Global Financial Crisis (GFC) the Present Global

Global financial Crisis (GFC)

The present Global Financial Crisis (GFC) has been considered by the financial experts and economists as the worst financial crisis apart from 1930s Great Depression. The GFC led to the collapse of large financial institutions and downturns of the major stock markets globally. The crisis led to the failure of several key businesses and s significant decline in the economic activities. The GFC started on the U.S. mortgage markets leading to the significant turbulence and uncertainty in the global capital markets. (Kalinowski, Marcin 2011). The source of the financial crisis was due to the excessive risk taking because of the sustained low interests rates leading investors to maximize their profits. The root cause of GFC started in 2001 when many U.S. financial institutions increase the number of mortgage loans due low interest rates and the issue led to the increase in the prices of residential real estate. At that period, there was a dramatic increase in the number of group lenders granting loan to people with poor credit history. However, between 2006 and 2007, the reversal occurred, the increase in the interest rates led to the decline in the price of residential properties in the United States. Many high risks borrowers were unable to meet their financial obligations and the crisis that started from subprime loans was transferred to a global liquidity crisis.

The objective of this paper is to explore Global Financial Crisis.

Global Financial Crisis

The intensification of global financial crisis leading to the bankruptcy and collapse of Lehman Brothers in 2008 is the source of current financial and economic problems in the United States. The global financial market is currently facing the financial turmoil, and the subprime mortgage crisis is rapidly spreading to many financial markets across the globe. With the intensification of financial crisis, there is a substantial fall of assets prices and crisis in the stock markets globally led to the liquidity problems of many banks and financial institutions. Unlike past financial crisis such as 1999 Brazilian crisis, 1997 Asian crisis, and 1998 Russian financial crisis, the current global financial is the most influential of all financial crisis because it triggers prolonged worldwide fear and spillover and correlation among international financial markets in both developed and emerging markets.

(Cheung, Fung, and Tsai 2010).

Fig 1: U.S. house prices

The major cause of the GFC is attributed to the subprime mortgage sector and the collapse of housing markets in the United States. Between 1997 and 2006, the prices of American housing increased by 124%, and the decline in the interest rate led to the growth of subprime lending. In the United States, there was intense competition among the mortgage lenders leading mortgage lenders to provide loans to people with bad credit history. Typically, the subprime lending was below 10% before 2004, however between 2005 and 2006, the subprime lending increased to nearly 20%. The concept of subprime lending refers to the action of the some financial houses giving loan to the people with bad or weakens credit history. In 2007, the U.S. Subprime mortgage was estimate at $1.3 trillions. (See Fig 1). Throughout 2000s, there is significant growth of mortgage predatory lenders which is the practice of unscrupulous leaders enticing the customers to apply for unsafe secure loans. A classic technique to lodge people into unsecure loan agreement is by advertising the low interest rates of between 1% and 1.5% for the mortgages. Upon entering into the agreement, consumers will be put into adjustable rate mortgage (ARM) making consumers to pay higher interest rates than the interest rates initially advertised. The practice has made the prices of housing to increase because many people were lured into buying houses due to the practice of information asymmetrical practice of the mortgage lenders. However, between 2006 and 2007, there was a noticeable concern about inflation leading to the increase in the price of the commodities in the United States. Meanwhile, U.S. passed the tightening policy to implement the tight control on the monetary policy. When there was a decrease in the interest rates in 2008, an average U.S. price decrease by 20%. With gradual decline of housing price, many borrowers with adjustable rate mortgage were unable to refinance their mortgage. Many borrowers started to default in their borrowing. By 2007, the lenders foreclosure nearly 1.3 millions properties. The significant event that follows is that sub-prime lending has dispersed and created financial crisis to big mortgage firms such as AIG, Bear Stern, and Lehman Brothers.

Typically, GFC has made investors to the gradual lose confidence in the U.S. financial market. There crisis led to the damage of investor confidence because of its impact in the global stock market. Between 2008 and 2009, there was a decline in the U.S. economy leading to the decline in the global economy, and the U.S. government responded to the financial shocks by implementing bail out policy. (Merrouche and Nier 2010).

Igbal (2010) argues that the financial crisis has led to the decline of standard of living of billions of people worldwide. Developing countries are in a peculiar situation where the issue pushes many people back into poverty. The economy of Europe faces the worst slump with the effect of GFC. Crotty, (2009) argues that globalization has made the banking system to become global where there is an interdependence of global financial system. The results is that when the present GFC was about start in the U.S., BNP Paribas, one of the top French banks announced that there is shortage of liquidity.

However, Kalinowski (2011) argues that derivative has been the major causes of the financial crisis. The practice of derivatives such as swap, credit rating financial institutions involves in the speculating bubbles in the U.S. financial institutions.

Many financial institutions in the U.S. take excessive risks leading to uncertainty and liquidity constraint. Typically, some banks have to write off their balance sheet due to the decline in the credit availability. Derivative market is one of the largest in the U.S. financial market, and the market is largely unregulated with the respect of information disclosure between the parties involved. Since banks and other financial institutions participate in the derivatives market, the parties engage in the hedge funds. In the U.S., derivative market practice could occur in private without activities being visible. The control of derivative is lower making the transaction to involve higher risks, and since many companies participate in the derivative practice to protect their core businesses, there is an increase in the derivative markets and many parties misuse the financial instruments. Typically, derivatives make financial firms, corporation, and industrial to hedge the risks. In 2007, there is systematic risks build up in derivatives market leading to the present global financial crisis. Although, derivative market has benefits in the U.S. economy such as upgrading liquidity, and assisting the market participants to manage, however, the transaction were not well controlled. Since derivatives markets were not well controlled, it is possible to engage in a risky transaction without being observed. While companies used derivates to manage their financial risks such as currency fluctuation, changes in interest rates, fluctuations of fuel prices, and rise and fall of commodities prices, banks also tried to make addition earning from derivative markets by engaging in the speculative practice. However, speculative transactions have made many financial institutions to secure loss leading to the gradual drying up of liquidity. This is the more reason Warren Buffet labels derivative or credit default swaps as financial weapons of mass destruction. Mishkin, (2011) reveals that many banks are unable to convert their long-term assets into cash because of the derivatives practice. The practice of derivatives led many banks to take risky ventures by practicing shadow banking system and allowing the borrowers to post collateral of 5%. For example, when a borrower borrows amount worth $100 millions dollars, banks allow the borrower to post the collateral that worth $105 millions dollars of mortgage backed securities. In 2007, there was a fall in the mortgage backed securities leading many banks to run at financial losses. The result was that the same amount of collateral could not support the same borrowing, and to cover the loss, many financial institutions have to sell of their assets. Evidence has shown that fourth largest bank in the U.S. Lehman brother was deeply involved in the shadow banking system because the bank recorded losses in the subprime making the bank to file for bankruptcy in 2008.

Typically, the bankruptcy of the Lehman brothers started the evolution of the global financial crisis because its collapse sent wave of panic among investors leading to the drying up of liquidity and collapse of asset prices. Lehman Brothers take excessive risks because the company was capitalizing on moral hazard and shadow accounting practice in order to hide its leverage. Lehman was among the most leverage of the investment bank with poor risk management. The bank has high exposure to subprime mortgages where the bank large holding of securities are tied to valuations. Lehman Brothers also participates in the derivates contract which was unwound after Lehman's bankruptcy.

The effect of the global financial crisis has biggest negative impact on the U.S. GDP with permanent loss of wealth of household, and there is gradual decrease of household consumption. The value of the stock markets decline due to the crisis and the equity risks make investors to divert into other domestic assets such as government bonds and assets purchase overseas. Typically, the effect of U.S. financial crisis translates into the global financial crisis because U.S. has business relations with many countries in the world. Typically, many countries depend on the U.S. economy. For example, United States is the largest importer of Chinese goods, and the collapse of U.S. stocks reflect on the Chinese stock markets.

Douglas, (2009) argues the global crisis is attributed to excessive domestic and international borrowing. The excessive borrowing is prevalent in the commercial real estate, commodities, corporate lending and international equity. The excessive borrowing is not limited to the United States alone, the issue is a global problem. Intensification of excessive borrowing fueled the increase in the excessive investment globally. Excessive borrowing is interconnected with securitization.

"Securitization allows originators (such as banks) of assets (such as residential mortgages) to transform a future stream of revenue (i.e., loan repayments) into a present value pool of capital, which can then be used to support further lending. In order to be effective, this process requires investors willing to purchase the resulting securities." (Douglas, 2009 P2).

However, securitization makes sense because it allows redistribution of risks to wide range of investors. Over the years, the securitization translate into more complex financial techniques such as collateralized debt obligations (CDOs), structured investment vehicles (SIVs), and collateralized loan obligations (CLOs) and many of these transaction occur over-the-counter (OTC) derivatives especially through credit default swaps (CDSs). A CDS is a type of derivatives bilateral transaction which serves as protection in case of default. However, by 2007, derivative transactions have reached unsustainable level where countries around the world continue to increase the interest rates to address the potential inflationary rates. Many borrowers in the United States are confronting challenges in meeting their obligations, and there are dramatically increase in the number of borrowers defaulting loans. At this period, information has spread throughout the housing markets that many people were unable to meet their loan obligations. The issue led many potential home buyers to stop purchasing new homes leading to the decline in the housing prices. The issue has negative impact on all classes of assets globally except the U.S., German and Japanese government bonds. Typically, there was loss of economic value, and the events led to the collapse of many financial institutions around the world. The event led Bear Stearns, the fifth largest investment bank in the U.S. To file for bankruptcy. Bear Steams has direct involvement in the U.S. capital market, while the company faced the severe liquidity problems in 2008, the Federal Reserve Bank provided the emergence funding to save Bear Steams from the problems. However, the emergent funding could not bail out the company from its immediate liquidity problems, making Bear Streams to file for bankruptcy protection on March, 17 2008. Typically, event surrounding the bankruptcy of Lehman Brothers and Bear Streams led much business to secure loss in the derivative markets.