By the summer of 2005, the housing bubble begins to bust and the sales volume in the US real estate sector begins to drastically plummet (Morse 2006). People simply started to default from their mortgage obligations. Banks, already deprived of returns on their investments in the real estate loans, got credit starved and simply refused to lend to each other and to the common man. The credit crunch in the financial markets had finally arrived. 0.2.1.2 Lax Lending Provisions A lot of social and economic factors within the US acted and interacted with each other to give way to a somewhat irresponsible, lax and sentimentality driven lending environment, which eventually led to a full blown credit crisis in the financial markets. There already existed strong social justice oriented sentiments in the US politico-economic framework that led to the statutory provisions like Community Reinvestment Act (Galster 1987). The purpose of these statutory provisions, to begin with was to encourage the political and financial institutions to strive for a just and equitable distribution of national wealth and growth opportunities (Richardson 2002). Such provisions to a great extent made it mandatory for the banks and financial institutions to extend loans to the underprivileged segments of the society, who under normal circumstances simply did not qualify to avail bank loans (Richardson 2002). Come housing bubble, such ethical provisions rendered a moral loophole to the irresponsible bankers and creditors. In the times to come these provisions got carried away by sentimental considerations, thereby suppressing the voices of logic and restraint. In addition, other more contemporary and pressing factors like the gaping recession, Dotcom bubble bust, 9/11 generated national mood of apathy and insecurity and the fear of deflation made the Federal Reserve go easy on interest rates, thus making the credit market quiet easy and willing. In the mean time, the fast fattening housing bubble was well prepared and ambitiously hungry for easy loans coming with loose commitment clauses. All these factors acted in unison to create a financial environment that was more than willing to extend credit to the customers, while ignoring the fundamental principles of banking and finance, to reap almost sure, rich returns in the future. There is no denying the fact that much before the onset of credit crisis, the financial environment in the US was fast disassociating from the basic fundamentals of banking and finance. 0.2.1.3 Sub-Prime Lending Sub-prime lending by the US banks was the single most vicious factor that could even be labelled to be the topmost culprit behind credit crisis. What is a sub-prime loan? In the most basic terms, a bank before extending a loan to a prospective customer is required to authenticate that the customer to whom the loan is being extended is able enough to discharge one’s future financial obligations associated with that loan. This logic constitutes the first fundamental principle of banking and finance. However, a customer who does not have a sound credit rating could opt for a sub-prime loan. A sub-prime loan is extended by a bank to a customer who has a shaky credit rating or history (Johnston 2009). The interest rate charged by a bank on a sub-prime mortgage is usually higher than the one levied on a regular loan (Johnston 2009). However, sound banking policies require any bank to not to extend a sub-prime loan to a customer whose credit rating is too severe or bad (Johnston 2009). Besides such loans ought to be extended to only those customers whose credit rating has diluted or suffered owing to understandable reasons like job loss, illness, business losses and the like (Johnston 2009). Yet, this is not what most of the US banks did while passing loans during the onset of the housing bubble. The credit crunch in the financial markets was singularly a saga of ditched sub-prime mortgage liabilities. Every second person in the US, during the housing bubble, was extremely interested in investing in the real estate. Some of these potential investors were competent and sincere in their intentions and means. However, a considerable proportion of them were irresponsible and intended to benefit from the housing bubble by availing sub-prime loans. On the supply side, the banks were eager to extend housing loans to fast reap the associated high interest rates; that too at the cost of ignoring the doubtful credit rating of a large proportion of their customers (Johnston 2009). The subprime lending of the US banks begin to soar at a fast and steady pace. In the first quarter of 2007, the net worth of the US sub-prime loans was calculated by some conservative estimates to amount to US dollar 1.3 trillion (Johnston 2009). If on the one side the banks and financial institutions were irresponsible with their sub-prime loans, on the other side, the US government and state organizations also encouraged them and some believe, even pressurized them to be liberal with their sub-prime lending (Demyanyk 2009). The reasons behind such a credit policy were not based on credible data and authentic research, but solely on the speculative belief that the US real estate sector was sturdy enough to bear the burden of such debt liabilities (Demyanyk 2009). Sub-prime lending by the US financial institutions, which rested at a tolerable ten percent of all of their mortgage liabilities, at the end of 2004, spiralled to an intimidating twenty percent, just before the busting of the housing bubble (Demyanyk 2009). One still wonders as to how such gross deviation from the established economic theories and basics continued to exist and thrive in those times. This speculative trend boldly spread its tentacles to the foreign financial markets (Davis & Brown 2008). When the US housing market was hungry for funds, foreign investment institutions were eager to lend their money to the US banks to benefit from the elevated returns offered by the American financial institutions (Davis & Brown 2008). A big chunk of foreign funds landed in the US financial institutions. The US consumers exploited the money borrowed from the foreign investments to further buoy the speculative bidding in the local real estate sector. Since, times immemorial, banking and finance has been all about a responsible effort to balance between greed and fear. However, the tragedy of the situation was that all the stakeholders in the banking and finance sector, be it the local banks, statutory watch dogs, regular creditors, foreign investment institutions, etc. ended up becoming the hapless victims of uninformed and misguided greed and speculation (Brown & Davis 2008). The much readily available credit was soon to become a coveted and scarce commodity, even for the most conservative and disciplined of financial organizations around the world. 0.2.1.4 Faulty and Speculative Economic Forecasting Never before the econ economists and financial experts around the world, so unanimously failed in forecasting and predicting the impending credit crisis in the international financial markets (Davis & Karim 2008). There were some conservative economists who preached in favour of moderation, without being elaborate about the grossness or gravity of the future turmoil (Davis & Karim 2008). Some economists to some extent succeeded in predicting the coming financial crisis, but their opinion was suppressed by the overwhelming majority riding the wave of a hollow sense of optimism (Davis & Karim 2008). The credit crisis in the financial markets was also a great academic failure. The above mentioned reasons were not the only ones to contribute to the debilitating credit crunch. There existed a plethora of other associated factors like predatory lending, economic and institutional deregulations, the accompanying commodities boom, faulty risk estimation and management by the financial institutions, ill-timed innovations in the financial sector, which also made significant contributions towards worsening the credit problems. 0.2.2 Impact of the Credit Crisis on the Financial Markets and Economies International banks and financial institutions were hit hard by the credit crisis. Massive losses and bankruptcies were the plight of a great number of reputed banks and financial institutions that got carried away by the housing bubble. According to a report published by Reuters in 2009: “Top U.S. and European Banks have lost more than $ 1 trillion on toxic assets and from bad loans since the start of 2007, and were expected to top $ 2.8 trillion form 2007-10 with roughly two thirds from loans and the remainder on securities, according to the International Monetary Fund forecasts.” In the US, more than 115 big and small banks either failed or went bankrupt. The credit crisis not only destroyed the banking system, but led to a wave of takeovers, mergers and acquisitions (Reuters 2009). The most publicized victims of this credit crisis included reputed names like Lehman Brothers, AIG, Merrill Lynch, Washington Mutual and Wachovia. With banks getting cautious about extending credit, the impact soon percolated down to the trade and industries, stock markets to right down to the common citizens. As European banks and financial institutions choose to park their funds in the US banks and financial institutions, so following the US credit crisis, Europe rolled into a credit crunch of its own. The irony of the matter was that this financial distress was not of Europe’s own making but was the result of the faulty policy pursued by a dependable ally (Davis & Brown 2008). The European banks also begin to tighten their lending standards. The thing is that bank loans are not only required to be invested in housing speculation. They are required for other productive activities as by the industries and trade to finance their long term and day today activities, by the students to support their academic efforts, by the entrepreneurs to finance their enterprises and by the households to sale through rough times. In that context, a constrained credit market further tightened by the crisis of trust has impacted all the aspects of social and financial life of the developed economies. Voices decrying the validity of capitalism and free market, advocating closing of economies and nationalization of banks and financial markets are already on the rise. Recession and credit crisis gave way to a self perpetuating vicious spiral (Haldane 2004). A slow economy operating in a financial environment defined by a supply side credit squeeze can have no hope of being revived or rescued (Haldane 2004). The converse is also true, in an economy defined by recession and slow down, banks and financial institutions could not get but cautious to pursue an easy going credit policy, especially more so when they have already suffered massive losses, courtesy the busting of the housing bubble (Haldane 2004). The situation is complex and despite some slight improvements in the last two years, much remains to be seen and observed. The exact estimation of the impact of the credit crisis is still continuing and economies are finding out ways to move out of its negative influence. It still remains to be seen that whether the developing nations are able to chart out their way out through the financial crisis that stalled the American and European economic growth. Many Asian economies which had a strong tradition of domestic saving and ample government reserves are expected to do well as far as economic growth is concerned (Young 2009). Falling levels of consumption in the developed economies are expected to influence their export performance. But, it remains yet to be seen as to how much and to what extent. By those standards, even many Latin American economies are also doing well (Young 2009). However, fluctuations in the oil prices in the international markets, rising speculation in the international food and commodities markets and the accompanying high inflation are to some extent expected to make things difficult for the developing economies (Young 2009). Especially the African economies dependent on foreign aid are expected to face a difficult situation (Young 2009). Though the Western economies are saying that they will not dilute their commitments to the developing nations owing to the credit crisis and the accompanying financial problems, the long term validity of these aspirations yet remains to be seen and tested. To be more logical and pragmatic, the economic slowdown in the developed countries is bound to influence the developing economies to some extent at least. The economies like China and India has been growing at a steady pace. This has to a great extent increased their dependence on imports like oil, minerals and technology. In that context, the weaker economies like that of Africa will have to pay more for these inputs in the international markets, as they will have to compete with the relatively developed economies of Asia (Young 2009). The developing economies are also expected to bear a fall in remittances from tourism and associated services (Young 2009). The Foreign Direct Investment (FDI) in the developing economies will also shrink (Young 2009). 0.3 Conclusion The initial public reactions towards credit crisis were more emotional and less logical and well meditated. The detractors went to the extent of advocating extreme measures like doing away with capitalism, further closing of economies and nationalization of banks and financial markets. However, a deep and thorough scrutiny of the recent credit problems in the financial markets strengthen the conclusion that credit crunch was not something that fell from the blue, but a man made crisis of irresponsibility, complacence and overconfidence. The West, which was the breeding ground of capitalism got carried away with the robustness of its economy and choose to deliberately overlook the fundamentals of capitalism and sound economic management of financial markets. The busting of housing bubble, sub-prime mortgage debacle and failure of sound economic forecasting testify to this fact. On the contrary, the developing economies like China and India, which were not forthright capitalist, choose to stick to the fundamentals of capitalism and managed to glide over the economic and financial crisis facing the West. The wisdom lies in learning from this financial and credit crisis and not to repeat such mistakes in the future. Word Count: 3,510 References Allen, Roy E 2000, Financial Crisis and Recession in the Global Economy, Edward Elgar, Cheltenhalm, England. Bernstein, Jared & Mishel, Lawrence 2008, ‘Escape from Recession’, These Times, Vol. 32, no. 3, pp. 18-23. Brownell, Charles 2008, Subprime Meltdown, GreatSpace, New York. 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