Raphael Bartmann. A short summary of this paper. Download Download PDF. Translate PDF. Literature cited The domino effect of several events and occasions were leading first to a countrywide recession in the USA then later spreading globally. In the following this term paper will deal with the main causes and effects of financial crisis. Unlike other topics in literature there is no consensus about the question of guilt in this sense.
Among economists there are different approaches to explain the main causes of the financial crisis. Therefore, the central ideas behind this paper are first to clarify different trigger points and secondly to answer critically the question who is to blame for it. Another part will then deal with the resulting effects for all involved parties and will show the consequences for the US and global economy. The last part will refer back to the questions posed, summarizes the main parts of this paper and will take a look in the future of the financial sector.
Causes To analyze the main reasons for the meltdown of the financial sector resulting in a worldwide recession and economic crisis one have to look back into US history. A complex mix of government policy, financial market structure and the development of the real estate market in the USA were only a few of the main forces to collapse the financial sector.
In the following it will be analyzed that also a mix of failed regulation and pure greed of money on side? Therefore, America introduced a new lending system coming from England, called mortgage - a legal agreement between two parties which transfers the ownership of a property to a lender as a security for a loan2. A mortgage allows you to loan money from a bank or other institutions in order to finance a house3.
A verification of employment and income are minimum requirements for taking a mortgage loan. If a mortgage borrower fails to repay the monthly rates plus interest, the exchange value of the mortgage, as in this case the property, gets into possession of the mortgage lender. Therefore, these loans were only made for prime market citizens which means a lot of citizens were frozen out of the American dream of homeownership.
Traditional underwriting standards like down payment were relaxed and a second market for so called subprime mortgages was created. What followed was a fundamental change in the housing market. Due to low interest rates the demand for the mortgage loans increased heavily as more and more citizens saw their chance to own a house. At this time house prices were steadily rising and were expected to rise further due to increased demand in the real estate market.
US Banks and other investors saw their chance to gain money in the housing market. In literature these loans are seen to be the starting point for the financial breakdown, but why?
In order to obtain a profit, US banks sold these mortgages, also called mortgage backed securities, to other Banks and investors not only in America but all around the world. Against a specific fee the claim for repayment plus interest gets transferred to the buyer party. As default rates were historically very low due to high underwriting standards for mortgage backed securities and are also seen to be secure because of the rising prices in the housing market, banks and investors as well as pension and retirement funds invested in MBS as they promised steady continuous interest payments.
The demand for these new financial products increased heavily and soon banks were not able anymore to stimulate the demand given on the market.
The maximum capacity of prime mortgage takers was reached. Due to this, US banks started to issue subprime mortgages, to borrowers with no proof of income and employment, to create more mortgages for the market.
Banks guaranteed low and flexible interest rates, diminishing down payments and often more than one mortgage, which enabled low and middle class Americans to borrow even more money for bigger houses they normally could not afford. The housing boom was created.
What followed next is a downward trend due to several events. Subprime mortgages default rates soon started to rise as borrowers were not able anymore to serve the monthly payments. Especially subprime mortgages with flexible interest rates were effected the most.
Their monthly payments increased heavily as interest rates rose. The result was that these houses went into property of banks and investors who issued or buyed mortgage backed securities. But soon the house supply in the US market exceeded the demand for houses which indicated a stagnation of house prices immediately. As a 5 Ibit. The housing bubble busted and what happened next can be described as a domino-effect. The downward trend in the US housing market was now unstoppable.
Even prime lenders got into trouble as their houses value decreased steadily. At this time, continue paying the mortgage was more expensive than selling the house. Suddenly as the riskiness of these subprime mortgages became clear, the first actors in the financial sectors were concerned about the subprime mortgage development. Numerous of banks were now big enough to go public and further enlarge their business. Through mergers and acquisitions, investment banks grouped together and soon reached a monopoly status in the US financial market where only a few huge firms influence and control the market development.
Based on less regulation the financial market was enabled to develop financial products with speculative character and riskiness. At this time investment bankers were given almost free space on how they have to build up their business and in which sectors they focus to speculate in. Because of the introduction of subprime mortgages in the housing market, speculation for investment banks got profitable as they created special financial products for the market.
One innovation and form of speculation was that mortgage payments can be sold to other actors in the market. US banks started to sell mortgage backed securities to investment banks to sell them again to other investors. Therefore, investment banks created a new financial derivative called collateralized debt obligation CDO.
As the terms says, a CDO contains numerous debt obligations, in fact thousands of home mortgages and other loans like car and student loans. As in the financial markets are investors with different risk preferences, there is demand for different kind of yield rates. The idea of pooling different loans into one product and later separate them into different tranches is that the risk gets divided and is seen to be lower than one individual mortgage loan when different kind of mortgages can be put together into one financial product.
The senior tranche11 is seen to be the most secure. Senior holders of debt obligations are the ones who get served the first when money repayments from mortgages and other loans get filled in. As this premium tranche of a CDO is characterized by a triple A rating, the highest and safest investment rating, investors with risk restrictions like pension and retirement funds were now able to invest into these derivatives. The middle slice called mezzanine tranche12 is usually rated with A and B ratings carrying moderate interest rates as debt holders of this tranche get served secondly.
The equity tranche13 is the one providing both the highest possible risk and highest possible interest rates in the market. Only after all investors of other tranches have being served with payments, money gets filled in the equity tranche. Risky investment seekers like speculative hedgefonds were typical for this kind of tranche. Local banks and retirement funds from all over the world, especially in Europe, started to buy CDO shares. This means that mortgage payments from American house buyers were no longer transferred to their local lender but to banks and institutions all over the world.
Investment banks received their fees for every sold CDO share and made millions of profit in this time. The new loaner and borrower relationship also added up to a new form of complexity in the financial market. In contrast to old ones, they were now filled up with a lot of subprime mortgages containing a high default risk. Rating agencies not only tripled or quadrupled their profit, they also formed alliances with the big investments banks to continue their partnership. The fact that competition was high under the three main rating agencies, not giving the desired rating may have resulted that investment banks just went to another rating agency next door to finally receive their triple A rating.
As barely no one exactly knew what kind of mortgages and loans were bundled together in a CDO, not even the investment banks, buyers trusted rating agencies and felt secured by the rising house prices in the real estate market.
The financial sector created a ticking time bomb and it was just a matter of time when the first losses for investors should occur before the whole financial market was ready to explode. A credit default swap CDS is probably the most important one. An investor who purchases a credit default swap had to pay a quarterly premium to AIG.
And they could also sell them in huge quantities as there was no government regulations for CDS requiring to put money aside. Instead they paid huge bonuses for their employees as soon as contracted were signed. Not only AIG managers were greedy to boost their profit to the top, Investment bankers were so too.
Consequences 3. Unable to serve their mortgages, people had to leave their homes for sale. Foreclosure of houses reached 6 million until Potential borrowers had only simply to declare their income without being made any further control by the lenders and to show that they have deposits No Income, Verified Assets NIVA.
Furthermore the applicant for loan was not necessary to submit documents certifying that works. The only prerequisite for lending was to demonstrate that has deposits. NINA loans are official loan products that allow consumers to borrow only with the commitment to comply with the terms related to the repayment of the loan. Furthermore to make it more tempting for the consumers to take a loan, it was introduced by the banks the measure called Adjustable Rate Mortgages ARM.
This measure allowed the borrower to choose to pay only the interest during an initial period, and to pay an amount of his choice as a resulting the transfer of the remaining amount to the rest, but with the new rate. According to statistics one in ten chose to get a loan with the ARM option, which meant that he could give an amount of his choice having as a consequence the increase of the loan balance each month with a different rate Financial Crisis Inquiry Position, Banks urged people where instead of getting another kind of loan to choose the ARM loan.
Moreover, several brokers have taken appropriate incentives from lenders to grant such loans regardless of whether the persons concerned complied with the conditions for a non-subprime ARM loan. These tactics of relaxation to lending criteria in conjunction with the promotion of the ARM loans had as a result the skyrocketing of the objective values of real estate.
Figure 4 shows the trend in the value of real estate throughout the housing bubble. Figure 4: Trend in the value of real estate throughout the housing bubble Source: U. During this period, in which the housing bubble was growing increasingly there have been a number of factors that made the financial system more vulnerable. This system had the ability to keep hidden the levels of leverage from investors through complex instruments such as derivatives off-balance sheet and securitizations.
These tools provided banks and mutual funds the ability to guarantee high profits and shield against any potential financial risk. With the derivatives market stay uncontrolled, many financial institutions acted with naivety in their effort for increased short-term gain.
Figure 5 shows a figure presenting the path of the derivatives market from Figure 5: Securitization Market Activity Source: Mark Zandi, The Rating Agencies Rating agencies are financial institutions that have the role of the evaluator in the finance industry.
They evaluate everything related to the financial markets and everyone takes their reports very seriously. Their ratings cover a wide range, from investment products to the economic progress of states and firms based on their creditworthiness.
These institutions have a lot of responsibility for the credit crisis. Their role in the various stages of the housing bubble and the crisis was a catalyst for the spread of it. The rating agencies were rating the derivatives derived from risky loans with the best rating AAA , considering them as a reliable investment and absolutely safe.
From research done, it has found that there was pressure on rating agencies for good rankings from financial institutions, which they were paying to show that the derivatives are safe. In the years before the crisis, rating agencies evaluated on a daily basis a large number of derivatives from the field of mortgage loans. The excellent ratings made the most reluctant to invest by purchasing derivatives from the mortgage market.
Big firms of the finance industry had in their portfolio a large number sub-prime mortgages in the form of derivatives. When the bubble burst, the majority of these products were downgraded from the agencies making impact more intense Financial Crisis Inquiry Position These downgrades which were the result of objective evaluations spread the panic. The panic was translated into a lack of confidence among banks making interbank borrowing very difficult.
Although it was not the only cause, the role of rating agencies is often considered crucial for the burgeoning of the housing bubble with the high ratings values for sub-prime derivatives. It was also vital the decision of degradation of the derivatives market, which exacerbated the credit crisis. The interbank lending was weak as banks refused to borrow each other. The distrust has brought huge liquidity problems leading to a failure of the debt refinancing.
Especially after the collapse of Lehman Brothers in September , the uncertainty that prevailed made banks reluctant to loan. This hesitation reflects both the fear of an impending bankruptcy of the borrower whether a bank or consumer and preserving their own liquidity. The liquidity problems brought several financial institutions around the world close to suspend their operation.
Within this climate of panic several countries assumed the role of guarantor and pumped their banking systems with money. The financing of the banking system from the sovereigns transformed the crisis from credit to debt crisis.
The debt crisis was created by the involvement of several states in an effort to rescue and recovery the financial sector. With these movements the banking system was strengthened but public debt increased in several countries. In some cases the financial packages, which were given account for a large percentage of the Gross Domestic Product GDP. The first two saw their public debt rising at an alarmingly levels whilst the latter two were faced with the possibility of default.
The reason was the Dubai where in September , stated that it cannot serve the needs of public debt repayment. The atrophy of regulatory authorities combined with the deregulation based on the doctrine of free market economy led to a failure of the entire financial system. Major financial institutions have reached the brink of bankruptcy. From the events it is concluded the greed of bankers for more profits, granting brazenly mortgages even to homeless people.
It is also concluded the power relations of the financial sector lobby with politicians in order to act undisturbed. The so-called "pressure groups" had a tremendous influence over the last thirty years in order to be voted laws and regulations that allowed the uncontrolled speculation. Several new evidences emerged for bribing important persons.
Banks that specialize in buying mortgage bribed several members of Congress and those responsible for the regulatory bodies in the United States. Even the former governor of the Fed, Alan Greenspan pushed to keep the derivatives market deregulated. Also the CEOs of the government sponsored enterprises in mortgages, Fannie Mae and Freddie Mac used their acquaintances in the government to act autonomously without checking their moves.
As a consequence of all was the degradation of the real economy. The citizens were those who were called to pay from their income the wrong moves of that were made from the political authorities and the financial industry.
In countries such as Great Britain and Ireland in order to reduce the fiscal deficit created by the partial nationalization of the banking system, citizens are subject to austerity policies. The Wall Street Journal. Board of Governors of the Federal Reserve System. The Dot-com Bubble. Irish Government: Financial Crime. The Financial Crisis Inquiry Report. Financial Crisis Inquiry Position. Related Papers Financial crisis of —08 - Wikipedia, the free encyclopedia By ravi kant jangid.
The role of systemic people risk in the global financial crisis By Patrick McConnell. Financial crisis - US versus Asian.
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