Financial Crisis In Usa
The financial crisis of 2007-2010 is a catastrophe triggered by a liquidity crisis in the United States banking system. It has resulted in the collapse of large financial institutions, the bailout of banks by national governments and downturns in stock markets around the world. The housing market has also suffered, resulting in numerous evictions, foreclosures and extended vacancies. It is considered by many economists to be the worst financial crisis since the Great Depression of the 1930s.
It contributed to the collapse of key businesses, declines in consumer wealth estimated in the trillions of U. S. dollars, substantial financial commitments incurred by governments, and a significant decline in economic activity. Many causes have been proposed, with varying weight assigned by experts. Both market-based and regulatory solutions have been executed or are under consideration, while significant risks remain for the world economy over the 2010–2011 periods. The global financial crisis really started to show its effects in the middle of 2007 and into 2008.
Around the world, stock markets have fallen, large financial institutions have collapsed or been bought out, and governments in even the wealthiest nations have had to come up with rescue packages to bail out their financial systems. Also most people have been rendered jobless due to the crisis globally. On one hand many people are concerned that those responsible for the financial problems are the ones being bailed out, while on the other hand, a global financial meltdown will affect the livelihoods of almost everyone in an increasingly inter-connected world.
The problem could have been avoided, if ideologies supporting the current economics models weren’t so vocal, influential and inconsiderate of others’ viewpoints and concerns. 2 Rating agencies- Critics argued that credit rating agencies and investors failed to accurately price the risk involved with mortgage-related financial products, and that governments did not amend their regulatory practices to address 21st century financial markets. Governments and central banks responded with unprecedented fiscal stimulus, monetary policy expansion, and institutional bailouts.
Causes-The immediate foundation or cause of the crisis was the bursting of the United States housing bubble which peaked in approximately 2005–2006. High default rates on “subprime” and adjustable rate mortgages (ARM) began to increase quickly thereafter. An increase in loan packaging, marketing and incentives such as easy preliminary terms and a long-term inclination of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms.
However, once interest rates began to rise and housing prices started to drop moderately in 2006–2007 in many parts of the U. S. , refinancing became more difficult. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated, and ARM interest rates reset higher. Low interest rates and large inflows of foreign funds created easy credit conditions for a number of years prior to the crisis, fueling a housing construction explosion and encouraging debt-financed consumption. The combination of easy credit and money inflow contributed to the United States housing bubble.
Loans of various types (e. g. , mortgage, credit card, and auto) were easy to obtain and consumers assumed an unprecedented debt load. Falling prices also resulted in homes worth less than the mortgage loan, providing a financial incentive to enter foreclosure. The ongoing foreclosure epidemic that began in late 2006 in the U. S. continues to drain wealth 3 from consumers and erodes the financial strength of banking institutions. Defaults and losses on other loan types also increased significantly as the crisis expanded from the housing market to other parts of the economy.
Total losses are estimated in the trillions of U. S. dollars globally. While the housing and credit bubbles built, a series of factors caused the financial system to both expand and become increasingly delicate, a process called financialization. Policymakers did not identify the increasingly important role played by financial institutions such as investment banks and hedge funds, also known as the shadow banking system. Some experts believe these institutions had become as important as commercial (depository) banks in providing credit to the U. S.
economy, but they were not subject to the same regulations. These institutions as well as certain regulated banks had also assumed significant debt burdens while providing the loans described above and did not have a financial cushion sufficient to absorb large loan defaults. These losses impacted the ability of financial institutions to lend, slowing economic activity. Concerns regarding the stability of key financial institutions drove central banks to provide funds to encourage lending and restore faith in the commercial paper markets, which are vital to funding business operations.
Governments also bailed out key financial institutions and implemented economic stimulus programs, assuming significant additional financial commitments. Deregulation-Critics have argued that the regulatory framework did not keep speed with financial originality, such as the increasing importance of the shadow banking system, derivatives and off-balance sheet financing. Laws were changed or enforcement weakened in parts of the financial system. Main examples include: Banking deregulation that assisted contribution to the savings and loan crises of the late 1980s/early 1990s, and the financial crisis 4
of 2007-2010, Financial institutions in the shadow banking system are not subject to the same regulation as depository banks, allowing them to assume additional debt duties relative to their financial cushion or capital base. This was the case despite the Long-Term Capital Management tragedy in 1998, where a highly-leveraged shadow institution failed with systemic implications. Increased debt burden or over-leveraging-Leverage ratios of investment bank increased significantly 2003-2007. U. S.
households and financial institutions became increasingly indebted or overleveraged during the years preceding the crisis. This increased their vulnerability to the collapse of the housing bubble and worsened the ensuing economic downturn. Incorrect pricing of risk-The pricing of risk refers to the increased compensation required by investors for taking on additional risk, which may be measured by interest rates or fees. For a variety of reasons, market participants did not accurately measure the risk inherent with financial innovation or understand its impact on the overall stability of the financial system.
As financial assets became more and more multifaceted, and harder and harder to value, investors were reassured by the fact that both the international bond rating agencies and bank regulators, who came to rely on them, accepted as valid some complex mathematical models which theoretically showed the risks were much smaller than they actually proved to be in practice. MAJOR ENTITIES From 2004-07, the top five U. S. investment banks each significantly increased their financial leverage, which increased their vulnerability to a financial shock.
Fannie Mae and Freddie Mac, two U. S. Government sponsored enterprises, owned or guaranteed nearly $5 trillion in mortgage obligations at the time they were placed into conservatorship by the U. S. government in September 2008. Regulators and accounting standard-setters allowed depository banks such as Citigroup to move significant amounts of assets and liabilities off-balance sheet into complex legal entities called structured investment vehicles, masking the 5 weakness of the capital base of the firm or degree of leverage or risk taken.
As early as 1997, Federal Reserve Chairman Alan Greenspan fought to keep the derivatives market unregulated. With the advice of the President’s Working Group on Financial Markets, the U. S. Congress and President allowed the self-regulation of the over-the-counter derivatives market when they ratified the Commodity Futures Modernization Act of 2000. Derivatives such as credit default swaps (CDS) can be used to hedge or contemplate against particular credit risks. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with approximations of the debt covered by CDS contracts.
Total over-the-counter (OTC) derivative notional value rose to $683 trillion by June 2008. Warren Buffett famously referred to derivatives as “financial weapons of mass destruction” in early 2003. Timothy Geithner — who in 2009 became Secretary of the United States Treasury — placed hefty blame for the freezing of credit markets on a “run” on the entities in the “parallel” banking system, also called the shadow banking system. These entities became critical to the credit markets underpinning the financial system, but were not subject to the same regulatory controls.
Further, these entities were vulnerable because they borrowed short-term in liquid markets to purchase long-term, illiquid and risky assets. This meant that distractions in credit markets would make them subject to rapid deleveraging, selling their long-term assets at decreased prices. Paul Krugman, laureate of the Nobel Prize in Economics, described the run on the shadow banking system as the “core of what happened” to cause the crisis. He referred to this lack of controls as “malign neglect. ” This meant that nearly one-third of the U. S. lending mechanism was freezing and prolonged to 6 be frozen into June 2009.
According to the Brookings Institution, the traditional banking system does not have the capital to close this disparity as of June 2009. While traditional banks have raised their lending standards, it was the crumple of the shadow banking system that is the primary cause of the reduction in funds available for borrowing. STRATEGIES: Foreign governments supplied funds by purchasing USA Treasury bonds and thus avoided much of the direct impact of the crisis. USA households, on the other hand, used funds borrowed from foreigners to finance consumption or to bid up the prices of housing and financial assets.
Financial institutions invested foreign funds in mortgage-backed securities. Extra downward pressure on interest rates was created by the USA’s high and rising current account (trade) deficit, which peaked along with the housing bubble in 2006. Ben Bernanke explained how trade deficits required the U. S. to borrow money from abroad, which bid up bond prices and lowered interest rates. Financing these deficits required the USA to borrow large sums from abroad, much of it from countries running trade surpluses, mainly the emerging economies in Asia and oil-exporting nations.
The balance of payments identity requires that a country (such as the USA) running a current account deficit also have a capital account (investment) surplus of the same amount. Hence large and growing amounts of foreign funds (capital) flowed into the USA to finance its imports. This produced demand for various types of financial assets, inflated the prices of those assets while lowering interest rates. Foreign investors had these funds to loan, either because they had very high personal savings rates (as high as 40% in China), or because of high oil prices.
Bernanke referred to this as a “saving glut”. This contributed to an increase in 1-year and 5-year adjustable-rate mortgage (ARM) rates, 7 making ARM interest rate resets more expensive for homeowners. This may have also contributed to the deflating of the housing bubble, as asset prices generally move inversely to interest rates and it became riskier to speculate in housing. USA housing and financial assets dramatically declined in value after the housing bubble burst. REFERENCES Atwood, Margaret, Payback: Debt and the Shadow Side of Wealth. (2008) John C.
Hull, The Credit Crunch of 2007: What Went Wrong? Why? What Lessons Can Be Learned? Rothman School Research Paper: (2007) Kenneth Rogoff, The Recession that Almost Was. , International Monetary Fund, Financial Times, April 5, 2002 Nassim Nicholas Taleb ,The Black Swan Theory is used (2007) Stewart, James B. “Eight Days: the battle to save the American financial system”, The New Yorker magazine, September 21, 2009. Woods, Thomas Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse. Washington, DC: Regnery (2009).
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