Causes And Effects Of The Global Financial Crisis

Major financial instruments and factors that caused the financial crisis

The spectacular burst of the US housing bubble has shaken the US financial system and many global nations. In 2007, the spending power of the consumers has decreased, foreclosures related to property has increased coupled with housing market collapse and fall in the stock market. Due to such situations, the banks and global financial markets have suffered heavy losses (Charles, Hurst and Notowidigdo 2016). The current report intends to evaluate the main financial instruments and factors that have resulted in the crisis. Based on the instruments identified, the use of collateralised debt obligations, debt securitisation and credit default swap in the report. In addition, the report covers brief description of the strategies of the banking organisations, which have lead to default and their collapse. Finally, it sheds light on discussing whether derivatives are real reasons of the financial crisis and risk management solutions to prevent such situation.

The main financial factors and instruments that have resulted in the global financial crisis are briefly depicted as follows:

Despite the lower savings rate at the time of housing bubble, an incursion of saving entering the economy of US from nations like China and Japan has enabled in keeping low rates of mortgage interest. The investors in these nations made investments, which contain lower risk and higher returns (Cheng, Raina and Xiong 2014). Initially, the investors have focused on US government securities. This is because they have assumed that these securities contain lower risk, as the federal government might resolve the troubles, if aroused. However, there has been a change in the attitude of the investors, as they begun investing in mortgage-backed securities issued on the part of Wall Street firms. Such mortgage-backed securities carry low risk, as the top rating agencies like Standard and Poor’s and Moody’s have provided favourable ratings. Thus, the low rates of mortgage interest has resulted in housing bubble, as the payments of monthly mortgage are kept low with rise in house prices.

From 2002 to 2004, the Federal Reserve has pushed down the rate of federal funds to low levels for strengthening the recovery from the recession of 2001. From 2001, the Federal Reserve has reduced the rate of federal funds 11 times, from 6.5% to 1.75% (Damianov and Escobari 2016). Thus, this low short-term rate of interest has contributed to the US pricing bubble in two basic ways. Firstly, the lower short-term rates of interest have encouraged the utilisation of “adjustable rate mortgages (ARMs)”. Thus, increase in home prices in contrast to household incomes has caused problems for the speculative house buyers. This is because they were unable to afford home payments under the mortgages of fixed rate (Fitwi, Hein and Mercer 2015). However, ARMs have provided opportunity to the purchasers through lower monthly payment in the initial stage, as the interest rates in short-term were lower in contrast to long-term.

Hence, with the heating up of the housing market, the mortgage lenders have been more innovative in relation to ARMs. With the help of ARMs, the borrower could select to make standard payments of both interest and principal, which would help in minimising the outstanding loan balance on each month. Along with this, the borrower could select for making interest payments on a certain due interest. Thus, ARMs have helped in reducing the monthly mortgage payments for the buyers as well, which has led to increased home prices. The second method through which the short-term rates of interest have contributed to housing bubble is through encouragement of leverage (Gelain, Lansing and Natvik 2016). Due to the lower short-term rates of interest, the investors have been able to maximise their returns through borrowing at lower short-term rates of interest and investing in greater investments that re long-term in nature like mortgage-backed securities. Thus, this leveraging practice has increased the available funding in relation to mortgage lending, which has resulted in increased home prices and ultimately, the US housing bubble.

Low rates of mortgage interest

The standards related to mortgage loans have been tranquil due to the governmental policies intended to foster a rise in rates of home ownership for the lower income households. In addition, higher competition in the market of mortgage loan, increased securitisation of debt related to home mortgage and irrational exuberance have engulfed each party associated with the process of mortgage lending. In 1996, the US government has started to enhance the percentage of mortgage loans to households having lower income. However, Fannie and Freddie has relaxed the standards that mortgages need to be classified as “conforming” and hence, Fannie and Freddie could purchase this. In addition, the increased competition in the mortgage loan market has been exemplified with the fall in mortgage fees (Goswami, Tan and Waisman 2014).

Collateralised debt obligations:

In the words of Jin, Soydemir and Tidwell (2014), collateralised debt obligations (CDOs) are type of structured securities that are backed by assets. The CDOs are developed for the corporate debt markets, which are used to encompass the “mortgage and mortgage-backed security (MBS)” markets. The rating agencies have been more significant in disposal of the MBS branches, which could not be rated AAA. Despite these are composed of a minority of the value of MBS branches, it has not been beneficial to make security in the initial stage. In addition, the conventional mortgage investors have been risk-averse and thus, these lower safe branches have been most difficult to sell.

In order to sell “mezzanine tranches”, the investment bankers have developed a new security in the form of collateralised debt obligations. These obligations have been developed due to deregulations and excess of cheap credit that have provided opportunities to the investment banks in issuing a unbalanced volume of controlled financial products. Thus, these CDOs developed through loan securitisation concluded up being largely correlated to the housing market. This is because a vast portion of the assets in the pools of CDO has become residential mortgage-backed securities (Kouwenberg and Zwinkels 2014). With the rise in demand for CDOs, prime mortgage supply for the process of securitisation has depleted. Due to this, the mortgage lenders are compelled to alleviate standards of lending and issue mortgages of subprime adjustable rate that are risky in nature through unusual schedules of amortisation. This weird and substantial mortgage issuance has inflated the US housing market price into historic levels during 2004-2006. The bubble, which the issuance of subprime mortgage has inflated, outburst in 2007 due to increased interest rate and subprime lenders defaulted on their mortgages (McDonald and Stokes 2013). As a result, the prices have declined in an iterative process leading to the collapse of US and the global economy.

As commented by Meng et al. (2013), credit default swap (CDS) is a specific type of exchange framed t0 transfer the exposure of credit related to products of fixed income between two or more parties. In this type of exchange, the purchaser makes payments to the seller until the contract maturity date. However, the role of CDS is significant in case of US housing bubble. Due to CDS, the insurance firms, derivative product firms and monocline insurers have sold insurance without pasting adequate collateral or equity capital. This situation has aroused due to wrong rating of credit risk and non-posting of collateral to trade in CDs. The CDS market is a portion of the over-the counter (OTC) derivative markets, in which there is absence of regulations from their initiation.

Lower short-term rates of interest

Due to the above-stated reasons, the CDS pricing has reflected an opportunity of arbitrage, which has resulted in additional supply. Thus, with the default of mortgage and crash of housing prices, the global financial institutions have greater positions in CDs and inadequate equity capital to absorb losses (Miles 2014). As a result, default contagion occurred, which has led to the financial crisis.

According to Moroni (2016), debt securitisation is a process that the banks use in developing securities through loans and other assets that generate income. The investors use to purchase these securities and it helps in writing off the loans from the balance sheet statements of the banks. However, in the US housing bubble of 2007-2008, the investors in tranches formed out of subprime mortgages do not ensure the payment of principal and interest amounts. In addition, the information that was provided during application denotes includes loan-to-value ratio and FICO score of the borrowers. Along with this, some borrowers have provided incomplete documentation related to assets and income. Thus, lack of regulations relating to debt securitisation has resulted in burst of the US housing bubble.

The banking organisations have used the following strategies, which have lead to default and purchase of their businesses:

• The GSE-government sponsored banking firms have bought mortgage from a group of mortgage organisations over the decade along with selling bonds. Such bonds depict the first mortgage-backed securities (MBS). The banking organisations have the mission to provide help to the lower income households in buying homes through mortgage purchase (Nneji, Brooks and Ward 2013). In addition, there is small percentage of non-prime loans.
• The banking firms have financed the housing boom along with packing mortgages into MBS to sell their own accounts. As MBS is in demand, the investors have considered them as safe investments due to greater rate of return compared to treasury bills during period of boom, in which there is minimal default. In addition, CDS has been available to deal with insurance of credit risk. Due to the opaque investment nature of CDS and MBS, it had become difficult to ascertain the valuation with the bubble outburst.
• The banks have ready availability of loan-able funds because of lower rates of interest in the early decade, low taxes and adequate flow of foreign capital into US economy.
• In order to build reserves, the banks have enhanced risk due to higher debt-to-equity ratio that multiplies profits in boom; however, it reduces the same in bust. As a result, it has damaged the liquidity positions of the banking organisations and thus, many banks have liquidated after the US housing bubble due to their inabilities in absorbing the losses incurred.

As commented by Summers (2014), derivative instruments have been created for handling risk and insurance against downside. The major types of derivative instruments include options, CDS, CDO and MBS. Based on the above discussion, it could be stated that derivatives were the major reasons of the financial crisis due to the following reasons:

The banks not having any desire of credit clutching, pooled these advantages into vehicles to make securitised instruments that they sold to investors. Since there were lesser number of credit-commendable clients to provide loans, banks swung to subprime borrowers along with developing securities with poor basic credit-quality advances that were transferred to the investors. The investors have relied on the rating organisations for assuring the credit quality of the securitised instruments (Tan and Cheong 2016).

The Banks held a hefty portion of these instruments on their books. This is a method for meeting the wage prerequisites and utilising such benefits as security. It is assumed that the rate of average for the “top notch” instrument was around 32 cents on the dollar. In addition, the mezzanine instrument provide five cents, which has caused the investors and banks to experience a gigantic negative amazement.

The banks have borrowed funds for developing increasingly securitised items. Subsequently, a number of these instruments were made utilising edge, or acquired assets, so that the organisations might not provide entire capital expenditure. The enormous amount of leverage used during this time has increased the issue. Due to this, the capital structures of the banks have increased from 15 to 30. For example, by mid 2008, the credit default swaps market has exceeded the entire global monetary yield by $50 trillion. Subsequently, there has been amplification in any benefit or misfortune. Furthermore, in a system that had extremely poor direction or oversight, an organisation could experience greater trouble.

Tranquil standards for mortgage loans

In order to avoid such situations, the following solutions related to risk management could be adopted:

• In order to improve liquidity or investor confidence, the central banks need to diversify their supplies related to money and lending for offsetting the fall in lending on the part of the investors and private institutions.
• Even after the outburst of the US housing bubble in 2007, some financial institutions are prone to risks in terms of solvency, as they are struggling to meet their debt obligations. Therefore, the options that could be used to minimise such problem include bondholder haircuts, restructuring through bankruptcy and bailouts of the government through purchase of assets.
• The government spending needs to be increased or tax rate needs to be reduced for offsetting fall in business investment and consumer spending.
• The banking organisations are required to modify their mortgage loan terms for avoiding foreclosure in order to increase cash payments. For instance, the government could provide financial incentives for the lenders to extend support to the borrowers.
• There is need for modification of banking regulations in order to stabilise the financial system of the US economy in the long-run for preventing any identical financial crisis.

Conclusion:

From the above discussion, it has been evident that lower mortgage interest, lower short-term interest rates and tranquil standards of mortgage have been the major financial factors contributing to the US housing bubble in 2007. The main derivative financial instruments involved in the crisis include collateralised debt obligations, securitisation of debt and credit default swaps. The banking organisations have the mission to provide help to the lower income households in buying homes through mortgage purchase.

In order to build reserves, the banks have enhanced risk due to higher debt-to-equity ratio that multiplies profits in boom; however, it reduces the same in bust. As a result, it has damaged the liquidity positions of the banking organisations and thus, many banks have liquidated after the US housing bubble due to their inabilities in absorbing the losses incurred. Finally, it has been evaluated that derivatives are the real cause of the financial crisis and therefore, adequate risk management solutions have been developed in order to prevent such situation in future.

References:

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Cheng, I.H., Raina, S. and Xiong, W., 2014. Wall Street and the housing bubble. The American Economic Review, 104(9), pp.2797-2829.

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Jin, C., Soydemir, G. and Tidwell, A., 2014. The US housing market and the pricing of risk: Fundamental analysis and market sentiment. Journal of Real Estate Research.

Kouwenberg, R. and Zwinkels, R., 2014. Forecasting the US housing market. International Journal of Forecasting, 30(3), pp.415-425.

McDonald, J.F. and Stokes, H.H., 2013. Monetary policy and the housing bubble. The Journal of Real Estate Finance and Economics, 46(3), pp.437-451.

Meng, H., Xie, W.J., Jiang, Z.Q., Podobnik, B., Zhou, W.X. and Stanley, H.E., 2013. Systemic risk and spatiotemporal dynamics of the US housing market. arXiv preprint arXiv:1306.2831.

Miles, W., 2014. The housing bubble: How much blame does the fed really deserve?. Journal of Real Estate Research, 36(1), pp.41-58.

Moroni, S., 2016. Interventionist responsibilities for the emergence of the US housing bubble and the economic crisis:‘neoliberal deregulation’is not the issue. European Planning Studies, 24(7), pp.1295-1312.

Nneji, O., Brooks, C. and Ward, C., 2013. Intrinsic and rational speculative bubbles in the US housing market: 1960-2011. Journal of Real Estate Research.

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Tan, J. and Cheong, S.A., 2016. The Regime Shift Associated with the 2004–2008 US Housing Market Bubble. PloS one, 11(9), p.e0162140.