Reasons for the recent global financial crisis

Name: Mariya Todorova

University: London Metropolitan University

Course: Banking and International Banking Systems

Tutor: Dr. Nirmala Lee

Date: 07/03/2012

Introduction

The cause of the recent financial crisis and economic recessions has been

attributed to various factors in the economy (Freedman 2010). The initial trigger of

the financial crisis has been traced to the toxic mortgage backed assets whose decline

in value and uncertain duration led to massive losses in the U.S economy. Fannie Mae

and Freddie Mac were both taken over by the US government. Lehman Brothers was

declared bankrupt since it could not increase its capitalization (Joseph 8). Merrill

Lynch was bought by the Bank of America while American International Group

(AIG) was rescued by the Federal government through an $ 85 billion capital bailout.

Washington Mutual which is currently the largest bank failure was purchased by JP

Morgan Chase. Northern Rock was nationalised by the British Government with bank

loss of £585million due to financial problems caused by the subprime mortgage crisis

(Shin 2009). The crisis can be traced to the failure of the real estate market due to
subprime lending which saw the commercial and residential housing prices increase

for a decade from 1990 (Freedman 2010). The Asian financial crisis of 1997-1998

saw the economies in Asia generate huge current account surpluses which were

invested offshore in economies like US and UK in order to keep the nominal

exchange rates low. The US stock prices went high due to the influx of capital. The

high growth in economic demands and especially in China saw commodity prices

such as minerals, oil and food soar up from late 2004 to late 2007.

Explanations for the financial crisis

There are numerous explanations and arguments which have been proposed as

the causes of the 2008-2009 financial crisis and the recessions. The entire

explanations combine together to give an overview of the severity of the crisis. The

bursting of the housing bubble resulted to decline in housing prices where consumers

were forced to cut down spending. Another shock was the sharp rise in equity risk

premium which led to rise in cost of capital further declining the rate of private

investments in the world economy (Lewis 2009).

Failures of real estate values and subprime lending

It has been proposed that the immediate trigger and cause of the crisis was the

bursting of the housing bubble which had initially had picked in 2007 particularly in

countries like US and UK. The burst of the housing bubble led to massive loan

defaults which led to the decline in the values of the mortgage backed securities

(Freedman 2010). The subprime mortgages were risky since their true values were

hidden in the house price appreciation which allowed mortgage refinancing. The real
estate bubble was occasioned partly by easy credit in the economy which was

facilitated by expansionary monetary policy of the Federal Reserve where the Fed

funds rate was cut from 6.5% in 2000 to 1% percent in 2003 (Freedman 2010).

Innovations in the financial system resulted to collateralized debt obligations

and other derivatives which fuelled the housing bubble. The British biggest banks

recorded loss more than 12 billion pounds in 2007 as a result of the meltdown in US

property market. The sub-prime losses in Britain are far less than those announced in

America and at some investment houses on the continent.(dailymail.co.uk).

Losses of US subprime mortgages were estimated at $ 250 billion dollars in 2007

while the decline in the stock market capitalization was $ 26,400 billion dollars from

the period July 2007 to November 2008. Weak banking regulations and poor risk

assessment methods forced coupled with the government regulations which blended

the operations of mortgage providers and investment banks saw many risky and

unqualified customers access the housing mortgages (Freedman 2010). According to

the Securities Industry and Financial Markets Association, the aggregate

collateralized debt obligations issuance expanded from USD $ 150 billion in 2004 to

US $ 500 billion in 2006 before increasing further to US $ 2 trillion by the end of the

year 2007. The value of the Mortgage backed assets held in banks’ books, insurance

companies and other major financial institutions explains how the burst of the housing

bubble led to massive losses to holders of the mortgage backed securities. However,

subprime mortgages had higher interest rates after the initial offer and only 43 percent

of the adjustable rate mortgages were subprime (Longstaff 29).

 Bad quantitative risk models in banks (Basel 2)

Many economists have blamed the Basel 2 framework for the bank

capitalization inadequacy. The framework provides for the banking rules and

regulations which are issued by the Basel Committee on Baking supervision. The

primary objective of the framework is to capital utilization in the bank is risk sensitive

and to identify and separate the credit risk from the operational risk. The

implementation of the regulations which should have come to effect in 2004 was

delayed by four US Federal banking agencies which are the Federal Deposit Insurance

Corporation, Office of Thrift Supervision, Office of Comptroller of Currency and the

Board of Governors of the Federal Reserve System (Freedman 2010).

Rating agencies failures

Credit rating agencies have been cited as principal contributors to the credit

crunch and financial crisis. The rating agencies are expected to accurately identify the

riskiness of the financial securities and institutions and report transparently their

findings to the stakeholders in the financial system. The AAA tranches of the

mortgage backed assets and collateralized debt obligations exhibited a high rate of

default most of the times that was expected since their trading prices were below their

face values (Freedman 2010). Rating agencies such as Standard & Poors, Fitch and

Moody’s used the quantitative statistical models which are based on Monte Carlo

simulation to predict the probability of default and the risks that were inherent in the

derivative instruments (Freedman 2010).

 The models were incorrect since the calculations were based on the default

probabilities from the data collected in the period 1990-2000 when mortgage default

probabilities and rates were low due to escalating housing prices. The models could

not predict the housing bubble burst since the mortgage backed securities and

financial institutions were rated highly. Financial innovations and new financial

derivatives presented challenges to the rating agencies since no historical return and

default data was available which could be used in the risk assessments. Some rating

agencies deliberately inflated their ratings in order to maximize their consulting fees

because financial institutions were contracting the highest rating agencies (Joseph 8).

Underestimation of aggregate risks

Financial innovations created the illusion that default risks held by the lenders,

banks and other financial institutions could be diversified. The perception ignored the

strong inter-dependencies in the financial system that was created by the financial

innovations. Globalization of the financial system and international banking

interdependencies led to capital flight for safety when the mortgage backed securities

started declining in values. The banks scaled down the inter-bank lending due to fear

of counterparty defaults. Financial institutions tightened their lending practices by

implementing stringent borrowing procedures which ultimately dried up credit

availability in the economies (Casu 2011).

Mark-to market accounting

The Financial Accounting Standards Board (FASB) requires all financial

institutions to report their current or fair market values of the securities they hold in

the books accounts. Critics of this accounting requirement argue that banks are forced
to recognize prices based on such prices that prevail in distressed markets since the

prices are believed to be below the long term fundamentals values of the security

(Freedman 2010). These losses that are recognized by the banks will undermine the

market confidence and exaggerate the banking problems. Generally, market

uncertainty will increase if the investors perceive published the financial statements to

be unreliable (Walter 15).

Shadow banking system

Most of the risky and worst performing mortgages were financed by the

shadow banking system. High competition in the economy from the shadow banking

system pressurized the traditional mortgage lenders to lower their lending rates which

increased the mortgage accessibility. The shadow banking system was not subject to

stringent regulatory control hence the entities created maturity mismatch since they

borrowed short term in the liquid markets and financed long term investments in the

illiquid markets. The shadow banking system increased the leverage level since risky

financial activities which were initially conducted by regulated banks that had deposit

insurance and safety net through regulation migrated to the shadow banking service

providers. In early 2007, variable rate demand notes, tender option notes, commercial

paper conduits, and structured investment vehicles had a combined asset base of

almost $ 2.2 trillion (Nouriel 9).

Assets financed through tripartite repos jumped overnight to $ 2.5 trillion

while those in hedge funds were close to $ 1.8 trillion. In overall, the five largest

investment banks had a balance sheet of $ 4 trillion against $ 6 trillion for the five

largest commercial banks. Private bonds in the economy in the commercial mortgage

backed securities segment and collateralized debt obligations stood at $ 2 trillion in

2006 but declined to less than $ 150 billion in 2009 where most of the issuances were

backed by Federal Reserve TALF program. The SEC had relaxed the net capital rule

of 2004 hence investment banks attained high leverage ratios since even the

Consolidated Supervised Entities Program which was applicable to the largest

investment banks was voluntary (Walter 15).

Off-balance sheet financing

Beginning early 1990s, the banking regulators encouraged the off-balance

sheet finance as a means of managing banking risks. Most of the banks established

off-balance sheet entities including structured investment vehicles that could engage

in speculative investments (Heffernan 2005).

Credit default swaps and over-the counter derivatives

Credit default instruments that were developed initially as a risk management

tool increased the risk exposure to the market participants. The use of the credit

default swaps shifted from risk management to speculation (Jongho 708). The credit

default swaps were unregulated hence the market participants had little information

on the inherent risks. Defaults in Bear Stearns triggered uncertainty in the market

where other counterparties in the derivative markets were forced to default due to

declining prices of the securities (Heffernan 2005).

 (Source, Freedman 2010).

Fraudulent lending, bad corporate governance, predatory lending and lack of

transparency in mortgage finance

More than half of the mortgages purchased by Citi Bank were not written according to

the policies. Countrywide Financial advertised for low interest home loans but

included detailed contract terms where consumers would repay the mortgages using

adjustable rates. This led to negative amortization whereby the interest paid would be

greater then interest paid. Once the housing prices declined, homeowners in the

adjustable rate mortgages could not afford the monthly payments hence faced

foreclosures on their homes (Walter 15). Many participants in the mortgage industry

contributed to the issue of bad mortgages since they felt not accountable for their

actions (Moshirian 508). Many contractual agreements had no recourse against the

securities issuer hence the non-bank mortgage lenders collapsed since they were

forced to take back the defaulting loans.

Moral hazard problem

 Government occasioned subprime lending to help the low income households

led to a moral hazard in the mortgage lending. Fannie Mae and Freddie Mac’s

affordable housing projects led to many banks to issue imprudent mortgages since

they were guaranteed of government assistance in case of default (Niinimäki 2009).

According to the banking theory, availability of collateral reduces the bank risk even

when the borrowers have insufficient means to refinance the loans (Casu 2011). The

fluctuation in value of the collateral generates a moral hazard between the banking

regulators and the banks. The banks gamble with the collateral and refrains from the

costly customer evaluation to focus lending decisions on the availability of collateral

(Freedman 2010).

Conclusion

Various causes have been attributed to the recent financial crisis. The

subprime lending and burst of the housing bubble that saw decline in the mortgage

backed assets was the primary trigger of the crisis. Low risk assessment methods,

rating agencies failures and unregulated financial system contributed to the crisis.

Imprudent accounting practices and complexity of the financial instruments

contributed to the crisis. Shadow banking system which was deregulated and the

government assistance programs together with securitization created a moral hazard

problem.
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