Causes of 2008 Global Financial Crisis - Case Study Example

Running Head: Causes 2008 Global Financial Crisis Running Head: Causes 2008 Global Financial Crisis Name Course Lecturer Date Causes of 2008 Global Financial Crisis The 2008 global financial crisis (GFC) has been termed the worst by economists, since the great depression that occurred in 1930s (Shiller, 2008). The crisis were marked by a major decline in global economy beginning in late 2007, which then experienced a sharp downturn by September 2008. Frankel and Saravelos (2010) assert that, the initial phases of the financial crisis which started as a form of liquidity crisis became patent from august 2007. This is when BNP Paribas ended it withdrawals from the potential three hedge funds, referring to a “total evaporation of liquidity”. The global financial crisis has affected the whole global economy, but with greater detriment in some countries as compared to others (Shiller, 2008). Various factors have been directly or indirectly known to 2008 financial crisis, with analysts placing varied weights upon specific causes (Frankel & Saravelos, 2010; Shiller, 2008). The crisis resulted as failure or even the risk of failure within major financial institutions worldwide. The crisis is associated with complex financial activities of the period between 2002 and 2008. These included the easy credit conditions experienced during that period which promoted high risk lending and extensive borrowing practices; real estate bubbles which caused their burst since then (Shiller, 2008); international trade imbalances (Obstfeld & Rogoff, 2009).; securitization; monetary policy choices that related to government expenses and revenues. Moreover, the approaches employed by countries in bailing out the then troubled private bondholders, banking industries, as well as assuming socializing losses or private debt burdens (Rose & Spiegel, 2012). The 2008 financial crisis was a major global downturn which was characterized by various kinds of systematic imbalances and sparked by the outbreak of subprime mortgage crisis in the United States. According to Obstfeld and Rogoff (2009); (Frankel & Saravelos (2010); Shiller (2008), the GFC began as subprime mortgage crisis in US. The bursting and peaking of the housing bubble by 2006 in the U.S. caused the plummeting of values in securities associated with real estate pricing in the U.S. Origin of housing bubbles is believed to constitute two major factors; significant increasing in savings available from many developing countries due to continuing trade imbalances. Secondly, housing bubbles resulted from low interests on rates within Europe and U.S. following the recession of 2000 to 2001. In turn, the demand for high yield investments increased. This then lead to indulgence in housing market by large investment banks. Many of these institutions lowered their credit standards in order to meet the demand of global mortgage securities (Crotty, 2009). Large profits were generated but the entire risk passed to investors. On the other hand, as bubbles increased developed, levels of household debts rose globally after 2000. As such, many households depended on refinancing their mortgages. Easy credit coupled with a belief of appreciation of housing prices caused many subprime borrowers to acquire adjustable rate mortgages as they enticed them with a very low interest rate (Obstfeld & Rogoff, 2009). Once the grace period ended and borrowers were unable to repay the loans, many turned into refinancing their mortgages which become even more difficult as housing prices continually declined in the U.S. As a result of unbearable high payments many borrowers defaulted. By 2007, the global credit markets stopped funding the mortgage related investments and had began foreclosure. This caused many homeowners unable to refinance their loans; leading to the ultimate collapse of securities backed the specific mortgages (Shiller, 2008). Source: http://www.commonsenseeconomics.com/Activities/Crisis/Economic%20Crisis%202008.pdf Another major factor that lead rise of 2008 financial crisis is the high levels in private debts. In an attempt to counter the 2000 stock market crash followed by the slowdown in economy credit availability was eased and low interests rates which have not been seen in decades were offered. The low interest rates promoted the growth of debts at all levels of economy, the main portion being private debt needed for better housing. Obstfeld and Rogoff (2009) argue that, debts of high level measure have been extremely termed as causative factors associated with recession. Crotty (2009) observes that, the 2008 financial crisis also resulted from shadow banking system. These are the availability of many non-bank financial institutions offering services that are similar to those of traditional commercial banks. A major risk allied to shadow banking is the fact that they do not take deposits (Obstfeld & Rogoff, 2009). Therefore, these intermediaries are only subjected to very minimal regulations as compared to traditional commercial banks. The institutions are in better a position to augment rewards from investments by the way of leveraging more than the mainstream banking system counterparts. Through this they are able to avoid the rules set in place to counter financial crisis (Obstfeld & Rogoff, 2009; Crotty, 2009). . According to Merrouche & Nier( 2010), there are a number of channels identified through which the monetary policy played part in building up financial imbalances. Most of these were identified to have worked by policy rates that were kept low for a long period of time. Loose monetary policy may have abridged the cost of wholesale funding for the intermediaries, which led to intermediaries building-up leverage. Additionally, it may have caused banks to take more risks which include credit as well as liquidity risks. In addition it increased the supply of and demand for credit in mortgages, which caused the price of assets to rise. According to Jickling (2010), relaxed regulation of leverage is another cause of financial crisis, whereby some firms liberalized their net capital rules which allowed the investment bank holding organizations to obtain very relatively leverage ratios. Some of their consolidated supervised entities program, which applied to the biggest holding banks, became voluntary as well as unsuccessful. Securitization is another cause of economic crisis in 2008, which fostered the “originate-to-distribute” model which decreased lenders incentives to the prudent; this is especially in the face of the huge investor demand for subprime loans packed as AAA bonds (U.S Financial Crisis Inquiry Commission, 2011). In regards to this, ownership of mortgage-backed securities was broadly dispersed, which caused repercussions throughout the worldwide system when subprime loans went awful in the year 2007. Another factor that led to global crisis is lack of risk management system; this is through some global firms separating analysis of market and credit risk. This division failed to work for complex structured products, where those risks were impossible to differentiate. As Acharya et al (2010) states, tail risk is a cause of financial crisis whereby investors as well as risk managers sought ways to enhance their profits by providing insurance or writing options against low-probability financial events. Under the normal market, these strategies create a stream of small gains, but causes big losses during crisis. When market member comes to learn that many such possible losses are dispersed throughout the structure, but not aware of where exactly or how large, doubts as well as fear aggravate when markets come under stress. This dispersal of structural risk via financial novelty was thought to make the financial system more flexible to shocks. Global imbalances is another major factor that caused global crisis, whereby the worldwide financial flows have been distinguished in latest years by an indefensible pattern (Blanchard et al, 2009). Some countries such as China, Japan and Germany run big surpluses yearly, whereas others like U.S and UK run deficits. For instance, U.S external deficits have been mirrored by internal deficits in the household as well as government sectors. The borrowing of U.S cannot continue indefinitely since the results of stress lie beneath financial disruptions. In regards to this, none of the adjustments that have been made would in any way reverse the fundamental imbalances which have yet occurred. This means that, there has not been a sharp fall in the exchange value of dollar’s and U.S deficits persevere (Jickling, 2010). Lack of transparency and accountability in mortgage finance led to global crisis. Many participants in the housing finance value chain played part in creating a bad mortgages as well as selling bad securities, actually feeling secure that they would not be held responsible for their deeds (Humphrey et al, 2009). For instance, a lender could sell exotic mortgages to home-owners, without fearing the repercussions of the failure of those mortgages. Similarly a dealer could sell toxic securities to investors, without fear of individual accountability if those contracts failed. Therefore, it was for agent, realtors, persons in rating agencies, as well as other market members, everyone exploiting their own gain and passing problems on down the line awaiting the scheme itself to crumple. Due to lack of responsibility in the mortgage finance, with their great promises of risk management, they became huge creators of risk themselves (Jickling, 2010). Conclusively, the 2008 global finance crisis was termed the worst by economist since 1930, which was marked by the decline in worldwide economy from late 2007, and a sharp downturn which was experienced in 2008. Global financial crisis affects the whole world economy but with great loss in some countries than others. The economists, financial advisers and researchers should give directives to major financial institutions, since through they were the genesis of the global crisis. In order to avoid another downturn like the one experienced by the whole world in 2008, factors that led to global crisis should be reviewed and measures should be taken. References Shiller, R. J. (2008). The subprime solution: How today's global financial crisis happened, and what to do about it. Princeton University Press. Frankel, J. A., & Saravelos, G. (2010). Are leading indicators of financial crises useful for assessing country vulnerability? Evidence from the 2008-09 global crisis (No. w16047). National Bureau of Economic Research. Crotty, J. (2009). Structural causes of the global financial crisis: a critical assessment of the ‘new financial architecture’. Cambridge Journal of Economics, 33(4), 563-580. Obstfeld, M., & Rogoff, K. S. (2009). Global imbalances and the financial crisis: products of common causes. Centre for Economic Policy Research. Obstfeld, M., & Rogoff, K. S. (2009). Global imbalances and the financial crisis: products of common causes. Centre for Economic Policy Research. U.S, Financial Crisis Inquiry Commission. (2011). Financial crisis inquiry report: final report of the national commission on the causes of the financial and economic crisis in the United States. Government Printing Office. Acharya, V. V., Cooley, T., & Richardson, M. (2010). Manufacturing tail risk: A perspective on the financial crisis of 2007-2009. Now Publishers Inc. Humphrey, C., Loft, A., & Woods, M. (2009). The global audit profession and the international financial architecture: Understanding regulatory relationships at a time of financial crisis. Accounting, Organizations and Society, 34(6), 810-825. Blanchard, O. J., & Milesi-Ferretti, G. M. (2009). Global imbalances: in midstream?. International Monetary Fund. Jickling, M. (2010). Cause of the Financial Crisis. Washington DC: CRS Report for Congress. Ouarda., Eriend, N. (2010). What Caused the Global Financial Crisis?-Evidence on the Drivers of Financial Imbalances. Washington DC: International Monetary Fund . Read More