No Pain No Gain. The more the risk, the more the return. All most all of the investors know this principle and they always try to achieve more. But they differ in how they want to gain better in a short term or the long term. Who wants to ride the high tides of the gains gets it better if everything goes right and if not they lost the high. The higher gains need the higher risk to be taken. The risk taken will definitely pay off with a better return. The risk and return differs with the life cycle. Everything has its own life and has to collapse down one day. The living being and non living beings have their own life cycle. The products have their own life; introduction, growth, maturity and decline. Each and every product follow the same life cycle. The time frame and the return might be different but they follow the same patterned life cycle. The similar case happens to the whole economy.
After the Great Economic Depression of the 1930s, the whole world has experienced the economic downturn on the year 2007. Though the economic situation is trying to pick up now but still the experts are signaling about another crash down. The whole world collapsed on the economic terms. The people and the country as a whole suffered a lot from the down turn. The companies collapsed, people went out jobless and homeless. The more they have invested on the risky business the more they suffered. The third world countries are suffering till date while the developed ones have already got the good vibes of improvement. The crisis has created chain reaction from one category to another, from one country to another, and the whole world economy came to its knees. Some weak and immature decisions have created a ground for this economic havoc. The way how we do business and the top business brains do the businesses differ in real terms but the result comes out the same, only the differences are on the level of loss and gain.
Every thing has its own reasons for its existence. Similarly, the financial crisis has it’s as well. The causes of the financial crisis are interlinked with each and could bring the stronger impact on the overall economy. It all got ignited with the US subprime mortgage crisis. The causes have created a vulnerable financial system, including complex financial securities, a dependence on short-term funding markets, and international trade imbalances. The increase on the consumer and corporate debt levels exert pressure on the overall fragile financial system. Regulation authority and markets system could not safeguard the rising debt level and the whole economy went on going down under the heavy loaded debt levels. The key financial institutions failed to be regulated properly creating the shocks for the market system such as ongoing foreclosure and failures. The stock market and real estate market played the most important role in the economic downturn. The debts were not managed properly. The mortgage could not be regulated and the debt kept on increasing with a little back support of the mortgage. The main setback was on the financial and economic regulation of the States. The U.S. Financial Crisis Inquiry Commission reported its findings in January 2011. It concluded that "the crisis was avoidable and was caused by: Widespread failures in financial regulation, including the Federal Reserve’s failure to stem the tide of toxic mortgages; Dramatic breakdowns in corporate governance including too many financial firms acting recklessly and taking on too much risk; An explosive mix of excessive borrowing and risk by households and Wall Street that put the financial system on a collision course with crisis; Key policy makers ill prepared for the crisis, lacking a full understanding of the financial system they oversaw; and systemic breaches in accountability and ethics at all levels.” US has announced the Financial Crisis Inquiry Commission to figure out the causes for the financial crisis on July 2009.
During the period of 1997 to 2006 the American real estates prices kept on increasing. It went up by 4.6 times on 2006 as that of 1997. The price appreciation boosted the homeowners to gain much higher loan amount on the similar assets. The people gain much loans than they could pay for. But the real estate market went on the decline stage from 2008 September. This decline has diminished the real estate prices by 20%. There were easy credit facilities and the people were sure about the appreciation of the prices. These factors encouraged the subprime borrowers to borrow loans on adjustable rate mortgages. These mortgages enticed the borrowers to borrow at the lower interest and aspiring to pay the make up by the remainder of the mortgage terms. Then, who could not pay the initial high interest started the refinancing process and start another cycles of refinancing. Once the refinancing started, the prices declined and the loan availability too. Then it came up to be the painful story of going default. The borrowers who could not pay the higher interests, started to go default and the cycle continued.
During 2007, lenders had begun foreclosure proceedings on nearly 1.3 million properties, a 79% increase over 2006. This increased to 2.3 million in 2008, an 81% increase vs. 2007. As of August 2008, 9.2% of all mortgages outstanding were either delinquent or in foreclosure. The fault of the US Government sponsored enterprises and the investment bankers are none the less. They have supplied very well for the subprime lending cycles in the US. These loans were very good for the sub prime borrowers but they were too risky for the government. If anyone defaults the loan then there goes out the investment. The lenders could not recover their investments. Subprime mortgages remained below 10% of all mortgage originations until 2004, when they increased to nearly 20% and remained there through the 2005-2006 peak of the United States housing bubble Subprime mortgage payment delinquency rates remained in the 10-15% range from 1998 to 2006, then began to increase rapidly, rising to 25% by early 2008.
Not only the lenders were considering the high risk borrowers but they were also offered high risk loan options and borrowing incentives. During the price boomed period the mortgage underwriting got loose and the loans were being provided without proper audits and review of the related documents. The underwritings were basically done on an automated system. On those periods sub prime borrowers collected the 40% of the loans on their accounts as a subprime loans. The brokers and the bankers got their high profit but they could not anlyse about how the borrowers will pay the loans. They just kept on increasing their loan amounts. Thus the fraud kept on increasing. The quality of the loan kept on decreasing. The credit standard kept going under gradual declination but the defaulters kept on high speed booming.
The down payment and the equity kept on going down. There was the situation of negative equity and very low level of down payment for the purchase of the property. There were 2% of first time home buyers but 43% among them did not pay off any down payment. Economist Nouriel Roubini wrote in Forbes in July 2009: "Home prices have already fallen from their peak by about 30%. Based on my analysis, they are going to fall by at least 40% from their peak, and more likely 45%, before they bottom out. They are still falling at an annualized rate of over 18%. That fall of at least 40%-45% percent of home prices from their peak is going to imply that about half of all households that have a mortgage—about 25 million of the 51 million that have mortgages—are going to be underwater with negative equity and will have a significant incentive to walk away from their homes." According to the LA Times, strategic defaults were heavily concentrated in markets with the highest price declines. An estimated 588,000 strategic defaults occurred nationwide during 2008, more than double the total in 2007. They represented 18% of all serious delinquencies that extended for more than 60 days in the fourth quarter of 2008. More than 50% of the borrowers were strategic defaulters though they have better credit score at the mortgage time. The credit ratings performed were also not of the great relief. They were inaccurate on most of the cases. Author Upton Sinclair (1878–1968) has stated: "It is difficult to get a man to understand something when his job depends on not understanding it." The agencies did not follow the provided rules and regulations and figured out their own credit ratings. Some of the sub prime defaulters were rated to be with high credit ratings. From the period 2000-2006, structured finance (which includes Collateralized Debt Obligations) accounted for 40% of the revenues of the credit rating agencies. During that time, one major rating agency had its stock increase six-fold and its earnings grew by 900%. There might have been the conflict of interest on the credit rating scales, which have been backed up by the bankers and the investors. Thus created rating might have created huge differences from the actual credit rating. It has been estimated that about & USD 3.2 trillions has been sanctioned to the bad credit home owners. Later, after the critics from various sectors, the credit ratings have been lowered by the agencies by USD 1.9 trillion on mortgaged securities. The decreases in credit ratings have forced the financial institutions to collect more capital by selling their shares. The values degraded shares ultimately diminished the overall stock market figures for the institutions.
Under those periods the financial institutions were not able to back up their losses caused due to subprime lending. They were highly leveraged and have less capital to be put up as collateral. They have high debt ratio; i.e. the equity was lower than the debt supplied. The most critical role for regulation is to make sure that the sellers of risk have the capital to support their bets. But the financial institutions lacked the same point to be considered. The executives of the financial institutions have been rewarded recklessness rather than responsibility and the people buy houses without responsibilities. There were high debt and low capital to support them leading to an economic downturn. Speculative housing also forced the economic downturn. More than 22% houses were bought for reinvestment during the year of 2006 and 14% more were for vacation spots. With the scale of 28% and 12% in the year 2005, approximately 40% of the houses were not for the primary housing; they were either for the business or for the vacation which could be used for a month or two in the whole year. Media widely reported condominiums being purchased while under construction, then being sold again for a profit without the seller ever having lived in them. Some mortgage companies identified risks inherent in this activity as early as 2005, after identifying investors assuming highly leveraged positions in multiple properties.
Under the 2004 the new net capital rule allowed the investment banks to issue higher debt amount, which in turn helped the real estate price hike after the low price cycle of the houses. From 2004-07, the top five U.S. investment banks each significantly increased their financial leverage (see diagram), which increased their vulnerability to a financial shock. These five institutions reported over $4.1 trillion in debt for fiscal year 2007, about 30% of USA nominal GDP for 2007. Lehman Brothers was liquidated. The other companies such as Bear Sterns, Merill Lynch and Goldman Sachs survived with the Government funding support.
Not only that the innovations on the financial sectors also adversely affect the overall economy, market participants did not accurately measure the risk inherent with this innovation or understand its impact on the overall stability of the financial system. The Collateral Debt Obligations (CDO) enabled financial institutions to to obtain investor funds to finance subprime and other lending, extending or increasing the housing bubble and generating large fees. A CDO essentially places cash payments from multiple mortgages or other debt obligations into a single pool, from which the cash is allocated to specific securities in a priority sequence. Those securities obtaining cash first received investment-grade ratings from rating agencies. Lower priority securities received cash thereafter, with lower credit ratings but theoretically a higher rate of return on the amount invested. A sample of 735 CDO deals originated between 1999 and 2007 showed that subprime and other less-than-prime mortgages represented an increasing percentage of CDO assets, rising from 5% in 2000 to 36% in 2007.
Risk is the most important player in the economic and the financial market. If you could handle the risk properly you will achieve more return and if you could not then you will crash down. Similar was the case related to the mortgage backed securities and the collateral debt obligations. The financial players could not figure out the exact level of risk related to mortgage backed securities (MBS) and CDO. The insurers were also unable to provide the required amount of return to the parties bearing the default loss. They were unable to figure out the level of risk associated to which they could not arrange up for the payments on time. The players could not find out the related risk factors. They could not find out what was really going on in the risk part of the financial assets. The credit risk was misinterpreted and the credit amount kept on increasing. Banks have already issued US$450 billion of CDOs. According to JP Morgan the average recovery rate was expected to be 32% but the actual recovery rate was only 5%.
The capital crisis also supported the financial crisis to a large scale. The capitalist countries were mostly affected by this crisis. This systematic crisis of capital was the most disruptive one creating a huge impact rather than the financial one. The average GDP of the developed countries have been decreasing since 1970 releasing out more unused capital. The market has been getting saturated leading to the decrease in the GDP. The unused capital was kept idle due to the lack of investment sectors. Thus the capital came into the financial market sector supported by the deregulation. The financial investment has turned out to be the most profitable rather than the capital investment.
Another important factor was the commodity market, the commodity prices kept on increasing after the collapse of housing bubble. The prices of every commodity kept on increasing at a steady rate. This has been due to the decrease in prices of raw materials and the speculative flow of money from the real estate and financial sector to the commodity market. The most important commodity markets were oil, crude oil and the metallic products. The price of copper and nickel kept on surging during the 2000s. Some of the nickel plants have already gone bankrupt, due to unavailability of the nickel ores in Australia.
Though the financial crisis could have been foreseen, it could have been properly handled or minimized as far as possible. If the economic plan was able to be built up to be prepared for such disaster the crisis could not have come up. Though some of the economists and market experts have foreseen the disaster but the regulatory authority did not prepare for the same rather they just took it just as a theory. Since the Great Depression the economists are being out casted on their forecasting due to the fact that they could not forecast the great depression. Now the people could not believe that the economists could forecast the economic movement. They are being flooded with various market related information and they don’t believe on such forecast. The lack of proper economic regulations and the drawbacks of the system have supplied energy for the crisis.
In this present global economic market nothing remains within the boundary of a country. Similarly the economic disasters also get into the other countries and affect them as well. The countries depend on each other and work together for their betterment. They relied upon each other and MNCs are the one among them. If an MNC goes bankrupt then it will bankrupt all over the world. All its business gets down and the company gets doomed. Not only that the foreign exchanges among the various currencies also depend upon each and sustain the market. If a country goes down the economy the other countries can’t escape. Thus the financial crisis engulfed the whole world. The first financial crisis of 21st century went increasing larger and larger until it swallowed the whole world economy. The European countries get suffered and Iceland collapsed as a result of the financial crisis. The euro zone courtiers tried and worked various measures to safeguard the crisis. UK has implemented the systematic capital injection to safeguard the economy from the collapse. The economy of Iceland collapsed and the economy of three countries, Iceland, UK and Netherlands were shaken. Due to the interdependence in between the countries like Norway, Denmark, Sweden and Iceland, each and every involved country got the low economic and mere away from collapse. Then after the collapse of Iceland economy the European countries cooperatively work together to avoid such collapse. They were able to save the Greek economy as well and the Europe as a whole.
Conclusively, the financial crisis has shaken the whole world economy. It has provided us the idea about how we treat the economy and how to safeguard from another crisis which might come sooner or later. There should be proper economic planning to handle each and every critical situation. Not only there should be a proper planning but it must also be implemented accordingly. Whenever we took any economic decision there should be proper consideration for he related risk and return. This will definitely help us in the future to avoid another financial disaster.
References :
1. www.wikipedia.org
2. www.forbes.com
3. Financial Times
4. www.msn.com
5. Google Images
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