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MScFE 560 Financial Markets

Group #: 34 Submission #: 1

THE GLOBAL FINANCIAL CRISIS

Introduction
The financial crisis of 2007-2008 had its origins in the U.S mortgage-backed securities (MBS). When
borrowers of these subprime mortgages defaulted on their loan repayments as the prices of U.S houses
fell, these securities became worthless resulting in losses to the banks and investors. These events
spilled out into other banks around the world as many of these U.S banks had international presence
and many other financial institutions in other countries had also invested in these securities for
speculative profits. It became a global crisis in which reduced the employment rate and output of
resources around the globe.

1. The Primary causes of the financial crisis of 2007-2008, also known as The Global Financial
Crisis.
Financial crisis of 2008 was primarily caused by deregulation which permitted banks to
participate in hedge fund trading with derivatives, banks which demanded more mortgages and
the rise of interest rate of central bank of US (Federal Reserve). Primary causes included:
 Imbalances in world trade.
 Deregulation of financial industry -Securitization.
 Collapse of the Financial Markets.
 The growth of subprime mortgages -The Fed raised rates of the subprime mortgages.
 The boom in housing costs and therefore the ultimate burst of the housing bubble.
 The massive leverage magnitude relation of banks that led the whole banking industry
to loss spiral and margin spiral.
 The flood of low-cost credit and low disposal standards.

2. The market features and conditions

During the financial crisis the market was characterized by business decline, less business
economic activity and inflation. This era was characterized by low client demand that was
principally because of 2 reasons: Lower buying power because of high inflation, stagnant wages,
and low-income unpredictability of the economic conditions.

 Crisis of debt and of inflation (easy access to credit, relaxed disposal standards).
 regulative crisis: inadequate rules (regulations failed to keep step with innovations in
financial merchandise, resulting in abundant higher quality, poor transparency, and
larger risk).
 advanced credit by-products: the invention of advanced derivative like CDOs
(Collateralized Debt Obligations) created but failed to spot and contain the subprime
problem once default rates began to rise.
 Increasing use of latest world money instruments – displayed risk (but heightened risk)
plus reduced transparency (opacity of markets: the counterparty risk).

3. How primary causes led to conditions of Financial crises

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MScFE 560 Financial Markets

Group #: 34 Submission #: 1

 Deregulation of monetary industry is the act of reducing or eliminating the participation

of government power in monetary trade. Liberalization place customers, depositors,
and banks at high risks. Issues that banks faced embody adverse choice and financial
loss, whenever borrowers used the funds for what they were not planned for.
 Securitization: throughout the monetary policy, lenders pooled the subprime mortgages
into MBS and CDOs. These products usually received a high agency rating. Also,
securities were sold-out to unsuspecting investors who were not attentive to the
associated risk. This disposition caused dramatic increase in offered mortgages credit.
 The growth of subprime mortgages: Hedge funds, banks, and firms of insurance caused
the subprime mortgages crisis. Banks and hedge funds created mortgage-backed
securities. Insurance covered them with credit default swaps. Demand for mortgages
led to bubble in housing.
 The Fed raised rates of the subprime mortgages: In Gregorian calendar month 2004,
housing costs were inflated rapidly by U.S. financial organization chairman Alan
Greenspan. The Fed conjointly raised the fed funds rate speedily by 2004, 2005 and
2006. This raised monthly payment for those that had interest solely and alternative
subprime loans supported the fed funds rate till these owners could not pay their
mortgage, nor sell their homes on profit therefore the sole choice was to default.

4. The response of policymakers and regulators -

 Adoption of Basel III capital ratio.
 Agreement reached on one in each of two unreal liquidity standards – Liquidity
Coverage relation (LCR).
 Enhancements to the “securitization model.”

Some specific regulations/reforms in response to financial crisis included:

 Emergency Economic Stabilization Act of 2008.
 Dodd-Frank Act.
 The Temporary Liquidity Guarantee Program (TLGP).
 The city III restrictive framework was adopted, that was targeted towards bank capital
adequacy, stress testing, and market liquidity risk.
 The restrictive authorities started aggregation consolidated data on bilateral
counterparty and credit risks of major banks.
 Some unlisted derivatives reform.

5. The intended effects of policymakers and regulators responses.

Money regulative policy therefore strives to realize 3 goals:
 Market potency
 Money stability

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Group #: 34 Submission #: 1

 Capitalist protection.

Market potency ensures money mediation - providing a variety of merchandise desired by

borrowers and lenders - is provided at all-time low-price potential. Laws that support money
stability and capitalist protection produce confidence in markets, serving to beat adverse choice
and financial loss issues.

6. Roles each of the following has in the housing market:

 Home Builders: These are the building developers or holding companies who engage
with the necessary raw materials and contract in building these homes.
 Mortgage Lenders: Are the financial institutions, mortgage brokers and banks who give
out loans to borrowers in return for interest payments which is traditionally paid
monthly and with repayment schedule.
 Mortgage Back Securities (MBS) Structurers: These are both prime and subprime
mortgage loans repacked as financial assets by banks and financial institutions with
different tranches where willing investors could purchase with its mortgage interest risk
and the banks guaranteeing the default risk.
 Realtors (real estate brokers): Are usually trained professionals in their field with
brokage firms and handle the legal and compliance aspect of the real estate transactions
while having agents working under them.
 Real Estate Appraisers: Assesses a piece of property or building for its market value
either for taxation reasons, selling, insurance or for mortgage.
 Townships that collect local real estate taxes: These are local branches of government
responsible for local real estate laws beneficial for the community.
 Homeowners using a mortgage: Are individuals without adequate fund to purchase a
house outrightly but take out a loan from banks or financial institutions with a recurring
interest payment being paid and loan repayment.

7. If housing prices increases-

 House owners or
 investors holding of Credit products such as CDO, Mortgage linked securities etc. would
tend to have higher income

8. In the event of borrowers’ default

 Banks or Financial Institutions bear more liabilities in the balance sheet and could lead
to their collapse if the loan were massive.
 The government: If the bank or institution were a large bank or a too big to fail bank,
government would have to step in to bail them out especially if it were to cause a
systemic risk in the economy or grant them funding to improve their capital.
 Taxpayers: Government would have to bail out or fund large banks to prevent any
collapse in the event of borrower default. This money is usually from taxpayers’ fund.

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9. Systemic risk is the type of risk which can cause the collapse of a whole industry or economy
due to the activities of financial market players where deposits, investors, lenders, and
borrowers lose trust in the financial system and a country’s medium of exchange.

A systemic risk was evident in the financial crisis in the case of liquidity problems where no one
was lending, and investors removed funding from the real estate market and its financial assets
to other less risky government assets like bonds.

10. Regulation- The U.S Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010 which
came into effect was instrumental in minimizing these risks.

Conclusion
The global financial crisis started with a collapse in the real estate industry that later spread the
adverse economic instability to other sectors of the economy. The financial institutions such as banks
and large insurance companies like the AIG were faced with financial troubles that threatened
downfall of other large organizations in the economy. Slow economic recovery in the United States is
attributed to the inefficient economic policies implemented to realize a boom. Investors in the American
economy is faced with diverse risks that were evidenced by the global financial crisis such as the
liquidity, counterparty and systemic risks that pose threats of potential losses of investment in the
financial markets.

References

1. Arner, Douglas W. "The Global Credit Crisis of 2008: Causes and Consequences."   The
International Lawyer, vol. 43, no. 1, 2009, pp. 91-136. ProQuest,
https://search.proquest.com/scholarly-journals/global-credit-crisis-2008-causes-
consequences/docview/191633965/se-2?accountid=196966

2. Acharya, Richardson, M. Causes of the Financial Crisis. Critical Review: A Journal of Politics and
Society 21 (2-3), pg. 195-210. (2009).

3. Ashcraft, A., Goldsmith-Pinkham, P., Vickery, L.MBS Ratings, and the Mortgage Credit (2010).

4. Ashcraft, A., Schuermann, T., Understanding the Securitization of Subprime Mortgage (2008).

5. Bajari, P., Chu, C.S., Park, M. An empirical model of subprime mortgage defaults from 2000 to
2007 (NBER Working Paper 14625). Cambridge, MA: National Bureau of Economic Research.
(2008).