But with so much money chasing CDOs, banks were forced to lower credit standards, which led to the infamous subprime lending. ‘Subprime borrowers typically have weakened credit histories that include payment delinquencies, and possibly more severe problems such as charge-offs, judgments, and bankruptcies’ (FDIC, 2001). CDOs were sold on the notion that housing prices would continue to rise, for ‘between 1997 and 2006, according to the S;P/Case-Shiller national home-price index, American house prices rose by 124%’ (Economist, 2007).
To create CDOs, mortgages were made easily available to all and sundry. They were even offered to people with poor credit history, at a higher rate of interest (subprime). ‘According to a testimony last week, from January 2006 to June 2007, Clayton reviewed 911,000 loans for 23 investment or commercial banks. The statistics provided by these samples, according to Mr. Johnson and Vicki Beal, a senior vice president at Clayton, indicated that only 54% of the loans met lenders’ underwriting standards, regardless of how stringent or weak they were’ (Morgenson, 2010).
CDOs were now filled with high-risk mortgages, regardless of their ratings. When homeowners began defaulting on their payments (an estimated $1. 3trn in subprime mortgages were left outstanding in 2007) (Msnbc, 2007), it created a domino effect. Housing prices tanked (RealtyTrac reported 2,203,295 foreclosure filings by end-2007, up 75% from 2006) (RealtyTrac, 2008), sending the already fragile financial system into a free fall. Banks were stuck with mortgages and CDOs that institutions began shunning.
Mortgage lenders could not sell mortgages to banks, institutions worldwide held CDOs that were junk and they in turn started defaulting on their dues payable to the general public’s investments (Jarvis, 2009). This led to a credit crunch that eventually took several reputed institutions into bankruptcy, with it came job losses and unemployment throwing the global economy into recession. Discussion: Growing Capital mobility as a possible threat for crisis The process of individual savings collectively leads to the process of Capital creation.
This Capital is the reflective indicator of the financial health for the Nation. In order to overcome inflation and to earn interest on gathered capital it is better to use it as a source for investing. Investment of capital varies on many aspects such as preference of the investor, availability of investment opportunities, but more importantly on the risk weighted returns on the investment (Frankel, 1992). Some of the commonly used Investment strategies are based on the principle of diversification in different financial assets, markets and geographical locations.
Lately in the new emerging global capitalistic world, investors use a wide variety of investment opportunities in different nations to diversify their risk and to average their return. This has led to high volumes in International investment and foreign currency denominated opportunities have become highly liquid. As a result, the desire for investors to procure more foreign assets reduced formal restrictions on international capital mobility over the decade before the crisis and was more noticeable in advanced markets than in developing economies.
The growth in global financial linkages was followed with a rise in dispersal of current account balances and the magnitude of creditor and debtor’s position (Milesi-Ferreti, 2007). This led to the rapid rise of baking sectors in advanced economies and the banking integration was formed through cross border lending and operations by foreign affiliates, giving rise to regulatory arbitrage purpose and more complex portfolio models. The global financial crisis which began in 2007 halted the constant growth in international financial integration over the previous decade.
The retrenchment in international capital flows during the financial crisis in 2007 is greatly a heterogeneous occurrence: first across time, due to the Lehman Brothers’ collapse, second across types of flows,as banking flows were hit the hardest because of their sensitivity to risk perception, and third across globalized world, where emerging economies experienced a shorter span of retrenchment in compared to developed economies. Milesi-Ferreti (2007) forays that “The magnitude of the retrenchment in capital flows across countries is linked to the extent of international financial integration”
Growing International capital mobility has led to enhanced practise of Investment throughout the globe. It helps hedging for risk, optimize returns and also create economic liquidity. But this also have some serious limitations which supports economic crisis. Some of the limitations are discussed as below: Spread of economic meltdown: When there is an economic crunch in any of the markets the international funds tends to move away from them creating a multipliers effect i. e. every possible down turn causes much more negative impact to the market.
This implies the very factor that makes the capital market liquid affects adversely in the time of crisis. Essential feature of diminishing flows throughout the current financial crisis has been due to the shock of risk aversion, as confidence of investors reduced due to concerns in regard to the quality of financial assets and the solvency of major banks. Thus in a globalized world an impact of risk aversion for a specific country is subjected to the magnitude and nature of its transnational financial links, its macroeconomic environment, and its reliance on world trade (Milesi-Ferreti, 2007).
Concentration of economic power and arbitrage: Due to the a large amount of capital creation and foreign exchange reserves in some parts of the world, there exists a privilege to control the capital flow around the world and concentrate the process of wealth creation. Significant feature of globalization in relation to capital flows resulting in financial crisis is illustrated in developed economies value of both external assets and liabilities, as they rose considerably at a faster pace than the emerging markets (Lane and Milesi-Ferretti, 2007).
This tendency was also supplemented with the growth in flows for regulatory arbitrage purposes through international financial centres large and small, by transacting substantial shares in cross border capital movements (Milesi-Ferreti, 2007). In adverse it had also led to regulators creating strict Foreign Direct Investment regulations as preventative measure to crisis.