Capital Markets Effects on the New Economy Bubble - Essay Example

Capital Markets Effects on the ‘New Economy’ Bubble and the Banking Crisis. s Introduction Barely 20 years since the end of the Cold War and 30 years since the achievement of neo-liberalism, free-market fundamentalism, excessive greed and extreme capitalism has become the economic orthodoxy of our time. The agent for this change is referred as global financial crisis (Rudd, 2009). This crisis has become one of the most significant assaults on global economic stability. As cited by Carmen and Rogoff (2010), the ‘new economy’ bubble and the banking crisis are regarded as facets of the global financial crisis. Capital markets laid the foundation for the conditions that resulted to the ‘new economy’ bubble and the banking crisis. This is attributed to the fact that when a firm or a nation borrows money from the capital markets, the reason is often to invest in additional physical capital products that will be utilized to increase income. It usually takes several months or even years before the investments start generating sufficient return to pay back its cost thus leading to an economic crisis. Capital markets are usually concerned with long tern finance. It comprises of a series of channels through which the communities’ savings are made available for commercial and industrial enterprises and public authorities. Therefore, Chisholm (2009) defines capital markets as financial markets which are tasked with the buying and selling of equity-backed securities or long-term debt. These markets usually channel the wealth of the savers to those who have the capability of putting it into long-term use. The paper will offer evidence supporting the view that capital markets created the conditions that led to the ‘new economy’ bubble and the banking crisis. Discussion According to a view shared by Rudd (2009), prescriptions of the neo-liberal policy flow from the major theoretical belief in the superiority of unregulated markets, especially unregulated capital markets. These claims is based on the "efficient-markets hypothesis" , which claims that financial-market prices, such as stock-market prices incorporates all the available information representing the best possible estimate of asset prices. Therefore, it follows that if prices fully informed and markets are fully efficient, there exists no reason to believe that asset-price bubbles are probable which means that if these do occur, markets will self-correct. In the neo-liberal view, deviations from market efficiency are as a result of external causes. They ascertain that bubbles and other disruptions are caused by governments and other "imperfections", and not by markets themselves. According to Sullivan and Sheffrin (2003), capital markets are termed as markets in which money is given for periods longer than one year. The money is often used by governments and companies to make long-term investments. Gray and Stone (1999) established that the banking crisis and the economic bubble resulted from the increased savings that were available for investment during the 2000–2007 periods. During that time the global pool of fixed-income securities had actually escalated from an estimated $36 trillion in 2000 to $80 trillion by 2007. This huge pool of cash increased as savings from high-growth developing nations entered global capital markets (Mohan, 2009). In nation after nation, the temptation provided by such readily available savings overwhelmed the policy and regulatory control mechanisms, as borrowers and lenders put these savings to use, they generated bubble after bubble worldwide. While these bubbles burst, they caused a decline in asset prices such as housing and commercial property, the liabilities that were owed to the global investors remained at full price, thus generating questions relating to solvency governments and banking systems (Dale & Stone, 2009). The first signs of a serious crisis emerged in late 2007, when as a result of growing defaults on mortgages a German and a British bank IKB Deutsche Industriebank and Northern Rock, respectively collapsed (Lin & Treichel, 2012:12). As a consequence, banks which were struggling in Europe and the United States cut back on lending causing a credit crunch. Certain governments and consumers no longer had the capability to borrow and spend at pre-crisis levels. Moreover, most businesses also cut back on their investments as demand weakened and reduced their employees. Capital controls are measures employed a country’s government aimed at managing transactions of the capital accounts (Kahler, 2008:67). Whilst the domestic regulatory authorities attempt to make sure that the participants of capital market trade fairly with each other, and in some instances ensuring that institutions such as banks do not take excessive risks excessive risks, capital controls are aimed at ensuring that macroeconomic impacts of the capital markets do not have a net negative impact on the country in question (Mohan, 2009). In that perspective, capital markets transactions can result a net negative effect, for instance a financial crisis whereby there is a mass withdrawal of capital, leaving a nation without adequate foreign currency to pay for the required imports. For example, King (2001:441) wrote that “Thailand imposed capital controls that forced their finance minister to resign after failing to arrange a merger to save Finance One, the largest Thai finance company”, thus allowing it to fail. Foreign capital fled forcing the Thai government to devalue the currency. The devaluation of the baht and fall of Finance One resulted to foreign institutional investors reassessing the risks of investing in the region. Within a week the dominoes started to fall. Lin and Treichel (2012) hypothesised that the global imbalances were brought about by economic policies of East Asian economies. In this respect, the economy bubble and banking crisis in Thailand was as a result of the Japanese commercial banks, which were the major marginal lenders holding the largest share of foreign loans in Thailand. They inadvertently triggered the devaluation of the baht which led to the outflow of funds (Alvarez & Urban 2000:778). Wincoop and Yi (2000) reported that when the real estate and stock market bubbles began to burst in Asia in 1996, the Japanese banks viewed a repetition of the events from the Japanese bubble and chose to retreat to safer markets in 1997, most notably Europe. Mannepalli and Victor (2009) argued that according to the National Bureau of Economic Research, the United States has been in a recession since December 2007. Until 2006, America was experiencing an unprecedented housing boom, which inflated home prices. At the height of this housing boom, the fixed income desks t investment banks generated record profits through securitisation of high-yielding subprime mortgages. Many Americans bought homes that they could not afford. However, when the housing boom came to a halt, the market was already saturated with expensive new homes. When the housing bubble burst, the new financial innovations led to a systemic financial crisis in the U.S. and the whole world (Lin & Treichel, 2012:67). Supply outstripped demand by far and housing prices decreased drastically. This led to an increase in default rates on mortgages causing a wave of foreclosures. As the mortgage value deteriorated, the market for collateralised loan obligations dried up and debt investors became risk-averse. This contagion spread to other debt asset classes such as leveraged loans which were utilised to finance leveraged buyouts. As a consequence, the investment banks were stuck with huge portfolios of increased mortgages and leveraged loans on their leveraged loans on their balance which they could no longer securitise (Mannepalli & Victor, 2009). Supporting the view that capital markets laid the foundation for the conditions that resulted to the ‘new economy’ bubble and banking crisis, companies in the US that depended heavily on short-term loans were faced with liquidity constraints and thus had difficulties in meeting their working capital requirements. In that sense, banks cut back on corporate lending in an attempt to shore up their cash reserves due to plummeting stock prices and multi-billion dollar write-downs. These factors resulted in slower growth in industries, lay offs, reduced profits and increased bankruptcies. Therefore, the credit crisis worsened the economic downturn and resulted to a prolonged banking crisis. The low interest rates brought on board a new class of borrowers in the US who were enticed by mortgage brokers to purchase their own homes. As a consequence, a significant amount of capital was actually rushed into the sub-prime mortgage market, where it was directed towards borrowers with weak credit histories. When the economy boomed, these individuals were unable to pay for the debts and the house prices shot down drastically. As stated earlier, Mannepalli and Victor (2009) added that the "Giant Pool of Money" which represented $70 trillion in global fixed income investments, required higher yields as compared to those offered by the U.S. Treasury bonds early in the decade, which were low as a result of the low trade deficits and interest rates. In addition, this monetary pool had roughly doubled in size from 2000 to 2007, even though the supply of comparatively safe, income generating investments had not developed as fast. As a consequence, the investment banks on answered this demand with collateralised debt obligation and mortgage backed security. In effect, Greenspan (2009) noted that this pool of money is connected to the mortgage market in the United States, with the enormous fees that accrued to those all through the mortgage supply chain, from the mortgage broker selling the loans, to the small banks that really funded the brokers, up to the to the huge investment banks that were behind them. Mortgage supply originating from traditional lending standards had been exhausted by 2003. On the contrary, continued strong demand for collateralised debt obligation and mortgage backed security commenced to drive down lending standards, as long as mortgages could still be sold along the supply chain (Rudd, 2009). Ultimately, this speculative bubble was proven to be unsustainable (Zandi, 2009). Mohan (2009) claimed that fragmentation in the mortgage securitisation market resulted to decline in underwriting standards and increased risk taking. The dislocation of the credit markets made it hard for companies which had binged on excess leverage during the credit boom to refinance their debt. Besides, they also found it difficult to file for bankruptcy protection because the debtor-in-possession pulled back. The imbalances in the European economies were financed by credit flows from the euro-zone core to the overheated housing markets in nations like Ireland and Spain. In this respect, the euro crisis has been a continuation of the financial crisis. The capital markets have agonised over the weaknesses of European banks loaded with bad debts following property busts. In Japan, Yoshitomi (1998:23-32) pointed out that the economic bubble was caused structurally by means of bank deregulation. Previously, banks in Japan were regulated by the Ministry of Finance, thus they were assured of an appropriate profit in addition to being protected against bankruptcy. When the system was eliminated in the early 80s, competition set in resulting to banks loosing rents and franchise value of being a bank. Similarly, corporate clients moved away from borrowing from the bank towards other financing such as corporate bond issuance, retained profits and access to international financial markets. The Japanese banks rushed to look for borrowers in small and medium enterprises and projects in land property investment. When the economy boomed, they over-lent. Therefore, when the economic bubble ended, these enormous loans became a massive amount of bad debt. Considering the fact that banks failed to get rid of bad-debts, financial intermediation was impaired leading to banking crisis. As cited by King (2001:440), the aftermath of the real estate and stock market bubble which burst, Japanese commercial banks had severely damaged balance sheets. This domestic problem became international when the banks attempted to restructure their balance sheets and increase profitability by lending and investing abroad, only to experience hardships that forced them to withdraw in advance of the BIS deadline in mid-1998 (Bank of International Settlements, 2011). Grifith-Jones (1998) suggested that as non-performing loans accumulate, banks are usually faced with difficulty in observing the BIS capital adequacy requirement, which stipulates that a bank’s capital need to be at least 8 percent of the risk assets, if it wants to remain as an international bank. Conclusion The ‘new economy’ bubble and the banking crisis reflects the greatest regulatory failure in modern history. In that perspective, the global crisis is more that a crisis in debt markets, credit markets, derivative markets, equity markets, and property markets all of which make up the capital markets. Summarily, the new economy bubble and banking crisis was a result of the collapse of the sub-prime mortgage market in the United States, commencing in mid 2007. The other cause is sub-prime lending which refers to borrowers whose credit falls below a particular rating. And finally, is the aggressive securitisation of high risk assets. The banking crisis has led to global equity markets loosing an estimated US$32 trillion, which is similar to the combined GDP of G7 countries in 2008 (Gelinas, 2009). Besides, credit markets have dried up and house prices plummeting in numerous nations leading to unprecedented debts and costs for governments which will actually be felt for decades to come With regard to the banking crisis, the state’s governments need to recapitalize banks and the closure and merger of weaker banks. The banking crisis can actually be corrected by providing ample liquidity (Winters, 1999). Governments play a core role in the regulation of markets and the provision of public goods. In Australia for instance the Liberals in government set out a comprehensive deregulation of the labour market. To support intra-bank, the Australian government provides a facility for guaranteeing wholesale funding of financial institutions (Rudd, 2009). Current evidence has pointed out that governments have formulated consistent global financial regulations that would prevent a race to the bottom. They have also established stronger global disclosure standards for systemically crucial financial institutions. Furthermore, evidence has noted that state governments have built stronger supervisory frameworks to offer incentives for more responsible corporate conduct, including executive remuneration. However, there is still debate on the precise genesis of global crisis and whether efforts on solving the economic bubble and banking crisis ought to focus on adopting international standards of accounting and enhancing domestic supervision of banks. References Alvarez, F., & Urban J. 2000, Efficiency, Equilibrium, and Asset Pricing with Risk of Default, Econometrica 68, 775-798. Bank of International Settlements. 2011. BIS Quarterly Review. September. Basel: Bank of International Settlements. Chisholm, A., M., (2009). An Introduction to International Capital Markets: Products, Strategies, Participants. New York: John Wiley & Sons. Carmen Reinhart & Rogoff, K. 2010. 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