FINANCIAL CRISIS, HOME MORTGAGES, CREDIT MARKETS, FINANCIAL S, MORAL HAZARD, and ADVERSE SELECTIONS. [Insert al Affiliation] Question 1 The 2007-08 financial crisis is largely attributed to financial innovations such as sub-prime mortgage and securitization, which were envisioned to better the financial market, but desolately became the forces that drove the financial market into an all-time dissipated crisis. Rather than being a sustaining innovation, securitization became a disruptive innovation. It is a financial engineering technique where financial enterprises pool assets, such as loans and mortgages, and merchandise the repackaged assets. A typical example of ABS (asset-backed security) is an MBS (mortgage-backed security) which is a prominent type of securitization and of particular importance due to its role in the 2007-08 financial crisis.
Additionally, securitization allowed banks to have huge amounts of capital to give as loans to prospective homeowners through transformation of existing loan portfolios to cash (Manoj, 2010). Noteworthy, securitization is a precarious cause of financial flux. According to Shleifer and Vishny (2009), financial markets are swayed by investor sentiments. Through securitization, investor sentiments tainted the banking industry in early 2006, and domineered a cyclicality of returns and investments prompting banks to use all their capitals during boom.
Banks extend themselves fully during boom to amass the available opportunities and make money (Bonner & Wiggin, 2006). The commercial banks engage in money creation through giving loans and imposing interest on the loans. However, if they participate in financial markets using leverage and securitizing loans, financial instability and bank instability occurs and the two types of instability strengthen each other. In the mortgage market, as securitization gained supremacy, COD (Collateralized Debt Obligation) which enabled the manipulation of risks concomitant with mortgage emerged and ranked mortgages as a low risky investment (Coval, Jurek & Sttafford, 2009). Apparently, securitization transferred ownership of mortgages from lenders who had information regarding their borrowers default probability to non-bank financial institutions and investment banks that were not conversant with borrowers, but rather used CDO computations to ascertain the probability of default.
However, the calculation of CDO default probability disregarded the progression of the mortgage sector; the sub-prime mortgage innovation had prompted the mortgage sector to morph into a speculative bubble.
Consequently, banks experienced losses related to mortgage defaults and delinquencies while they had little money left to finance mortgage loans. Hence, an innovation such as securitization should be carefully assessed before a bank decides to engage in it since it potentially reduces banks capital reserves and increases default risks due to declined underwriting standards. Question 2 In reference to the philosophy of laissez-faire capitalism, commercial institutions will circumvent risks since failure to be risk-averse will inherently lead to liquidation (Christensen, 1997; Greenspan, 2004). However, the Community Reinvestment Act, Long-Term Capital Management hedge fund salvage in 1998, and liberation of Continental Illinois created the notion that the American government could protect institutions that failed to apply due diligence.
Consequently, morale hazard developed as big financial institutions believed that the government would not allow them to fail. They were convinced that their profits will be privatized while bankruptcies will be socialized, and many engaged in risky mortgage loan extensions as they were certain that the government will bear the innate risks. Likewise, during boom, people in the mortgage supply chain received enormous fees with those originating loans receiving fees for selling the loans notwithstanding the performance of the loans.
Through financial innovations such as securitization, mortgage originators transferred credit risks and default risks to investors. This resulted to a morale hazard as the mortgage originators were left with nothing to worry about and lending to households proliferated at extraordinary rates. Equally, adverse selection contributed to the crisis. Financial institutions faced adverse selection problems when offering mortgages since they were forced to give mortgage loans to borrowers whose credit worthiness they could not ascertain during the underwriting process.
Since finance syndicates were not exposed to the kind of regulatory oversight that banks were subjected to, incentive for responsibility plummeted, and borrowers sought more loans which they would default and lead the world into a financial crisis. Question 3 The subprime predicaments distinctive issues forced central banks all over the world and the U. S Federal Reserve to increase money supplies to circumvent the risk of a deflationary spiral where high unemployment and low wages leads to declining consumption. While the government intervention helped in resolving the crisis by increasing consumption, investment, and wealth, it is only a short-term measure and may lead to occurrence of an even worse crisis in future due to the kind of morale hazard it created (Bernanke, 2009).
For instance, since the demand in private sector declined as a result of the crisis, the government resulted in enactment of huge fiscal inducement packages and borrowed funds that would help increase its expenditure and offset the reduction in demand and consumption. In US, this stimulus package had reached $1 trillion by 2009 (Glaeser & Sinai, 2013).
Whereas the U. S federal reserves extended liquidity was aimed at enabling the central bank to return to its traditional role of lender of last resort and mitigate stigma, banks are using this opportunity to expand their investments. Similarly, through currency creation, the government wanted to battle the liquidity trap and spur banks to refinance mortgages and offer domestic loans, banks have reinvested the funds in more profitable ventures as they strive to create wealth. The reduction of discount rate to 1.75% and federal funds rate to 1% in 2008 also added onto the risk of emersion of another crisis as more money will be available in the economy (Friedman, 2011; Phillips, 2008).
What’s more, the National Economic Stabilization Act of 2008 which created $700 billion, a corpus to be used in purchasing distressed assets such as MBS puts the American and world economy into a more susceptible situation and might culminate in another crisis (In Alesina & In Giavazzi, 2013). Question 4 Due to the need to stop the crisis and governments’ intoxication by power, governments resulted in borrowing, a factor that led to the ballooning of the national debt.
A ballooning of the national debt has adverse effects in an economy (Conaghan et al. , 2013). Government borrowing is in form of bonds which attract interest. The accrued interest is paid for many years from the limited government receipts, and may result in deficit budgets for many years to come (Krugman, 2009; Taylor, 2009). Consequently, the government will be forced to cut its spending so as to meet its obligations. Similarly, the interest is dead money which implies that taxpayers will have to carry a heftier burden for more years to come (Foster & Magdoff, 2009).
A huge national debt that results from increased borrowing upsurges demand for credit in the economy. Consequently, borrowing costs will escalate thus making it costly to finance investment in capital goods, stock and equipment. The capable effect of this is a reduced aptitude and capability of the private sector to create jobs and generate wealth required to drive an economy out of recession (Batten & Szilagyi, 2011). In extreme situations, it might lead to collapse of the currency, as the country will be to print more money to repay the debt, and put the country into an even worse economic distress.
Bibliography Batten, J., & Szilagyi, P. G. (2011). The impact of the global financial crisis on emerging financial markets. Bingley, U.K: Emerald. Bernanke, B. (2009), Financial innovation and consumer protection, Federal Reserve System’s sixth biennial community affairs research conference, Washington DC, 17 April. Bonner, W., & Wiggin, A. (2006). Empire of debt: The rise of an epic financial crisis. Hoboken, NJ: Wiley. Christensen, C.
M. (1997). The innovator’s dilemma. Boston, Mass. : Harvard Business School Press. Conaghan, D., Smith, D., & Julian Flanders, N. (2013). The book of money: Everything you need to know about how world finances work. London: Mitchell Beazley. Coval, J. Jurek, J., & Sttafford, E. (2009), The economics of structured finance, Journal of Economic Perspectives, 23, pp. 8-25. Foster, J. B., & Magdoff, F. (2009). The great financial crisis: Causes and consequences. New York: Monthly Review Press. Friedman, J. (2011). What caused the financial crisis. Philadelphia: University of Pennsylvania Press. Glaeser, E. L., & Sinai, T. M. (2013). Housing and the financial crisis. Greenspan, A. (2004), Risk and uncertainty in monetary policy, American Economic Review, 94, pp.
33-40. In Alesina, A., & In Giavazzi, F. (2013). Fiscal policy after the financial crisis. Krugman, P. (2009), “Out of the Shadows, ” The New York Times, 18 June, 2009. Manoj, S. (2010). The 2007-08 Financial Crisis In Review. Retrieved from http: //www. investopedia. com/articles/economics/09/financial-crisis-review. asp Phillips, K. (2008). Bad money: Reckless finance, failed politics, and the global crisis of American capitalism. New York: Viking. Shleifer, A., & Vishny, R. W. (2009), Unstable banking. NBER Working Paper Series, February. At http: //www. nber. org/papers/w14943.html. Taylor, J.B. (2009), The financial crisis and the policy responses: an empirical analysis of what went wrong, NBER Working Paper Series, February.
At http: //www. nber. org/papers/w14631.html.