FINANCIAL CRISIS
Introduction
Financial crisis is a phenomena characterized by extreme change in the asset price and credit volume, disruption in the in the financial intermediation, and immerse problems of firm’s balance sheet.
The 2007-2008 financial crisis negatively impacted on the financial markets that show many banks and financial institutions sink due to insolvency crisis. The subprime lending style more often than not is consider to be the main cause for the 2007-2008 Credit Crunch. The lenders of the subprime mortgage and its derivatives formulated a model that triggered unexpected demand for the securitized mortgage products.
The assumption from the model was that the value for the high yielding assets would continue to rise as the interest remain low (Aikman et al, 2019, p.106). The assumptions also prospected a greater profit returns from the subprime securities as well as an exaggerated future growth. The brokers for the securitized products further triggered the crisis by mispricing the subprime products.
This resulted into shortage of the securitized mortgage product due to decline in supply as the trading volume increases leading to a lower intrinsic value for the assets in comparison to their prices. The above assumption increases the investor’s willingness to buy the products leading to the 2007-2008 financial crisis.
The paper discusses extensively on the role of sub-prime lending to the 2007-2008 financial crisis. The reasons for the decisions arrived at between the USA Treasury Secretary and the top bankers. The paper further explores how could have impacted on the financial markets in the United States as well as the UK and the development and regulation since the crisis.
Effects sub-prime lending on the 2007-2008 financial crisis
It is believed that sub-prime lending in the United States significantly triggered the 2007-2008 financial crisis. The housing and credit markets conditions, the accumulated effects of the credit scores from the previous years, the rise in the number of loans, and increase in the number of debtors with the highest credit scores, as well the use of brokers and agents on commission who were never after quality much triggered the crisis.
The credit crunch of 2007-2008 mainly resulted from the lending of subprime mortgages to borrowers at very low interest (Aikman et al., 2019, p.106). The low-interest rates for the mortgages made it cheaper and affordable to the borrowers. However, there were several side effects associated with low-interest mortgage. First, they were made in such a way that they were not as sustainable as the interest rate increase tremendously.
The mortgages were designed in such a way that their prepayment conditions limited the options for faster loan refunds (George, 2019). This was to ensure the scheduled time for repayment was considerably delayed so that the loans could earn voluminous interest. The conditions for lending further restricted the possibility of refinancing the acquired loans from other lenders but made it possible for the lenders to resell the loans in a securitized form.
Unfavorable conditions on the side of the brokers, to some extent, also contributed to the crisis. The high risks associated with the subprime mortgage made the brokers feel worried by their future reputations forcing them to fraudulently report misleading information on the loans to win more customers.
The super rise in the rates of the delinquent U.S. residential subprime mortgage imperatively contributed to the crisis. The increase in the lending interest rate rose to 18%, ten times higher than that of 2000-2002 during the U.S recession period (Dar, Bhanja, and Paul, 2019, p.369). The 18% rise in the lending rate for the loans forced the borrowers to find an alternative of refinancing their mortgages to evade the accumulating interest rate on their investments. The chart in figure1 can be used to illustrate the percentage rise in88/ the interest rate on the subprime lending from 1998 to 2008 during the financial crisis.
Figure1: Adopted from Mortgage Bankers Association.
The sharp rise in the subprime mortgage rates from 2006 to 2008, as illustrated by the above chart, significantly contributed to the 2007-2008 financial crisis. The inability for the loan borrowers to finance their loans from other lenders made a number of them to default the repayment. According to (Wójcik et al., 2019, p.687), most of the borrowers defaulted the loan repayment in the first 3 to 4 months of acquiring the loan.
It is imperative to note that the adverse effects associated with subprime lending went beyond the United States to the rest of the world.
The extreme high lending rate of the subprime mortgages due to the ease of borrowing and return significantly triggered the crisis that spread even in the overseas markets. The use of technology made outsourcing of subprime lending even cheaper and more comfortable in the overseas market. The high lending rate in the overseas market, more often than not, was as a result of the uncaring nature of the borrowers. The borrowers did not take into account the quality of the loans they were offered so long as they merit the minimal requirements for lending and resale (Aikman et al., 2019, p.106). The possible impact of the ease of subprime mortgage lending, according to the Governor of the bank of England, was that there was a rise in demand for the loan in the overseas markets.
The rise in demand for the subprime loans was accompanied by several inherent risks, especially to the overseas investors that did not know the United State real estate’s forcing most of the lenders to foreclose. Lack of clearly defined procedures for claims on the subprime assets for the foreclosing investors subsequently triggered the 2007-2008 financial crisis in the overseas markets.
The crisis was further worsened by the lack of property register in the United States that could allow the lenders to repossess their assets form the defaulters. The lenders could, therefore, not resale the repossessed, pooled, repackaged loans to get even a fraction of their losses as it was difficult for lenders to determine the real owners of the reclaimed assets.
Mispricing of the subprime mortgage in the United States markets significantly leads to the spread of the crisis (Fox, 2019). The willingness of the originators to sell their securitized subprime mortgage products as well as the investor’s desire to buy the products imperatively lead to the spread of the crisis far beyond the United States markets.
This was made possible due to the expected high yield and high returns characteristics associated with these products. The investors, therefore, found the securitized products from the subprime mortgage more attractive, leading to the spread of the crisis in Europe and Southern East Asia.
The lenders of the securitized sub-prime products made their loans look attractive to the investors by designing a model that mispriced the risks associated with the products. The model mispriced the interest rate to remain low throughout the repayment period and housing to continue rising to make more investors globally to acquire their loans.
It is imperative to note that the high yielding subprime mortgage products played a significant role in starting the crisis. This can be traced back to the prevailing investing climate at the time of the crisis. The investing environment at the time of the crisis was so unfavorable forcing the lenders to underprice the high yielding assets as well as creating a faulty assumption that the interest rate would remain low as the value for the high yield assets rise (Dar, Bhanja, and Paul, 2019, p.369). The mispricing of the sub-prime assets, as well as their fault assumption on the interest rate and the rising value of the high yielding sub-prime mortgage with no doubt, were the leading cause of the 2007-2008 financial crisis.
The reasons for the outcome of the USA Treasury secretary meetings with the top bankers and officials
The United States government, through the then USA Treasury secretary, Henry Paulson, made a decision not to use the federal emergency fund in stabilizing the Lehman Brothers and the liquidity the Lehman brothers required for their operations (Nocera, 2009). The main reason for the decision was as a result of the congress and the treasury does not use the taxpayer’s money in solving the crisis. The United States decision not to intervene in the Lehman insolvency crisis was also attributed to the unwillingness of the Lehman brothers to transfer $65million from their books into the government account.
In an attempt to rescue the sinking Lehman brother, a decision was reached between the Lehman CEO and the British bank, Barclays. Barclays bank saved the Lehman brothers by acquiring the full firm except for its 2,400 real estates except for its commercial. The main reason for the decision was that Barclays bank argued that the Lehman 2400 real estate had faced off in value.
The decision by the Financial Service Authority not to approve Barclay’s willingness to acquire Lehman that show them out of the deal was due to several reasons.
First, the FSA considered Barclays not to be in good shape and position to acquire the firm. Secondly, the potential risks that were associated with the deal. The Financial Service Authority did not welcome the idea of UK involvement in the crisis, so they were creating unfavorable conditions for the transaction.
The decision was further accelerated by the failure of the United States government to offer any assistance to the Lehman insolvency situation. The FSA was therefore very determined not to let the deal go through. Another possible reason for the decision was Barclay’s lack of effort to ensure they secured the approval from the FSA (Tiwari, Aye, & Gupta, 2019, p.398). They had a formed opinion that the permission had nothing to do with their purchase of Lehman firm. They, therefore, did not disclose the content of the deal to its vital senior officials making the transaction go sour.
The decision by the United States to set $150billion for the rescue of the collapsing Lehman and $700 billion as the Troubled Asset Relief Program was to ensure no firm in the United States would ever undergo the same crisis Lehman experienced.
Impacts of the 2007-2008 financial crisis
The 2007 -2008 created a financial mess in the USA as well as the UK business market. The crisis made the US housing marketing to burst in around 2009. There was unexpected demand for the derivatives built on the mortgages that the crisis made to look more attractive and new to the UK and the USA investors (Dar, Bhanja, & Paul, 2019. P.122). The crisis also created a lag in the supply of mortgage-based products. The demand for these products rose steadily despite the increase in cost.
The crisis leads to the collapse of real estate. This resulted in a sharp decline in value in a large amount of mortgage-backed securities and its derivatives. The decrease in value for the mortgage-backed securities created an insolvency crisis in banks and many financial institutions, as was seen in the Lehman brothers.
Lessons learned.
The financial or fiscal trilemma significantly contributed to the 2007-2008 financial crisis. Conclusively, economic integration 0
0and independent national fiscal policies cannot lead to financial stability. Because the financial risks of a country more often than not, is assessed by the nationally by the financial markets, consequently country relying on its assets would likely to give up on economic integration as well as the financial stability (Tiwari, Aye, & Gupta, 2019, p.398). A country can reduce its financial fragility to the minimum level possible by opting out of the integrated financial market if its fiscal space is limited to control and insulate its financial sector.
Since the financial institutions are interconnected and interdependent, a fail or loss or disruption of one financial institution leads to automatic failure of the third parties. Conclusively, the stability of the financial system can only be maintained by preventing the “too-big-to-fail” financial institutions from failing (Cukierman, 2019). Countries with more than one currency can support their economic systems during such a financial crisis by turning to a tool of money creation.
The 2007-2008 credit crunch pushed the economy of the UK and the USA into a deflationary spiral as a result of the accumulation of a large number of private debts leading to the crisis.
Global regulation (USA and UK market)
Several regulatory developments have been made undertaken in the financial sector since the 2007-2008 financial crisis in the USA and UK markets. A regulation was developed to regulate the activities of the originators and the brokers (Campiglio et al., 2018, p.464). It is evident that lack of a clear set of regulations on the mortgage originators and the brokers in the USA allowed them to misprice the cost of a securitized mortgage, consequently leading to the 2007-2008 financial crisis.
The regulation seeks to address scenarios where the mortgage could be originated without seeking the attention of the borrowers (Liu, Zhou, & Zhou, 2019, p.240). The regulation was to prohibit insurance of loans to borrowers without assessing their ability to repay. The rule required verification of the income and assets provided as collateral to determine their ability to repay the loan. The regulation was further developed to review the prepayment penalty. This was to revoke any penalty on the repayment that exceeded two years.
The new regulation was developed, making it a requirement for the creditors to ensure that all the first-lien mortgages to have escrow accounts for properties and homeowner insurance.
A regulation was also developed in the United States by the Financial and Accounting Standards to regulate off-balance-sheet vehicles and bank obligations to them.
A regulation was also developed on the Rating agencies, which was to improve on the efficiency in evaluating risks associated with a particular product. Moreover, the provision of fair value accounting was developed that required banking institutions to determine the capital to be held on various assets.
Possible measures for the improvement of the new regulations.
The regulation on the originators was also to reexamine the conduct of the originators to ensure their behavior is in the best interest of the borrowers (Biswas, 2018). This has successfully deconstructed the tendency of the originators of lending and selling loans without taking into account the interest of the borrowers as was during the 2007-2008 financial crisis.
The above regulation can be improved by making it a requirement that the originators of the mortgage set of gold standards as well as the minimum borrower standards (Liu, Zhou, & Zhou, 2019, p.240). Moreover, regulation on the originators can be improved by involving the sellers in offering an alternative minimum standard for the borrowers. This will ensure the originators, brokers, as well as the mortgage sellers, do not trigger another crisis in the future.
The regulation on off-balance-sheet vehicles and bank’s obligation effectively worked out in ensuring the bank could quickly transfer their assets and liabilities to SPVs (Brueggeman, & Fisher, 2011, p.6). However, further, improvement is required to ensure a stop to any future financial crisis. The regulation can be improved by making the regulators hold the riskiest segment of the market. The rule can further be enhanced by making it a requirement that every financial institution assesses its systematic risks that more often than not occur when one bank impinge on the markets.
The new regulation on the rating of agencies, however, have not effectively evaluated the risks associated with the securitized mortgage products due to the issue of conflict of interest involved (Zgarni, & Fedhila, 2018, p.138).
This development, therefore, needs to be improved to effectively perform its role to give the correct ratings for the products to avoid experiencing a number crisis similar to the one experienced in the 2007-2008 credit crunch.
The rating agencies in the United States should exist as one selling the same product to minimize any possible conflict of interest that can interfere with their ratings.
Another possible way through which this regulation can be improved by regulating the rating agencies in terms of qualification and methodology. This can be achieved by conferring status on the rating agencies that meet the requirement for the methods and eligibility. Implementation of this policy by SEC in the United States will see to it that only qualified rating agencies operate in the United States financial markets and bar the unqualified once.
The effectiveness of the rating agencies, especially in the UK and the United States, can also be improved by extending their operations to the rating of bank capital.
The new global development on stress testing that assesses the ability of financial institutions to operate in an environment when liquidity is limited (Tiwari, Aye, & Gupta, 2019, p.398). The regulation satisfactorily worked out in allowing financial institutions to distribute the risks they originated or rather securitized. The statute further allowed the adjustment of the bank’s portfolio and hedges in the face of the market prices. This development has ensured no repeat of use of the wrong and misleading model by the lenders to assess risks associated with a particular asset. This was observed in the 2007-2008 financial crisis when the brokers used an incorrect model that speculated rise in the value for the high yielding assets, possible drop in the housing prices, and a reduction in the interest rate to make the subprime mortgage products new and more attractive to the investors.
The regulation, however, needs to be improved by enhancing the management and supervision in the face of rapid financial innovation and the use of models. The systematic risks associated with these regulations can also be minimized in the future by increasing the scope of the rule.
Conclusion
Conclusively the mispricing of the sub-prime mortgage, extreme high lending rate of the subprime mortgages due to the ease of borrowing, and return substantially, the lack of property register in the United States that could allow the lenders to repossess their assets form the defaulters imperatively led to the 2007-2008 credit crunch.
Several regulations were put on the creditor’s lending rates, rating agencies, originators, and the brokers to ensure no repeat of the 2007-2008 financial crisis. However, several improvements, such as conferring of status and increased scope of the regulations, should be implemented to ensure the effectiveness of the rules.
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