The Financial Crisis of 2008 - Case Study Example

The financial crisis of 2008 was one of the toughest financial crises which engulfed all economies around the globe. It is considered as one of the toughest crisis since the great depression of 1930. Some of the prime reasons which were identified to have led towards the crisis are the incapability of multinationals to deal with the situation, decrease in the value of assets, increased government interventions and changes in the economic activity which impacted all world bodies due to globalization (Wadhwani, 2008). The world bodies have come together and have made the required regulatory changes so that such situation can be controlled and appropriate steps are taken from the beginning to prevent such incidents. This paper will look towards concentrating on the different reasons which led towards the financial crisis in 2008 and linking those with economic policies and strategies so that appropriate steps can be taken to prevent such situation in the future. The global housing bubble collapse can be considered as one of the prime reason which began the financial crisis of 2008. It was witnessed that the US housing prices fell down by over 40%. This impacted the securities which were linked to the housing sector as securities were backed by housing prices. Fall in the price of the housing sector reduced the value of securities which thereby impacted the financial market as the prices of securities started to fall quickly (Ryuhei, 2009). Stock markets started to face issues associated with liquidity as fall in housing prices created a liquidity crunch. Organizations stated to fail as liquidity credit was increasing and economies were facing liquidity crunch which thereby resulted in a financial crisis and impacted all world bodies due to globalization. Prior to the crisis the US was witnessing heavy growth rates especially in the housing sector as the prices were continuously growing. The chart below shows the manner in which US was witnessing strong growth due to rapid rise in housing prices which reduce after the financial crisis Figure 1: US Financial Growth Rate till the Crisis It can even be stated that before the crisis the US housing prices was overvalued and had become a bubble. The prices were continuously increasing and the entire world fraternity was of the view that it would continue to move upwards and won’t go down (Ahearne, Gagnon, Haltmaier and Kamin, 2002). This made the valuation to be overvalued as people were positive regarding the housing sector. This was matched by the fact that low initial rates on adjustable rate mortgages (ARM) and low down payment further made people to indulge into speculation activities. During this phase the growth rate in the housing prices was higher compared to the economic growth and was increasing at a pace of 124% (Dasgupta and Prat, 2006). This further increased speculation activities as people with the view that they can earn quick money got indulged into speculation activities. This increased the volume of trade and more and more securities started to be backed by the housing sector which was incorrect. Continuous increase in the adjustable rate mortgages (ARM) increased pressure on paying the debts as problem of refinancing surfaced. This started people to default their payments and was the beginning of the financial crisis. The process continued on and default on payment was continuously increasing which thereby created a financial crunch and resulted in the housing prices to drop as shown below Figure 2: Rate of change in house price. Shaded areas refer to recession. The impact was so strong that minions of dollar were wiped off as the asset base was falling strongly. Due to globalization and contagion effect other economies started to witness a dip in housing prices as well. This impacted other economies and slowly with the passage of time all economies became engulfed in a financial crisis which thereby led towards a global financial crisis. The other reason which led to the global financial crisis was easy availability of credit. The rate of interest was very low which thereby allowed people to raise easy finance from the market. The American economy was witnessing a huge growth in credit facilities due to the easy availability of credit. It was perceived that the rate of interest in 2000 was 6.5%. The American economy had realized that they were moving towards deflation and the housing bubble burst would happen which thereby made the Fed to reduce the interest rate by further 1%. This ensured further easy availability of credit and made more and more people to raise finance from the market. As a result the US economy started to witness a trade deficit making the US financial assets price to undergo change thereby impacting the yield from government bonds (Honkapohja, 2009). Increase in the current account deficit mad the US government to borrow more money from abroad. The amount which was raised from abroad was used to finance consumption expenditure instead of capital expenditure. The US economy was of the notion that the housing prices would improve which would bring liquidity and would help them to deal with the current account deficit which they were facing. Instead the situation worsened and complexities increased as current account deficit was continuously increasing which further impacted the situation adversely (Veron, 2009). The impact was so strong that it created a situation where loans were unmanageable and an already inverse relationship between asset prices and interest rates increased the level of speculation activities. This thereby multiplied the risk and increased the chances of speculation activities. As a result when the situation was out of control the economies started to feel liquidity issues which thereby led towards the global financial crisis. Another reason which has been identified to be associated with the global financial crisis is the increase in subprime lending. Subprime loans are those loans which are more risky in comparison to the conventional loans as subprime loans arise due to low down payment and poor credit rating of the borrowers. It was seen in 2004 that 20% of the housing loans in US consisted of subprime loans which itself signifies the risk which the housing sector was undertaking (Sen, 2010). The reason which led towards the creation of subprime loans was poor policies by the government and increasing competition among financial institutions. The relaxation of the net capital rules by Securities and Exchange Commission (SEC) increased the leverage for the banks which thereby ensure easy money. Banks resorted to this strategy and started to provide credit to borrowers who didn’t have a good credit rating which increased the degree of risk as interest and timely payment of the borrowed sum was in doubt. Borrowers found it easy to raise money and despite having a poor credit rating were able to easily raise finance from the market. This resulted in subprime defaults and borrowers were not able to pay interest or the borrowed sum. The situation was so grim that subprime defaults had increased to 25% in 2008 from 10% to 15% in 2006 (Barrell and Davis, 2008). This resulted in banks failure as banks were witnessing a huge amount of money being not returned to them. As a result liquidity problems started to rise which slowly engulfed all economies leading to the economic financial crisis. In addition to it another factor which led towards the subprime financial crisis is the manner in which predatory lending was increasing. Predatory lending is a process where people take loan for carrying out different unscrupulous activities. One such example is the switch and bait technique where people take loans at lower rate of interest and swap it for higher interest rate despite a higher risk associated with it (Ianchovichina and Sudarshan, 2007). This is a type of speculation activities which was increasing. People were taking loans at low rate due to easy availability of credit and were using the same for riskier investment activities with the expectations of high rate of return. These activities were carried out in a manner where people refrained to show this transaction in the books of accounts. This led towards false documentation and funds were used for activities which were unscrupulous. The money which was borrowed for different purpose was not used for the same purpose but for some other activities which didn’t turn out as expected. This resulted in money being lost and people were not able to pay back the borrowed money. This impacted the liquidity situation and created a financial crunch. The overall result was so severe that it impacted the economic performance thereby leading towards a financial crisis over a period of time. This was supported by the fact that lack of proper reforms and rules ensured easy finance which was used in unscrupulous activities. Lack of reforms to deal with the complexities which the banking sector was witnessing was one of the reason which impacted banks. The creation of new accounting techniques which allowed off balance sheet financing was adopted by the banking sector as it provided them with an opportunity to deal with speculation activities (Ghosal and Miller, 2006). Financial institutions resorted to this mechanism and started to use it as a form of financing by not showing the transactions in the balance sheet. This increased the financial leverage for the financial institutions but also increased the degree of risk which is shown below Figure 3: Leverage in US Financial Institutions The leverage was very high for five financial institutions as shown in the chart above. This increased the risk as increased leverage led towards more loans which increased the number of defaults thereby creating a liquidity crunch which ultimately led towards the financial crisis (Barrell and Karim, 2008). The complexities increased due to the fact that financial deregulation was simple and it provided an opportunity for financial institutions to raise easy finance from the market. Easy finance at predetermined rules and regulations especially at a time when the housing bubble burst was going to take place further increased the degree of risk. This created a situation where liquidity problems started to rise. Financial institutions started to fail which thereby over a period of time resulted in an economic crisis and led to a financial crisis. The overall situation was worsened by the fact that different innovative and financial products were developed which were new in the market and not tested. Some of the new products which were developed are ARM (adjustable-rate mortgage), CDO (collateralized debt obligation), CDS (credit default swap), CMO (collateralized mortgage obligation) and MBS (mortgage-backed security) (ESCAP, 2008). The new products which were developed increased the risk as reforms and policies to deal with the risk arising out of new products were not determined. The situation over a period of time led towards securitization which thereby multiplied the risk thereby having an impact on the prices of securities. The period of financial crisis led towards a situation where the prices of security started to fall rapidly and stock market crashed (Nanto, 2009). As a result the little liquidity which was present was wiped out which further raised alarm and made it difficult for the world economies to deal with the financial crisis. The world economies as a result was facing issues associated with falling share prices and decreasing liquidity which ultimately led towards the financial crisis. In addition to it the period of housing bubble economies were witnessing a global financial imbalance. Since the collapse of the Bretton Woods System, European and US economy has dominated the global financial market. During the Asian Financial crisis the Asian economies were denied credit so that they can come out of the financial crisis which they were facing (Girouard, Kennedy and Andre, 2006). As a result to deal with the crisis Asian economies started to stabilize their currency by increasing the foreign reserves. Asian economies started to hold foreign reserves in US debt thereby getting the required money to deal with the financial crisis. Instead it created a downward pressure on interest rates which impacted the monetary policies which were framed by the Federal Reserve. Lowering interest rate to manage the economy worsened the economy as easy finance was available which thereby ultimately led towards a financial crisis situation. The financial crisis of 2008 took place due to culmination of different factors which impacted world economies. Some of the reasons which were identified for the crisis are easy financing, easy credit availability and poor government regulations. The different factors together resulted in the financial crisis. It is important that proper polices and reforms are developed through which such situation can be prevented and better strategies can be developed. This will help economies to deal with the financial crisis and would provide an opportunity through which chances of financial crunch will be reduced in the future. References Ahearne, A., Gagnon, J., Haltmaier, J. and Kamin, S. (2002). Preventing Deflation: Lessons from Japan’s Experience in the 1990s. International Finance Discussion Papers 729 (Washington: Board of Governors of the Fed, June) Barrell, R. and Davis, P. (2008). The Evolution of the Financial Crisis of 2007-8, National Institute Economic Review 2008, 206, 5 Barrell, R. and Karim, D. (2008). Could Early Warning Systems Have Helped to Predict the Sub-Prime Crisis? National Institute Economic Review 2008, 206, 35 Dasgupta, A. and Prat, A. (2006). Financial equilibrium with career concerns. Theoretical Economics 1, 67-93 ESCAP, (2008). 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