The 2007-2008 Financial Crisis: Causes, Impacts and the Need for New Regulations

THE 2007-2008 FINANCIAL CRISIS: CAUSES, IMPACTS AND THE NEED FOR NEW REGULATIONS The initial cause of the financial turbulence is attributed to the U. S. sub-prime residential mortgage market.

The sustained rise in asset prices, particularly house prices, on the back of excessively accommodative monetary policy and lax lending standards during 2002-2006, increased innovation in the new financial instruments, unusual low interest rates resulted in a large rise in mortgage credit to households; particularly low credit quality households, the greed of investors’ for ever higher returns coupled with very minimal down payments, along with the dependence on major global rating agencies, allowed complex investments products to be sold to an extremely wide range of investors.

The repacking of credits with some other financial instruments, the rising complexity of the products, emerging “monoline’ guarantors in the marketplace – that are not being regulated, and the governments came into rescue, sometimes even difficult who’s the one to be blamed for the crisis. These would address the issue of transparency, conflict of interests among the market participants, regulatory and supervisory system, in particular their cooperation.

Development of the Crisis In order to keep recession away, the Federal Reserve lowered the Federal funds rate 11 times from May 2000 (6. %) to December 2001(1. 75%), and this creating a flood of liquidity in the economy. Cheap money, created a favorable breeding ground for reckless risk taking. It found easy prey in restless financial institutions, and even more restless borrowers who had no income, no job and no assets. These subprime borrowers wanted to realize their life’s dream of acquiring a home.

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For them, holding the hands of a willing banker was a new way of hope. There were more home loans, more home buyers, more appreciation in home prices.

The Federal continued slashing interest rates, perhaps, by continued low inflation despite lower interest rates. In June 2003, the Fed lowered interest rates to 1%, the lowest rate in 45 years. The whole financial market started turn just like a candy shop where everything was selling at a huge discount and with a very minimal down payment. Unfortunately, no one was there to warn about the tummy aches that would follow. The financial institutions thought that it just was not enough to lend out the loans with just minimal interest rates.

They decided to repackage the mortgage loans with other financial instruments such as collateralized debt obligations (CDOs) or asset-backed commercial paper (ABC paper), or structured investment vehicles (SIVs) and pass on the debt to another candy shop. As appeared by the Central Banks Governors, these risk-based instruments was an aid for the investors in the marketplace since enabled them to purchase the precise degree of risk they willing to tolerate with, at given alternate returns. And also the mortgage market would become more liquid as sales were facilitated.

The new financial instruments gave options to the banks to hold the loans they made as an off-balance sheet vehicle, or sell to others, or pay another institution to accept the risk of default. This was coupled with the belief one can sell or get ride off the risk via synthetic CDOs which was impossible to the system as a whole. One of the investment vehicles of the new instruments is the hedge funds. Investors of the hedge funds included financial institutions for example pension funds and non-for-profit institutions.

Many of these hedge funds just ignore the warning signals of their insolvency early in the financial crisis. Most of the hedge fund industry required no public reporting since was located in offshore tax havens and that experienced no supervision. Nevertheless, it was unclear on what level this industry to get negatively impacted by the financial crisis. Apart from these, it was a need in improving transparency. There were also dramatic rises where corporations offered guaranteed debts, with promising to the investors to pay debt if there were default, and the issuer would pay a premium for this guaranteed.

These corporations are known as the “monoline” insurers or “monoline” guarantors, and it became another casualty of the financial crisis. Globally, many financial institutions had purchased these new promising guaranteed of debts. But, every good item has a bad side, and several of these factors started to emerge alongside one another. Insolvency on one of these institutions could threaten the solvency of many others. When the “monoline” insurers started to fall into insolvency problem, the market was illiquid.

Suddenly, emerging financial institutions were short of cash, as well as become insolvent. Some of the affected are such Goldman Sachs, Merrill Lynch, and Bear Stearns. But, at the end of the day, the worst effected from this financial crisis were the mortgage borrowers. Most of these “monoline” insurers did not have adequate capital to fulfill their guarantee promises. Investors’ dependence lied mostly on the high ratings placed by major global rating agencies for these institutions put the investors in a position where they could experience enormous losses.

In order to survive, many banks turned to sovereign wealth funds to obtain new capital. Bad news continued to pour in from all sides. In August 2007 that the financial market could not solve the subprime crisis on its own and the problems spread beyond the U. S borders. Lehman Brothers filed for bankruptcy, Bear Stearns was acquired by JP Morgan Chase, Merrill Lynch was sold to Bank of America, and the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Mortgage Corporation (“Freddie Mac”) were put under the control of the U. S. federal government.

Governments started took over banks as done by the UK government on a bank named Northern Rock (a British bank) after a loan pumped nearly reached $50 billion. The idea was to enhance liquidity, to put the interbank market back on its feet and to restore confidence in financial system. Injections of liquidity by central banks include lending government’s paper, accepting high-quality assets owned by banks as collateral, and increased the loans maturity. On the other hand, central bank’s intervention indirectly would be a trigger to a global inflation.

The action would increase the prices of products based on oil, increase the price of food, increased in demand for agriculture products in manufacturing ethanol to substitute the gasoline. Few recommendations regarding central bank’s intervention for instance base any future government interventions on a clearly stated diagnosis of the problem and a rationale for the interventions, and keep policy interest rates on track in a globalized economy because it would help to introduce the notion of a global inflation target.

This would help prevent rapid cuts in interest rates in one country if they perversely affect decisions in other countries. This is because in monetary policy of different central banks will looking at each other. Number of debates arose whether the central banks should create new regulations instead of using monetary policy and interest rates when it comes to inflation in asset prices to recurrent. One of the ideas is new regulations to control the new financial instruments imposed by the government of Germany.

Others such government intervention in reduction in the face value of the mortgage, and a need to regulate the very used of financial instruments (of CDOs, for instance) so that the transparency of the market be restored and investors be adequately informed. Other than that, to enhance the monitoring process of non-transparent off-balance sheet financing, coordinating supervision and regulating activities in the short run and remodeled the Federal Reserve in the longer run. In terms of bank’s capital adequacy, the ratio should be raised above the eight percent as under the Basel Accord 1988. Conclusion

As to conclude, cutting interest rates below their natural level distorts time preferences and investment decisions, causing individuals and companies to take on more risk, the risk that they will later regret having taken. In effect, the central bank is leading people into miscalculating the riskiness of the decisions they are making by keeping interest rates artificially low. A perfect example is the previous housing bubble. If interest rates should be 5% but they are 1%, then home builders are going to increase their indebtedness to take on more projects with longer and longer completion time frames.

A project that comes online 5 years out looks much less risky when you can borrow money for 4 or 5% less. It is, therefore, very important that to identify the causes of the current crisis accurately so that can then find, first, appropriate immediate crisis resolution measures and mechanisms; second, understand the differences among countries on how they are being impacted; and, finally, think of the longer term implications for monetary policy and financial regulatory mechanisms. It was also possibility the government actions and interventions caused, prolonged, and worsened the financial crisis.

They caused it by deviating from historical precedents and principles for setting interest rates, which had worked well for 20 years. They prolonged it by misdiagnosing the problems in the bank credit markets and thereby responding inappropriately by focusing on liquidity rather than risk. Central banks should adopt a broader macro-prudential view, taking into account in their decisions asset price movements, credit booms, leverage, and the buildup of systemic risk. The timing and nature of pre-emptive policy responses to large imbalances and large capital flows needs to be re-examined” (IMF, 2009b).