International lending and the 2007-2009 financial crisis

International Lending and Financial Crisis

One of the major global financial crises is the financial crisis of 2007-2009. The financial recession that occurred between 2007 and 2009, encompasses the housing bubble that instigated the financial crisis, federal expenditure, and foreign exchange rates. Also, referred to as the 'Great recession', this global financial crisis had adverse impacts not only on the financial markets but also on the economies of nations across the globe, being the worst financial crisis in history. The financial crisis emanating from the U.S. affected other nations owing to financial globalization and led to discussions regarding restructuring of the international financial system (Ozkan, 2012). In particular, the global financial crisis originally started in and adversely impacted the financial sector of developed nations, especially in the United States, and subsequently had a detrimental impact of the real sector of affected nations as the financial institutions in the United States allowed unguaranteed loans (Ahid and Augustine, 2012). This research paper will discuss the cause behind the phenomenon (financial crisis), and also discuss the strengths and weaknesses of the methodologies that are implemented in solving such financial crises.

Root Cause of Financial Crisis

The root cause of the financial crisis lay in subprime lending. To start with, the mortgage brokers at the time were paid in terms of the number of mortgages collected instead of the quality of the mortgages. As a result, the mortgage brokers did not consider whether the borrowers participated in thoughtful transactions, or were bound to experience suffering and insolvency in the forthcoming periods. Secondly, banks and other financial institutions gave approval and consent to the mortgages subsequent to the assessment of the borrowing applications. Nonetheless, banking institutions were not intent on authentication, but instead endeavored to build leverage into their financial books. The implication was that the banks attempted to get the papers off the financial statements as quick as possible (Greycourt, 2008). Consequently, they were retailed into mortgage pools that were consequently retailed to imprudent investors. Soon enough, the standards for underwriting worsened and died out altogether in due course. The banks did not consider their substandard practices and this gave rise to lending money to individuals who could not conceivably pay it back and did not care for the implication to the ultimate investors of the papers (Argandona, 2012).

Another cause was the Securitization and the Originate and Distribute Strategy that was used by the investment banks. Unlike standard mortgages, subprime mortgages offer a greater and superior yield. With conditions in the market appearing to be normal and with the real estate prices increasing, this instigated a high demand for the securitization of subprime mortgage loans. As a result, this brought about the formation of mortgage backed securities (MBS) and collateralized debt obligations that in the end were handed to the security investment vehicles to be traded in the market (Feldstein, 2007).

According to Wray (2007), in order for the investment banks to move off the assets from their balance sheets, they created structured investment vehicles (SIV's). These SIV's were non-bank subsidiaries which functioned as outlets or channels and were the entities that would hold the securitized risky assets. The main investment banks functioned as the lender of last resort to the structured investment vehicles in the event that these SIV's turned insolvent or lacked liquidity (Goodhart, 2007). In turn, taking into account that the banks endeavored to leverage their balance sheets and financial books, ultimately, this resulted in a market for pooled mortgages. The most prominent and major banks, investment financial institutions, and most blatantly Fannie Mae and Freddie Mac placed these pooled mortgages and subsequently sold them to investors. This led to a financial crisis simply because these financial institutions failed to take any safety measures in ascertaining whether the paper they were selling was of proper quality and disregarded the plausible harm to the investors who ultimately purchased it. Rather, such financial institutions were concerned and apprehensive of diminishing their costs and increasing their level of profit. In addition, rating agencies that provide rating to such papers were unethical in their business undertaking and instead of impartially rating them ended up selling their rating to the entities that paid them heavily (Greycourt, 2008).

Conclusion

The housing crisis of 2007 gave rise to one of the worst global financial crises in history. The financial crisis caused severe concern globally. This unmatched event had severe and costly effects and consequence, felt even today. The root cause of this financial crisis emanated from subprime lending. Unlike standard mortgages, subprime mortgages offer a bigger and more superior yield. With conditions in the market appearing to be normal and with the appreciation in real estate prices, a high demand for the securitization of subprime mortgage loans was created. As a result, causing the creation of mortgage backed securities (MBS) and collateralized debt obligations (CDO's) that were eventually handed down to the security investment vehicles to be traded in the market (Feldstein, 2007). Quintessentially, the investment banks created the loans, securitized them and afterwards distributed them to various non-banking financial bodies. These actions gave rise to a lack of interconciliation of assets off the balance sheets of the banks (Goodhart, 2007).

There are strengths and weaknesses of methodologies utilized to implement solutions during financial crises. One of the strong suits takes into account a decrease in the rate of inflation and at the same time improvement of the employment rates within the economy to a stable and mandated rate. Another strength is increased disposable income for households and businesses, which results in greater level of spending and subsequently stimulates the economy. On the other hand, shortcomings of these methodologies encompass the liquidity trap and deflation. The former takes into account the action of cash injection into the economy not resulting in the lowering of interest rates and therefore failure in stimulating economic growth. On the other hand, the latter encompasses the decrease in money supply, increase in real value of debt and prospective aggravation of a recession (Boundless, 2016).