The paper 'Causes and Effects of the Global Financial Crisis" is a great example of finance and accounting coursework. History often repeats itself, and in some respects, this is true of the current financial crisis. The specific catalyst of the crisis was a housing boom, financed mainly through credit extended by banks, which ended suddenly and destabilized the financial system, a similar change of events as crises in Japan and Sweden during the 1990s. (Savic, 2008) The difference now, of course, is in the worldwide scope of the crisis and the underlying flaws in the financial system that allowed it to collapse so comprehensively this time. The structure of the financial system, at least as it was before the crisis began, is sometimes called the New Financial Architecture (NFA).
What the term NFA refers to is the unprecedented integration of normally highly-regulated financial firms such as banks and mortgage lenders with the comparatively lightly-regulated financial markets. (Crotty, 2008) One of the characteristics of this arrangement is a behavior known as regulatory arbitrage, wherein a large portion of the financial business normally handled by regulated banking institutions is shifted to less-regulated non-bank entities such as brokers, hedge funds, money market fund managers, and the like.
(Roubini, 2008: 3) That ability to evade most of the controls on the banking system combined with good economic conditions from 2003 to 2007, which featured low-interest rates, a relatively low rate of defaults on loans, high profits for companies, and rising stock prices. (Crotty, 2008) Obviously, this was a recipe for disaster. The concept of ‘ risk’ in loans and other financial transactions all but disappeared, thanks in large part to the development of mortgage-backed securities, the product of an idea called “ originate and distribute” .
(Roubini, 2008: 2) Under the optimistic theory of the NFA, not just the loan itself was distributed but also the risk associated with it. Diluting the risk, along with the natural, self-correcting mechanism of efficient capital markets would virtually eliminate the risk, or so the theory went. (Crotty, 2008) What happened as a result was that the size of the financial markets relative to the overall economy grew dramatically. Debt in the US credit markets was three-and-a-half times the GDP in 2007, and the paper value of financial assets was ten times greater than the GDP.
The financial sector generated 40% of the total corporate profits in the US in 2006. (Crotty, 2008: 10) The real basis of this phenomenal growth was the high level of risk that became acceptable. The “ originate and distribute” model of mortgage-backed securities removed the incentive for the originators of loans to prudently assess the credit-worthiness of the people they were signing to mortgages (Roubini, 2008: 2); after all, once the mortgage was bundled into a security and sold to someone else, the bank would be paid, and the repayment or default of the loan would become that someone else’ s problem, not the bank.
To make matters worse, compensation for managers and executives in the credit industry became increasingly based on incentives to generate more business in the highly-competitive market, encouraging even greater risk-taking. (Crotty, 2008: 4) Once the effects of defaults on mortgage loans began to be felt in the financial markets, the pricing of mortgage-backed securities began to show fatal flaws.
Securities had been priced on a “ mark-to-market” basis, which is another way of saying that they were priced not based on what they were really worth, but on what someone was willing to pay for them. This fed the “ bubble” by inflating prices above their fundamental value – which in the case of mortgages should be the value of the property for which the loan was made in the first place – and allowing investors to borrow and leverage more. When the bubble burst, “ mark-to-market” meant that the bottom dropped out of security prices, in most cases driving them below their fundamental value.
(Roubini, 2008: 6)
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