Today the global economy is facing the worst financial crisis since the great depression in 1930’s. The crisis has ruined markets across the world starting in the US from late 2007. It resulted from the failure of huge firms to manage risks and was aggravated by relaxed regulations. The housing market was the epicenter. Prices of homes continuously rose from mid 1990’s to the year 2006. People thought that the prices would always be rising. Sub prime borrowers (borrowers with poor credit history or who have no proof of steady incomes) drastically increased accelerating the rise in prices. Investors became very innovative introducing new products such as the Adjustable Rate Mortgages (ARMs) which had low rates, no down payments and even the provision to postpone interests and add it to principal amounts. The rise in price was however untenable. In 2007, the bubble finally burst. Sudden uncertainty in house prices made lenders cut on lending. Highly geared banks were severely vulnerable to plummeting asset prices yet they had very low capital base. This resulted to a credit crunch as mistrust among financial institution and later extending to other business entities became apparent. The hampered flow of credit sparked an economic slowdown as firms could no longer expand businesses. Incomes plummeted as unemployment rose spreading the effects globally through export markets and falls in asset prices. This paper discusses the financial meltdown in light of various financial principles and benchmarks which govern finance. It brings out the economic and financial failures which fueled the crisis. It incorporates the case of; and identifies possible parties which are at fault.
As mentioned above the key players in the financial turmoil are finance related institutions. This is because the housing market is heavily financed though debt. The continued rise in the prices of houses made the financial institutions gain ungrounded confidence in the housing markets making them direct a larger amount of lending funds to the housing sector. Therefore the burst in housing prices first impacted on commercial funds, mortgage companies, investment banks, insurance companies, hedges funds and pension funds. The financial products affected were mortgage loans, asset backed securities (ABS), and Mortgage backed securities (MBS) and Collaterised Debt Obligations (CDO) as well as Credit-default swaps (CDS) which is a form of insurance against a company defaulting on its debts.
Both prime and sub-prime mortgages facilities were used to extend credit. Prime mortgage loans are the normal home ownership loans extended to potential home owners based on their assessed ability to repay. Full and comprehensive assessments are performed on the prospective home owners to be able to fully substantiate their credibility to access certain amounts of credit mainly based on their level of incomes. The credit histories of the eligible borrowers are also very strong. Due to the perceived lesser risk of lending to this assessed individuals, the interest rates charged by the financiers is the competitive market rate which is usually very low especially in capital rich countries such as the US. Sub prime loans are thus the opposite of prime loans. They are mortgages extended to borrowers with very weak credit histories and low incomes. This is known to increase the risk of defaulting. Therefore the sub prime mortgage loan is usually offered at a higher rate of interest than the prime mortgage to take care of the higher risk. This being the case the sub prime borrowers pay more for the loans than the prime borrowers yet they are the people who are more likely to default in payments. The preference of this form of financing in the US became common in the 1990’s (Junior Achievement, 2008, Par4).
The bloated demand for houses caused by the increased access to credit drove up the housing prices to untenable levels. The prices later fell. The fall in prices lead to the imposition of tough standards for access to loans due to increased default rates. Many borrowers found it hard to refinance. Defaults and foreclosures steadily increased causing major losses for those holding mortgage backed securities (Junior Achievement, 2008, Par5).
A specific form of sub prime financing which was the first to backfire is the adjustable-rate mortgages (ARMs). ARMs have several characteristics. They have a variable rate of interest. For the first few months, the loan attracts a lower rate of interest usually several points lower than the prime mortgage rates. These low introductory rates are very enticing to the vast majority of borrowers. What is often forgotten is that the rates later adjust upwards above the prime rates and even then, they keep on varying (Blogger, 2007, Par 2).
The monthly repayments of sub prime mortgages are largely unlimited and even in instances where there exist some limits; they are way too high to accomplish any meaningful form of regulation. This means that the monthly repayment can potentially increase to unmanageable levels depending on the payout of factors under considerations in determining them. This is a potentially dangerous aspect of the sub prime loans (Blogger, 2007, Par 3).
Usually not much information on the borrower’s income is required. This is probably the most irrational and unrealistic element of the sub prime mortgages. The requirement of clear documentation of incomes however small is known all over the world to be the most significant reference point in determining the credit worthiness of any borrower.
The sub prime mortgages attract significant prepayment penalties especially after the introduction period. The heavy penalties often serve to increase the repayment burden for the borrowers.
The rise in demand for both new and existing houses fueled by the factors led to a sharp rise in housing prices in response o the basic laws of supply and demand. Between the year 1997 and 2006, house prices rose by an unprecedented 124%. Sub prime loans at the time grew from 9% to above 20% portion of the mortgage finance market. Again, the irrational optimism in assessing future trends in housing markets accelerated the lending spree. Nobody anticipated a scenario where interest rates could rise or where housing prices would fall (Jon, 2008, Par4).
Banks used the opportunity to borrow money from all available sources to build securitization. They stopped relying on saved monies as security for loans given out. They continued borrowing from each other and selling the borrowed funds as securities. Investment banks saw the opportunities in the mortgage industry. The intention was to was to convert them into securities and resell them. The worst mistake came when the financial institutions rub out of customers to loan. This is because they turned to lower income groups which were previously outside the loan bracket.
The drop in prices meant some homes were worth less than what the owners owed the banks. This being the case, a high number of borrowers had to loose their homes while others even opted to just walk away to avoid the high repayment for their lowly valued houses.
According to the world economic forum, several forms of financial risks result from the crisis. Systemic financial risks have become a reality. This is risk resulting from sharp falls in asset values and economic activity. It is the spread out instability in the entire financial system affecting the real economy. Food security has also been compromised by the high inflation in for many staple foods with food riots emerging (World Economic Forum 2008 par6).
Also supply chains have increasingly become vulnerable. Disruptions especially in external supplies are becoming more regular increasing the risks of doing business. Still, the need to use safe and environmentally friendly energy has brought further uncertainties in the business world. Pressure is mounting towards reduction in greenhouse gases from energy use which is expensive (World Economic Forum 2008 par7).
A combination of these risks generally presents a volatile global economic environment which is a major impediment to international business and flow of investments. Much caution has to be applied by investors across the globe. They will only invest in countries which they think have minimal financial and political risks in a bid to avert losses. The implication of this is a slowed recovery process as more will be needed to instill confidence among investors and lenders on the viability and future prospects of businesses.
The effect of the crisis on international trade and finance has been great. Investors have developed an acute less of confidence. Confidence loss within the investing community caused a drastic fall in the stock prices all over the world. Analysts estimate that the losses made by financial firms are in the range of USD 2.8 trillion.
In mitigating the effect of the crisis, governments led by the US have spent around USD trillion of tax payer’s money to help shore up financial institutions. The stimulus package was structured to comprehensively deal with the various sectors affected by the crisis. It comprised of bailouts, tax cuts as well investment in infrastructure to stimulate the economy. The effect of the stimulus plans has been enormous according to analysts. Below is an illustration of the effect of the stimulus package on the recovery process.
AIG insurance company is one company which had to be bailed out by the government US government. It is the biggest insurance company in the world. Fundamentally, the basic businesses practiced by the company are sound. Problems came with the accumulation of misplaced credit default swaps. Credit swaps are similar to insurance policies. It is used by debt holders as in speculation of any defaults in repayments. It protects the defaulter from the lender from defaulting a case which can result in bankruptcy or complete disorganization of financial plans. Through a subsidiary, AIG offered protection to the tune of $447 billion in the form of CDS. However the choice of borrowers to protect was flawed. A large composition of the clients covered was those who potentially could not pay back the loans (A world to win, 2006, Par 5)
The insurance company also offered insurance in the in the form of asset backed securities. Pools of sub-prime mortgages, Alt-A mortgages, collaterized loans and prime mortgages were insured. This made the company make enormous profits. The collapse of the housing markets led to the plummeting of housing prices. Foreclosures started rising. The supply forces made the insured pools drastically fall in value making the company loose huge values. Insurance claims in the form of CDS took a toll on the company’s finances. The effect was so huge that by the end of 2007 the company was feeling the pressure to fulfill obligations take a toll on the stability of the company.
It was later discovered that the company was improperly valuing its CDO liabilities and other related CDS obligations..Auditors discovered that the losses resulting from undervaluation were in the range of $20 billion. Accounting maneuvers had managed to hide these malpractices. The company posted $5.3 billion in the start of 2008 it had insured in the form of CDS contracts. This had to rise by $4.4 billions by April the same year. The onset of rating agencies hiked the value even higher by 14$ billion (Brookings, 2008, Par4).
The problem was inherent within the system. The valuation of CDOs, Asset backed securities and CDS is a daunting task. Valuing a simple CDO can take a super computer 48 hours. This necessitated the use of indexes to value them. It turned out that the system used caused massive undervaluation shih gave the company undeserved liabilities. Cash flow issues emerged. The obligations required higher levels of cash flows than inflows. This means that the company was running out of cash.
Faced with eminent collapse due to the overwhelming claims, the company had to seek help from the government. An $85 billion deal was reached at between the government and the company. This depicts the enormity of the problem. The argument was that the insurance company was too big to fail. Failure would only mean a complete restructuring of the entire financial system an exercise which would introduce excess uncertainties and a possibility of enormous losses both in monetary terms and in terms of lost employment opportunities. The bailout gave the government a 79.9% equity holding in the company. The loan would yield an interest rate of 8.5%. Security is by the firm’s assets as well as the profitable insurance business (World Economic Forum 2008, Par4).
As can be seen financial management calls for extreme caution. Thorough analysis has to be carried out to ensure the plausibility of lending policies in managing risks. Accumulated Improper valuations can potentially result in the outburst of a hard reality with the potential to take down the largest and strongest of financial firms.
It is clear that the government is set to recover a large portion of the money used to bailout the firms. The recovery proves is proving speedy and based on a much firm foundation than before.
References
A world to win, 2006. Global recession – local impact. [Online] Web.
Brookings, 2008. The Origins of the Financial Crisis. [Online] Web.
Junior Achievement, 2008.Understanding the Financial Crisis Origin and Impact. Web.
Jon S., 2008. Financial crisis: Reaction from around the world. Imperial Online [Internet]. Web.
Martin N., Robert E. and Matthew S., 2003. The Origins of the Financial Crisis. BROOKINGS [Online] Web.
Peter S., 2008.European reactions to the financial crisis. Covering their tracks and distancing themselves from the US. [Online]. Web.
World Economic Forum 2008: Highest levels of political and economic uncertainty for a decade [Online] Web.
World Economic Forum, 2008 Global Risks. A Global Risk Network Report. [Online] Web.