The Global Financials Crisis Finance Essay - Free Essay Example

Sample details Pages: 10 Words: 2994 Downloads: 7 Date added: 2017/06/26 Category Economics Essay Type Research paper Did you like this example? The world economy has been challenged by different financial and economic crisis over the last two decades. All over, we witnessed a fall in the stock markets, huge financial institutions fell or were bought out and even the wealthiest of governments had to come up with rescue packages to get these financial systems out of trouble. The literature review unfolds the aspects of the role the global financial crisis plays in economies and stock markets as authorities try to achieve its maximum potential benefit in the economy of a nation taking the least of losses. Don’t waste time! Our writers will create an original "The Global Financials Crisis Finance Essay" essay for you Create order The contagion spread to financial system in all advanced economies and the resultant flight to safety soon dragged in the emerging and developing economies as well. The meaning and origin of the Global Financial Crisis The term Crises can be defined as situations characterized by a pronounced instability, therefore they are accompanied by volatility and a growing incertitude. In a crisis situation (no matter what form it may take) we find ourselves in a permanent state of restlessness and uncertainty about our future, fear and even panic. The problem with defining a crisis consists in specifying how severe the volatility and downfall of the market must be to frame such an evolution as a crisis. Conventionally it was established that there is a recession when after two successive quarters we are dealing with the dropping GDP of a country or region. National Bureau of Economic Research (NBER) defines crisis as a significant decline in economic activity for several months reflected in lower GDP, lower individual income, reduced employment levels, reduced industrial production and consumption. De Bonis (1999) defines financial crisis to be a wider range of disturbances, such as sharp declines in asse t prices, failures of large financial intermediaries, or disruption in foreign exchange markets. It is difficult to make assessments about when a financial crisis becomes an economic one or if an economic crisis generates a financial one or vice versa. Basically we always talk about an economic crisis generated by financial, political or social reasons. The financial crisis is a form of the economic crisis and reflects a miss-trust in the financial system, a significant decrease in the volume of the transactions on the stock market, a disorder of market mechanisms. The stock market is the barometer of the economy and it trades businesses of different sizes and from different sectors. Review of literature Many economists have offered theories about how financial crises develop and how they could be prevented. There is little consensus, however, and financial crises are still a regular occurrence around the world. Soludo (2009) identified five ways in which the global economic and financial crisis has impacted on the global economy: declining real output growth leading to slower economic growth; weakened financial systems leading to takeovers and bankruptcy; loss of jobs; loss of confidence in financial markets- leading to inability to carry out their intermediation role in the economy; and Stock Market Crashes. The evidence provided in the paper showing how the global economic and financial crisis has affected economies, did not adopt any econometric technique to measure the impact. However, a major strength of the study was that it identified the stock market as a transmission channel through which the global economic and financial crisis impact on economies across the globe. According to OECD (2009), the origins of the global financial crisis have been traced to the excess liquidity, asset bubbles and leverage in western economies which in turn resulted from macro accommodation arising from large trade deficits faced by these countries. The crisis first manifested itself in the sub-prime mortgage market of the United States in August 2007. However, with the subprime crisis the world economy bent but did not buckle. It was only later towards the middle of 2008 that advanced economies began to fall into mild recession with emerging and developing economies not affected. In September 2008 there was dramatic blowout of the crisis with the default by large investment banks and Government bailouts in both banking and insurance. An earlier paper that also identified the stock market as a transmission channel of the global economic and financial crisis into the economies of less developed countries was the study by Te Velde (2008). The study noted that the global economic and financial crisis have dragged Stock markets down by more than 40%. The paper provided trend analysis to justify the size of the impact. Coleman (2008) examined the impact of the global economic and financial crisis on African economies. The study provided trend evidence as well arguing that the crisis has affected selected African stock markets. The study examined the indicators of two developed stock markets (the DJIA and FTSE) and three African stock markets (the JSE, NSE and KNSE) over a period of 12 months (November 2007 to November 2008). The central conclusion drawn from the study relating to the selected African stock market was that African capital markets have fallen by 30-40% over the study period but private equity investors remained committed to Africa. The African Development Bank (2009) in studying the impact of the Global economic and financial crisis on Africa drew certain conclusions that are of importance for this present study. Among othe r arguments, they noted that Africa was not severely affected by the global economic and financial crisis because of its low level of financial integration with the developed economies. The study identified two transmission channels of the crisis into Africa: trade flows and capital flows (such as foreign direct investment-FDI, private capital flows and remittances). Similar study by the International Monetary Fund (2009) however noted that Low Income Countries (LICs) are exposed to the current global downturn more than in previous episodes because they are more integrated than before with the world economy through trade, FDI, and remittances. Though the study by the IMF and the ADB identified same channels of transmission, they differ in their argument concerning the level of integration of the African economy with the rest of the world. These channels of transmission were also acknowledged in Fundangas (2009) speech. UNESCECA and AUC (2009) in their study pointed out that th e global economic and financial crisis was not expected to impact on African economies because of low integration of Africa into the global economy. Recent developments have, however, shown that the negative contagion effects of the crisis are already evident in the Africa region the study further noted. On the impact of the crisis on African stock markets, the study noted that the global economic and financial crisis has had a direct impact on Africa. The study argued that stock market volatility in Africa has increased, leading to wealth losses in major stock exchanges such as Egypt, Nigeria and Kenya. Te Velde et al (2009) in their synthesis of ten draft country report funded by the ODI and DFID documented that the main transition belts of the global economic and financial crisis are trade, private capital flows, remittances and aid. The study noted that Portfolio investment flows experienced a dramatic drop in 2008 in most countries, shifting sometimes to large net outflows a nd a significant drop in equity markets in 2008 and into 2009. Clearly, the study showed that stock markets (equity markets) are a veritable channel of transmission of the global economic and financial crisis into the economies of less developed countries. Stages of the crisis are discussed further below: First Wave: Sub Prime Crisis The sub-prime mortgage market in the United States was a securitization market whose underlying asset was mortgages primarily issued to individuals to purchase homes. In a traditional banking model, the banks comparative advantage stems from its local knowledge and individual attention given to customers. This enabled banks to give loan to those borrowers who were most likely to repay and to insist on collateral where there was more risk. For mortgage lending, however, this traditional model creates a mismatch between assets and liabilities as the mortgages are long term but most bank deposits are short term in nature. Governments have tried to address this mismatch through deposit protection, capital requirements, regulation and other interventions with limited success. Securitization was seen as a more sustainable and market driven solution to the asset liability mismatch in mortgage lending. By securitizing a set of mortgages and selling the new security to other investors ha ving long term funds, the mismatch is addressed and the risk is transferred to investors better suited to handle it. Securitization was also seen as a means of lowering the cost of capital for borrowers and integrating regional markets with national ones. The mortgages were securitized through Collateralized Debt Instruments (CDOs) which consisted of a pool of mortgages. The CDO could consist of high quality mortgages only, or a mix of high quality and lower quality mortgages and each CDO would be priced accordingly. These CDOs would in addition be rated by credit rating agencies hence allowing different investors to purchase different ones depending on their individual risk tolerance. Unfortunately, this process led to a serious misalignment of incentives between the banks issuing the initial mortgages and the investors in the CDOs. The banks no longer focused on the quality of the borrower and local knowledge as in traditional banking but instead focused on generating a higher volume of mortgages. With the stream of revenue from the mortgage (as well as the risk) having been transferred to other investors, the primary interest of the bank was to generate fees and commissions by issuing a higher number of mortgages. Hence, individuals who previously would never qualify for a loan were suddenly being issued mortgages on very generous terms. The lending was further fuelled by the housing price bubble in the United States which had seen house prices rise continuously for several years. Indeed, whereas many mortgage takers had traditionally been first time home owners who lived in the houses, a new breed of borrowers had emerged who were borrowing to purchase second, third or fourth houses purely for speculative purposes. With this misalignment of interest between the banks issuing the mortgages and the ultimate investors carrying the risks it was expected that the Credit Rating Agencies (CRAs) that rated the CDOs would save the day by acting as an indep endent intermediary between the competing interests. Unfortunately, the CRAs were not able to effectively rate the products due to the newness of the instruments, the lack of historical data, the entry of a new category of mortgage borrowers and conflicts of interest with the CRAs desire to maximize their own revenue. The next step in the chain was the Credit Default Swap (CDS). The CDS was a primary insurance taken by an investor against default in a CDO. Unfortunately, insurance companies that issued CDS insurance also had an incentive mismatch of their own. Instead of a fixed premium, the insurance fee was often in the form of a percentage of revenues hence creating an incentive to insure more risky products that would generate more revenue. In addition, just like CRAs, many insurance companies used unsuitable traditional models that they had used for bonds in assessing the risk of CDOs. Banks that had CDS insurance were able to invest more in CDOs because the capital requi rements for CDS (which are an insured product) were much less stringent than for other non-insured assets. The subprime crisis thus emerged when housing prices stopped rising, putting pressure on the lowest quality mortgages (many of which were NINJA mortgages), which in turn put pressure on the CDOs and CDS. This compromised the balance sheets on banks and insurance companies holding these assets leading to a number of closures and bankruptcies. Activity slowed in the face of tightening credit conditions in the advanced economies and some countries fell into mild recessions. However, the impact of the subprime crisis was considered largely limited and contained until all hell broke loose in September 2008. Second Wave: Credit Crunch In September 2008 a large US investment bank with heavy CDO holdings, Lehman Brothers, defaulted on its obligations. The US Government allowed it to go into bankruptcy. This caused a panic situation with almost all banks coming under a lot of pressure. The insurance company AIG which was the worlds largest issue of CDS insurance was soon unable to meet its obligations and was rescued by the US Government which also had to make interventions in a large number of other systemic institutions. The same pattern soon followed in Europe with Government intervening in a large number of financial institutions. Financial institutions and even corporations in the advanced economies came to rely on central bank funding. Ironically, in an attempt to shore up cash positions financial institutions placed a lot of liquidity right back in the central banks resulting in excess liquidity in the central banks. Central Banks and Governments responded with a number of measures to inject liquidity int o the economies with huge rescue programs which in turn led to huge budget deficits. Despite policymakers efforts to sustain liquidity and market capitalization there was a huge increase in perceived counterparty risk, banks faced huge write downs, demand for liquidity continued to increase and market volatility surged. Third Wave: Recession The credit crunch inevitably resulted in a flight to quality that depressed yields for government securities (particularly US securities) and dried up wholesale funding and credit lines to other institutions. The strain in credit and absence of new borrowing impacted on companies ability to meet ongoing obligations. With a major decline in consumer demand coupled with constrained output the advanced economies soon fell into a major recession which eventually dragged down the emerging and developing economies as well. Causes of the Crisis The reasons for this crisis are varied and complex, but largely it can be attributed to a number of factors in both the housing and credit markets, which developed over an extended period of time. Some of these include: the inability of homeowner to make their mortgage payments, poor judgment by the borrower and/or lender, speculation and overbuilding during the boom period, risky mortgage products, high personal and corporate debt levels, financial innovation that distributed and concealed default risks, central bank policies, and regulation (Stiglitz, 2008). Avgouleas (2008) enumerated the causes of the crisis as: breakdown in underwriting standards for subprime mortgages; flaws in credit rating agencies assessments of subprime Residential Mortgage Backed Securities (RMBS) and other complex structured credit products especially Collateralized Debt Obligations (CDOs) and other Asset-Backed Securities (ABS); risk management weaknesses at some large at US and European financial i nstitutions; and regulatory policies, including capital and disclosure requirements that failed to mitigate risk management weaknesses. Taking the views of the various commentators into consideration, the current financial crisis is caused by the following; Firstly, Liberalization of Global Financial Regulations is one reason for the crisis. The regulatory model adopted by banks in the US emerged as a result of liberalization of banking business in the early 1990s and international consensus reached within the Basle Committee of Banking Supervision as regards the acceptable model of prudential supervision of banking institution (Scott, 2008 in Abubakar, 2008). This liberalization facilitates the global abolition of restrictions on capital flow in the 1990s and caused the operation of international investment funds to be largely unregulated. Another cause is the Boom and Bust in the housing market. A combination of low interest rates and large inflows of foreign funds help c reate easy credit conditions for many years leading up to the crisis. Due to low interest rates and large inflow of foreign fund, subprime lending/borrowing for investment became very attractive in both US and the UK. Since the demand for housing was rapidly rising in the US, most investors and homeowners took mortgaged loans and invested in housings. The overall US home ownership rate increased from 64% in 1994 (about where it was since 1980) to peak in 2004 with an all-time high of 69.2%. Furthermore, Speculations is also one of the causes of the crisis. Traditionally, homes were not treated as investment like stocks, but this behavior changed during the housing boom as it attracted speculative buyers. This makes speculation in real estate a contributing factor. During 2006, 22% of homes purchased (1.65 million units) were for investment purposes it means that nearly 40% of home purchases were not primary residences. This speculative buying makes housing prices to fall drastic ally. New Financial Architecture (NFA) according to Crotty (2008) NFA is a globally integrated system of giant bank conglomerates and the so-called shadow banking system of investment banks, hedge funds and bank-created Special Investment Vehicles. This makes excessive risk to build up in giant banks during the boom; and the NFA generated high leverage and high systemic risk, with channels of contagion that transmitted problems in the US subprime mortgage market around the world. Poor Credit Rating due to securitization practices, credit rating agencies have the tendency to assign investment-grade rating to Mortgage-Backed Securities (MBS), and this makes loans with high default rate to originate, packaged and transferred to others. Securitization is a structured finance process in which assets, receivables or financial instruments are acquired, classified into pools, and offered as collateral for third-party investment. High-risk loans There appears to be widespread agr eement that periods of rapid credit growth tend to be accompanied by loosening lending standards (DellArriccia, Igan and Laeven, 2008). For instance, in a speech delivered before the Independent Community Bankers of America on 7 March 2001, the then Federal Reserve chairman, Alan Greenspan, pointed to an unfortunate tendency among bankers to lend aggressively at the peak of a cycle and argued that most bad loans were made through this aggressive type of lending (IMF, 2008). Without considering high risk borrowers, lenders give Ninja loans high-risk loans to those with No income, No job, and no Assets. They also give home loans to immigrants that are undocumented. Government policies Some critics believed that the crisis was fuelled by US government mortgage policies which encouraged trends towards issuing risky loans. For instance, Fannie Mae Corporation eases credit requirements on loans and this encourages banks to extend home mortgages to people that do not have good enough credit rating.