The housing bubble of the United States was a bubble of the real estates that had an effect on more than half portion of the country. The price of the houses had been at a peak in the early years of 2006 and in 2007 and 2008, the prices declined with the lowest drop in the history in the year 2012. The studies suggested that the crisis of the credit was the major reason of such recessionary period and situation. The collapse had an impact of a direct nature on the valuations of houses, markets of mortgages, builders of home, hedge funds of the Wall Street held by large investors and banks that increased the continuous risk of the national recession.
The greatest shock to the financial system was the Global Financial Crisis (GFC) and it occurred from the time when the Great Depression had taken place at around eight decades earlier. Even though, it formed problems for the entire globe, the majorly affected financial markets were those of the US and Europe. The crisis resulted in various studies and while there are many general agreements, there are arguments against the major factors affecting the implications and consequences faced by the globe. The policy makers had been in a dilemma of getting a design of the optimum structure of the regulatory structures that lacks because of the instability in the financial markets.
The major reasons and causes of the financial crisis of the US House bubble include the following:
– Non-traditional mortgages: The credit spreads that were tightened and had overly positive supposition about the prices of the houses resulted into a poor instigation practices. There was a combination to augment the course of credit to the housing finances. The firms like Countrywide, Washington Mutual, Ameriquest, and HSBC Finance got simulated by the cheap credit risk and originated vast numbers of risky mortgages that were mostly confusing, misleading and frequently ahead of the ability of the borrowers to repay. Furthermore, many buyers and owners of home did not take an effort to comprehend the conditions of their mortgages and hence to make practical financial decisions. These reasons additionally augmented the housing bubble.
– Credit ratings and securitization: The collapse in the credit rating and securitization transformed bad mortgages into toxic financial assets. The Securitizers worsened the quality of the credit and the securitized mortgages. The agencies those who performed the Credit rating inaccurately rated the securities backed by mortgages and their derivatives to be safe and appropriate investments. The buyers were unsuccessful in looking behind the credit ratings and perform their own due conscientiousness. Therefore, these factors increased the establishment of additional bad mortgages.
– The intense concurrent risk of the financial institutions: The midsize and the larger financial institutions of the US collected a huge amount of the correlated risks of housing. While some had carried the purpose by full knowledge, some had not paid sufficient attention to the prospective risks of the carrying amount of the risks that would have a reflection on the balance sheets. Hence, the above had led to the losses of the increased collapse in the larger financial institutions.
– Liquidity and Leverage risk: The managers of the above mentioned financial institutions enlarged the concentrated risks of housing by investing into a small capital compared to the threat they were facing by the reflections on their balance sheet. A lot of them had started relying greatly on the short-term financing that included the investments in repo and commercial paper markets for the daily liquidity. They undertook bets on solvency both knowingly and unknowingly about their housing investments being solid, and bests on liquidity that there would always be availability of money overnight. But, both types of the bets turned out to be the bad bets.
– Risk of corruption: The corruption was an indispensable basis of the crisis. In few cases, the financial system was susceptible because the makers of the policies had feared of an unexpected and uncontrollable breakdown triggering the losses of balance-sheet in its counterparties. The institutions were judged to be too large and interrelated to the other firms through the counterparty credit risk for makers of the policy to be enthusiastic to permit them to be unsuccessful abruptly.
-Shadow banking: The shadow banks were majorly responsible since shadow the banks that are the investment banks and the Currency Comptrollers caused most of the damage.
The financial crisis caused an enormous damage and threat, the consequences of which are been faced even today.
Collateralized debt obligations
A Collateralized Debt Obligation (CDO) is a security measure, the value of which is backed up by a group of assets having a fixed income of an underlying nature. It constitutes a saving that gives way to a regular income and its payments are derived from the act of this group. The instruments that are not easily sold individually but by the traders and therefore, when the inflation in US had been taking place, the Central Bank raised the interest rates to consider it. The borrowing costs increased, and the borrowers started finding that they were unable to meet their payments of mortgage and was all the time defaulting on mortgages. The Lenders were at that time selling the houses i.e. the underlying security however, at that time into downward shifts in the housing market. The above had a reflection of a decline in demands for the CDOs, due to the increase in the amount of defaults on the payments on mortgages.
CDS is a form of insurance and is a derivative of credit allowing lenders to get an insurance against any changes in the credit ratings of the borrowers. The CDS enables the lender to make loans without facing possibilities of the default. CDS had an effect on the crisis of global finance and the response of policies in major ways like:
The uncertainty caused about the ultimate credit risk bearer.
The situation causing the sellers of CDS mutually vulnerable to the systematic risks
It made an easy situation for sellers of insurance to presume risk.
The ability of the transferring of the credit risks by means of CDS made it difficult for the estimation of the risky nature of the particular intermediaries. The major cause of the issue is the non reflection of the amount of CDS on the balance sheet and the lack of such revelation makes it uneasy for the counterparties to determine the risky nature of the same. Therefore, the loss of transparency of the CDS makes the threats invisible and an area of threat.
Securitization is comparable to a mutual fund and is defined a procedure of converting the financial assets of illiquid nature into the marketable securities. The banks and other financial institutions put together similar loans like mortgages, places into a fund, and issue securities tied to the assets of the fund. The investors purchase the securities to receive the income and on an average the group has an expected cash flow as the public repay their loans. The investors take these payments as their investment and the banks use debt securitization and computers for the simplification of the record keeping.
The banks started offering the loans to any categories of investors that was incorrect. The great recession of the year 2007 created the loans into poisonous ones as the borrowers began to default in loans as they had no good history of repayments, still got the loans.
The commercial banks had increased the availability of the credit amount that was subject to increased competition and prudential regulations. They moved their assets off the balance sheet resulting into no longer being acted as suppliers of credit and thus, the banks took a role of being mediators for special fees. A large range of institutions started playing related roles like the commercial banks and not getting included in the present structure of regulatory reforms and thus no detention of reserve capital had taken place.
The search for the instruments for removing the risks of credit from the balance sheets made them submit issued bonds and proportionate returns to the risk rating agencies. The bonds i.e. CDOs had a division in a variety of tranches and had various returns and risks.
Credit Derivatives Spread was created and through the same, one could buy the protective measures against the risks of credits of the loans. Not capable to collect the resources from depositors the financial intermediaries took help of the capital market, largely by issuance of the commercial papers and mutual funds.
Before the 1990s, the banks never used securitization on a large scale. The bankers after the simplified procedure for the tranches started applying securitization to a diversity of assets. They provided security to the mortgages like car loans, credit cards, and other types including the student loans. In case of the US housing bubble, the banks had put a relaxation to the requirements of loans and earlier to the year 2000, banks used to offer loans to the borrowers having stability in the history of work and credits. In addition, the banks also relaxed the standards of lending and granted loans to people having history of poor work and credits known as the Subprime loans.
Furthermore, the major fault of the bankers included the raising of the interest rates by the Central Bank at the recessionary periods. The costs of borrowings increased, and the borrowers were unable to meet their payments of mortgage and was all the time defaulting on mortgages.
Derivatives are tools of speculating risks and future returns and at the time of crisis the banks with poor quality pooled their assets for creation of the securitized instruments like the pension funds. The derivatives ensure the risks but do not work when the instruments are complicated in a way that both the credit rating agencies and borrowers do not understand and thus there is a failure in the original premises.
In the crisis time, the banks got stuck along with the investors of the pension funds as the securities held turned out to be risky due to the holding of the underlying loans i.e. the derivatives. The banks held numerous instruments in their accounts for using assets as a collateral one and also a means of satisfaction for the requirements of fixed incomes. The write downs that incurred in the institutions made it apparent that there was a non availability of required assets.
The banks started to borrow funds for lending for the creation of more securitized products and most of the instruments had a creation through margin or funds borrowed for allowing the firms that did not provide a full outflow of capital. Even though, the arguments of the causes of the financial destruction or crisis were imposed on the derivatives, one knows that the securities have an integral role in the collapse. The securities whose true motive was the lessening of the risk instead heightened the threats and thus, when the margins had an addition into the derivative mix that augmented the disastrous nature of the investments.
The policymaker needs to keep in mind that they are constructing an authoritarian infrastructure for the long run. Generally, a major financial crisis strikes rather, once in twenty to fifty years, making it remarkably difficult for controllers to be observant. Also, a universal supervisor would be stimulating with adapting the most powerful financial institutions in the country; it would be highly susceptible to falling under their power phenomenon. The correct approach is to be open about the systemic threats about the institutions and control them efficiently based on the strong prudential standards.
The financial crisis should strike a thought that the private financial institutions and marketplace cannot be considered for the optimality of the risks always. Approximately, everyone has had recognition that the government plays a critical role at the times of crisis like that of a lender, an insurer, and savior at last time. Other than, the effectual public risk, the efficiency of the management is also required in ordinary times to defend consumers and shareholders and to help avoid the financial crisis.
The best way to deal with the risks of threats is the identification, regulation, and potential insurance against the systemic noteworthy financial institutions in a continuous manner before the striking of a crisis. This would prove to be a mark of a foremost and indispensable restructuring to make sure a strong and productive financial system for the next twenty to fifty years at a stretch.
References
Banks, E., 2014. Liquidity and Financial Operations. In Liquidity Risk (pp. 24-47). Palgrave Macmillan UK.
Buchanan, B.G., 2017. Securitization and the Way We Live Now. In Securitization and the Global Economy (pp. 1-48). Palgrave Macmillan US.
Ciro, T., 2016. The global financial crisis: Triggers, responses and aftermath. Routledge.
Cukierman, A., 2013. Monetary policy and institutions before, during, and after the global financial crisis. Journal of Financial Stability, 9(3), pp.373-384.
Farlow, A., 2015. Financial indicators and the global financial crash. The world of indicators: The making of governmental knowledge through quantification, pp.220-253.
Grant, W. and Wilson, G.K., 2013. Consequences of the Global Financial Crisis (p. 287). Oxford University Press.
Greenwood, R. and Scharfstein, D., 2013. The growth of finance. The Journal of Economic Perspectives, 27(2), pp.3-28.
Loon, Y.C. and Zhong, Z.K., 2014. The impact of central clearing on counterparty risk, liquidity, and trading: Evidence from the credit default swap market. Journal of Financial Economics, 112(1), pp.91-115.
Obay, L., 2014. Financial innovation in the banking industry: the case of asset securitization. Routledge.
Tridico, P., 2012. Financial crisis and global imbalances: its labour market origins and the aftermath. Cambridge Journal of Economics, 36(1), pp.17-42.
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