Essay on Global Economic Crisis (1350 Words)

The root cause of the Global Crisis is the housing bubble that originated in 2007 in the US and the collapse of the sub-prime mortgage market. A sub-prime loan is a loan given to borrowers that are considered more risky, or less likely to be able to make their loan repayments, in relation to high quality of borrowers because of problems with their credit history. How did the crisis happen? Let us analyse the reasons:

First, the years leading up to the sub-prime crisis so called global imbalances were occurring – excessive borrowing in some parts of the world (particularly the US) and the excessive savings in Asia (particularly China). China’s excess savings were used to fund American borrowing. The situation was compounded by ultra-low interest rates as the Fed had aggressively cut interest rates to avoid going into recession after the dot.com bubble and Enron failure. Thus, the liquidity was in excess.

Second, low interest, easy credit, and lax credit due diligence created bubble in residential property market.

Third, the borrowers took out adjustable rate mortgages where payments rose if interest rates rose and low initially fixed rate mortgages that quickly converted to adjustable rate mortgages. Their plan was to refinance these loans using the expected increase in value of their house to help them qualify for a better loan.

But that did not happen! And they could not refinance and hence, were stuck up to pay a much higher mortgage payment as the harsher terms of the loans they agreed to kick in. This caused many of the borrowers being unable to pay their instalments and therefore, their house was foreclosed on. However, Americans have seen several instances in which individuals have been dispossessed of their houses even when they have no debt.

Fourth, the search for yield enabled the US and European banking systems to evolve from their traditional banking model (accept deposit and lend or originate and hold) to a new wholesale banking ‘originate to distribute’ model.

Using the asset securitisation and distributing such asset-based securities, the banks freed themselves from the constraints of limited domestic savings and could draw on global savings. Securitisation meant that assets could be moved off-balance sheet into unregulated special investment vehicles that did not require capital.

Fifth, the housing loans were not with financial institutions which gave the loans but had been sold off and traded among different financial institutions from around the world. As the sub-prime portion of these mortgage pools were defaulting at much faster rate than expected, the institutions that held them stood to lose a lot of money. This led to liquidity crunch.

Sixth, the financial institutions had inadequate levels of liquidity as they were sure of wholesale funding and ultimately central bank support.

Seventh, The risk management and internal controls in financial institution were allowed to fail – the risk management was predicted on historical data; too many financial institutions and investors simply outsourced their risk management; size matters, as miscalculations were too big; many risk models incorrectly assumed that positions could be fully hedged – without giving a thought to that liquidity can dry up, making it difficult to apply effective hedges; risk models failed to capture the risk inherent in off-balance sheet activities, such as structured investment vehicles; and complexities got better of industry.

The industry let the growth in new instruments outstrip the operational capacity to manage them. As a result operational risk increased dramatically and this had a direct effect on the overall stability of the financial system.

Corporate governance systems also failed to contain risk-taking behaviour, while bonuses and remuneration systems rewarded short-term risk-taking at the expense of the long-tem health of financial institutions and the interests of shareholders.

Eighth, five elements of financial innovation and deregulation and one black hole in regulation came together to create the toxic products that were at the root of the crisis:

i. Securitisation of residential mortgages into mortgages or asset backed securities (ASB) by government mortgage institutions such as Fannie Mae and Freddie Mac.

ii. The accounting and regulatory standards permitted such potential liabilities to be moved off the balance sheet so that banks benefitted from ‘capital efficiency’ meaning that leverage could increase using the same level of capital.

iii. The insurance companies (like AIG) and the newly evolved credit default swap (CDS) were used to enhance credit quality of the underlying paper.

iv. The last was the willingness of the credit agencies to give these structured products AAA rating for a fee.

The fragmented regulatory structure allowed gaps, inertia and arbitrage that weakened oversight of the industry. Not only did regulation fail to keep up with the changes in financial markets, but weakness in regulation encouraged innovation in an attempt to evade regulatory requirements.

It was known that banks and mortgage companies were engaged in predatory lending practices, and they used their political muscle to stop states from enacting law to curtail such lending. The separation of central banking from supervision, in some jurisdictions, meant no official institution was formally responsible for financial stability or had the information necessary to make quick decisions on lending to individual institutions in a crisis, “.at the root, the regulatory failure that gave rise to the current crisis was one of the philosophy more than structure.

In too many cases regulators had the tools but failed to use them. And where tools were missing, regulators too often failed to ask for the necessary authority to develop what was needed.” Fed has acknowledged its oversight was too complacent before the 2007-09 financial crises, but has also claimed that it has already taken steps to amend its ways.

Finally, the crisis became global because no economy was an island in itself. It would not be out of context to mention the post-crisis behaviour of the financial institutions. The rule of law, the universally-accepted hallmark of an advanced, civilised society, is supposed to protect the weak against the strong, and ensure that everyone is treated fairly. However, it is not so.

When it became clear that people could not pay back what was owed, the rules of games changed. Bankruptcy laws were amended to introduce a system of ‘partial indentured servitude. An individual with, say, debt equal to 100% of his income could be forced to handover to the bank 25% of his gross, pre-tax income for the rest of his life, because the bank could add on, say, 30% interest each year to what a person owed.

In the end, a mortgage holder would owe far more than the bank ever received, even though the debtor had worked, in effect, one-quarter time for the bank. Despite the crisis, the toxic real estate loans that lay at the heart of the crisis are still on the banks’ balance sheets.

Banks are reluctant to sell them or price them realistically for fear of exposing their weakness and cutting into profits – and regulators so far are willing to look the other way. “We are being very Japanese about the way we’re dealing with toxic loans.”

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