Financial Crisis and Economy

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).

Strengths and Weaknesses of the Methodology used to implement solutions

A financial crisis is a period that encompasses economic weakening; a fall in the stock market, aggravates unemployment, and in this case, a deterioration in the housing market. The methodologies used to implement solutions during a financial crisis are fiscal and monetary policies. According to Mankiw (2014), fiscal policies encompass the regulation of the aggregate level of economic activity through taxation and government spending. It is considered that the Fed stimulates the economy and increases national income through investment or government expenditure as the multiplier-accelerator interaction is an initial stimulus to expenditure (Mankiw, 2014). In addition, when the government makes the decision with regard to the goods and services it buys, the transfer payments it disseminates or the taxes it collects, it is taking part in fiscal policy. On the other hand, monetary policies encompass the public domineering measures intended to have an impact on the level and pattern of economic activity in order to realize specific economic goals and objectives. Monetary policy take into account all actions by the central bank and the government that impact the quantity, cost and availability of money and credit in the economy. Explicitly, monetary policy works on two principal economic variables, namely, the aggregate supply of money in circulation and the level of interest rates (Mankiw, 2014).

Monetary policies and fiscal policies are implemented by the Fed so as to stick to its legislative declaration of maximum employment, stability in prices and adequate long-term interest rates (Labonte, 2016). The global financial housing crisis that took place between 2008 and 2009 caused substantial decrease in output in terms of gross domestic product (GDP), a considerable rise in unemployment as well as a deflationary fear and worry in several nations. There are strengths and weaknesses of these methodologies utilized to implement solutions during financial crises.

One of the methodologies implemented by the Fed as a decrease in the federal funds target rate. In particular, the Fed decreased this rate from 5.25% to 0.25%. The key strength of this methodology is that it decreases the rate of inflation and at the same time enhances the employment rates within the economy to a stable and balanced rate (Dorn, 2012). Another strong suit of this methodology is that it has an impact on interest-sensitive spending, which encompasses spending by households and businesses (Labonte, 2016). Another strength of the methodologies is that by decreasing the increasing rate of inflation, these monetary policies implemented by the Fed stimulated price transparency and as a result gave rise to more sound economic decisions. What is more, another implemented methodology was the decrease in taxation rates. The strength of this particular methodology is that it increases the disposable income for households and businesses. Therefore, this results in greater level of spending, which stimulates the economy. Another methodology implemented by the Fed is the purchase of treasury and mortgage-backed securities. The strength of this particular approach is that it helps control the federal funds rate and by consequence, incidentally influenced money supply in the economy (Carvalho et al., 2012).

At the same time, these monetary policies had a weakness. One of the weaknesses of monetary policies is the liquidity trap. In delineation, a liquidity trap is a state of affairs where injections of money into the banking system by the Federal Reserve or central bank do not result in the lowering of interest rates and therefore failure in stimulating economic growth. As a practice, central banks attempt to decrease interest rates by purchasing bonds with newly generated money. However, in a liquidity trap, these purchased bonds recompense very minimal or even no interest at all, which makes them just about similar to cash (Mankiw, 2014). In particular, the Fed held very low interest rates between the years 2001 to 2005 in reaction to the fears of the forthcoming recession and considered this to be a solution. However, this monetary policy prompted a great deal of liquidity into the United States financial market, which in the end impelled the increase in real estate prices and eventually led to the credit crisis (Goodhart, 2007).

Another downside is deflation. In delineation, deflation takes into account the decline in the general price level of goods and services. More often than not, this takes place when the rate of inflation goes beyond the zero level. Owing to monetary policy methodologies, deflation takes place when there is a decline in the money supply for every individual in the economy. In essence, this encompasses the amount of times a dollar is spent in the market to purchase goods and services for every unit of time. This gives rise to a weakness because it increases the real value of debt and might also exacerbate recessions and give rise to a deflationary spiral (Boundless, 2016).