How capital markets led to the new economy bubble and the banking crisis - Essay Example

How Capital Markets Led To the ‘New Economy’ Bubble and the Banking Crisis The occurrence of the global crisis in 2008 started with developed countries particularly in the United States of America, and its impact spread rapidly to other parts of the world. The crisis was contributed by negligence of the financial institutions that issued insecure loans to the investors hence making the repayment hard during and after recession (Barth, 2009, p.73). The decline in the prices of residential houses made it difficult for mortgagees to repay their debt. Consequently, the investors withdrew their wealth from the capital market to repay their loans with other investors lost trust and confidence with financial institutions resulting to withdrawal of invested wealth from the capital market. Capital market refers to financial market in which the long-term debt or equity-backed securities are traded (Crisis & Commission, 2011, p. 136). The role of the capital market is to collect resources of the savers and distribute them to the long-term investment opportunities especially in government and companies’ investment saving schemes. This document gives the detail of how capital market was responsible for global crisis and its impact on the world economy. The contribution of capital market to global financial crisis gives and understanding of the financial markets operates and how different financial institutions are interlinked across the globe. During the period between 2000 and 2007 investors generated a lot of wealth and had enough to save in the banks. The fixed-income pool increased from thirty-six billion dollars to eighty billion dollars (Obstfeld & Rogoff, 2009, p.8). The banking and financial institutions had more than enough cash to lend to the willing borrowers. Since financial institutions wanted to make huge lending and generate huge income from the interests, they lessened the lending conditions in order to attract borrowers thereby institutions advanced cheap loans to the borrowers (McKibbin & Stoeckel, 2009). The lenders did not take into considerations the increased default-risk resulting from cheap lending. The borrowers did not have a sound investment projects ad most of the borrowed funds ended in housing facilities (Crotty, 2008, p.11). The ambitious investors expanded investments to the global community hence inflating the global capital market instead of investing in the usual U.S. Treasury bonds. The massive investment of huge saving in the global economy generated international financial bubbles. At some point, the bubble burst and resulted to a drop in the price of the assets (Barth, 2009, p.84). However, the credit liabilities of investors and consumers remained unchanged hence posing a challenge of how such investors would settle the obligations. The banks increased mortgages to the borrowers since they were hoping that the prices of houses would continue to increase exponentially. Since the banks were encouraging borrowers to acquire loans there was excess funds for investors to extend the investment in different parts of the globe (Crisis & Commission, 2011, p. 143). However, most of those loans were collateralized by the mortgages and other debt instruments. This posed a significant risk to the financial institutions since they were getting loans from other financial institutions. The most hardly hit institutions were Lehman Brothers due to huge lending they had made to other banks and financial institutions. The lenders were blindly issuing loans to borrowers with adequate considerations on how those borrowers would pay the loans (McKibbin & Stoeckel, 2009). Developed countries had enjoyed significant income from the growing export to developing countries. During the period presiding recession, developed countries had excess savings which they decided to invest globally. Most of the investments went into the real estates. However, prior to recession the American mortgage lenders hiked the interest on mortgages. Furthermore, during the 2007 and 2008 the mortgagers withdrew their support for mortgages. The household owners could not be able to continue repaying the mortgages (Barth, 2009, p.95). Consequently, this resulted to a collapse of the securities used to finance the mortgages thus crumbling the mortgage system. Investors had extended their investments across the globe. They mainly invested resources in the capital market with hopes of making huge returns. The banks issued Collateralized Debt Obligations (CDOs) that were backed by sub-prime mortgages (Crisis & Commission, 2011, p. 164). The lenders had never taking into considerations the possibility that the prices of the residential houses would fall in U.S. In fact, the lenders had relaxed the lending conditions and made mortgages available even to those who did not qualify. The assumption the lenders and investor had made was that in case of difficult in repayment of mortgages they borrowers would increase the prices of the commodities or the houses and raise enough funds to finance their obligations. Consequently, the initiation of huge resources in the capital market resulted in increase inflation in the global economy (European Communities, 2009, p.24). However, the decline in prices of the houses caught both lenders and investors by surprise because they little expected such a scenario. The decline in the value of the collateralized assets resulted to hopelessness of the investors of ever being able to repay the loans. Unfortunately, most of the investors had channelled the collateralized debts in the capital market (Crisis & Commission, 2011, p. 172). Therefore, with the decline in the value of sub-prime mortgage loan borrowers were adversely affected because in the real sense the debts became bigger than the assets held as collateral. The value of all investment properties escalated significantly beyond the actual economic value. Following the decline in the price of houses the investors started withdrawing huge chunks of money from the capital market in order to settle their mortgages (Obstfeld & Rogoff, 2009, p.24). Furthermore, the banks and other financial institutions engaged stringent measures to reduce lending especially to the borrowers without adequate collateral. The significance of reducing the borrowing was to minimize the risks of default in repayment of the loans. In reality, this decision had unexpected consequences on both borrowers and lenders. Since the rate of inflation was already too high the decline in the value of assets such as residential houses implied that the borrowers had debt greater than the assets they held. The only option available for them in order to repay the collateralized debt obligations was to dispose the stock in order to repay the loans (Lewis, 2009, p.59). Furthermore, since most of the collateralized debt obligations were backed by the mortgages the decline in the value of houses meant that the debt of the debt invested in the capital market was higher than the value of the asset used as collateral. Financial institutions had extended loans to other financial institutions. This created interconnectivity among the financial institutions including the insurance industry (European Communities, 2009, p. 35). Following the collapse of sub-prime mortgages and the subsequent failure by the borrowers to repay their loans, the banks started strengthening the lending policies in order to reduce the amount of funds they advance to the borrowers. There significant mistrust between borrowers and lenders, and borrowers became sceptical about the lenders capacity to sustain their performance in the financial market (Barth, 2009, p.104). As a result of the ensuing mistrust, the banks and other financial institutions stopped giving loans to one another and each bank had to struggle on its own. The decline in the value of market capital assets had serious consequences on the lenders. The U.K. and the U.S. banks tightened their lending policies in order to minimize the rate of risky lending (Crisis & Commission, 2011, p. 184). This move by the banks resulted to the credit crisis since the borrowers could not have access to loans for investing in various sectors of the economy. Some states and private consumers were unable to access bank loans, thus resulting to reduction in spending. Reduction in spending by the consumers thwarted demand for various consumer goods. Businesses could no longer sustain their capacity and off course they started cutting down their production output. This had adverse consequences on the economy because the level of employment started increasing, and those who were in employment were being retrenched (Lewis, 2009, p.51). The increase in the rate of unemployment hit back on the economy since lenders and borrowers could no-longer afford to repay their debts after they lost their jobs. The failure by the borrowers to repay the loans aggravated the credit crunch. Economist, states, organizations and consumers did not have a clear understanding of the operability of the financial system. The policy makers failed to perform effectively therefore, this created a violation of morality and responsibility. Furthermore, the working persons are the majority investors in the capital market. Therefore, after losing their jobs investors had no other alternative other than withdrawing their investment from the capital market. Huge withdrawals of resources from the capital market destabilized the global economy. The value of stock started declining drastically for various reasons (Crisis & Commission, 2011, p. 195). For example, the decline in demand and increase in supply caused the decline in stock prices. Decline in the rate of lending by the financial institutions diminished the available resources for investment and a consequent decrease in price of the stocks. The Lehman Brothers was serious affected and nearly collapsed before the federal government came to their rescue. Other huge financial institutions such AIG that incorporated numerous insurance companies were also affected (Crotty, 2008, p. 6). This scenario create fear among many people because it was unclear the extent to which financial institution are interlinked with one another. This killed the little hope that had been left among the investors. As different financial institutions continued to strengthen their lending conditions there was little amount available to invest in the economy (Kates, 2011, p.67). The consumption of various consumer goods declined signifying reducing purchasing power of consumers in the market. The issue was about how the government responded to the crisis. Usually the role of government is to set policies that regulate the capital market and create fairness to all potential investors such that all those who are interested in investing have equal opportunities (Crisis & Commission, 2011, p. 203). However, prior to the crisis the government had not done much to safeguard the investors and the financial institutions. There was the lack of accountability on the side of the government; therefore, institutions were at liberty to do whatever they wished with investors resources. Due to lack of government controls the financial institutions ended up releasing a lot of funds in the market through uncontrolled lending that resulted to increase in inflation (Crotty, 2008, p.9). The approaches taken by the government to contain the crisis after it occurred was stunning to the financial institutions. The government feared that the collapse of West Street would have adverse consequences on the economy. In order to protect the economy, the federal government reacted to the crisis by bailing out those institutions such as Lehman Brothers using the public resources (Barth, 2009, p.113). This move by the government had negative consequences on the financial institutions since it could have appeared as though such institutions were unsafe for the investors because they could not be able to contain the crisis. Furthermore, it could mean that such institutions lacked managerial capacity, and that is what may have resulted to global financial crisis. The financial crisis in the year 2008 could have been avoided had all the stakeholders taken serious precautions to safeguard the financial institutions (Kates, 2011, p.36). For example, the government did not set up adequate measures to safeguard the economy against the financial crisis. The lenders undertook great risk by issuing risky loans to the investors instead of lending according to the borrowers capacity to repay the sum of loan advanced and the interest charges. Since the banks made mortgages cheap almost all interested took mortgage and literally almost everybody was able to own a house. This resulted to decline in demand for the commercial houses thus making it tough for landlords to repay their loans (Crisis & Commission, 2011, p. 136). This scenario could have been prevented by regulating the issuing of mortgages in order to limit the number of persons who could manage to finance mortgages. The demand for the housing would remain high hence the mortgagees would be able to service their mortgages. In conclusion, the global financial meltdown was caused by the failure of capital market and decline in the value of real estate that made it hard for the borrowers to repay their mortgages. When there was surplus investment resources as a result of unregulated lending by the banks and financial institutions, investors spread investments to various parts of the globe, thus resulting to increase in inflation. The mortgagees withdrew their investments from the capital market following the crisis to settle their mortgages, therefore, resulting to decline in the performance of the economy. Finally, the collapse of Wall Street and subsequent government intervention made investors lose confidence and trust on the financial institutions. The crisis would have been avoided with adequate regulations on lending and government policies. Bibliography Barth, J. (2009). Rise and Fall of US Mortgage and the Credit Markets. U.S.A: John Wiley & Sons. Pp. 64-128. Crisis, F. & Commission, I. (2011). The Financial Crisis Inquiry Report. Cosimo, Inc. Pp. 126- 234. Crotty, J. (2008). Structural Causes of the Global Financial Crisis. Working Paper Series no. 80. Pp.3-14. European Communities, (2009). Economic Crisis in Europe: Causes, Consequences and Responses. European Economy. Pp. 21-57. Kates, S. (2011). The Global Financial Crisis: What Have We Learnt? Edward Elgar Publishing. Pp. 23-124. Lewis H. (2009). Where Keynes went Wrong and Why World Governments keeps Creating Inflation, Bubbles, and Busts. Axios Press. Pp. 42-87 McKibbin, W. & Stoeckel, A. (2009). The Global Financial crisis Causes and Consequences: Working papers in International Economics. Vol. 2(9). Obstfeld, M. & Rogoff, K. (2009). Global Imbalances and the Financial Crisis: Products of Common Causes. Pp. 6-43. Read More