Causes and Effects of the Global Financial Crisis

The Federal Reserve under the leadership of Alan Greenspan lowered interest rates from 6.5% to 1.0% between January 3 2001 and June 25 2003. People believed that it was done to prevent a recession but it was actually done to make access of money easier for people. If people would borrow more, they’d buy more and consume more. In addition to this, financial sector underwent unethical practices and advertised the “American Dream” of every citizen owning a house.

The Financial Crisis didn’t just happen unknowingly, it was the result of a few people selfishly hoarding on money no matter what was at risk. I partially agree with Nobel laureate and liberal political columnist Paul Krugman who said that politicians and government officials should have realized that they were re-creating the kind of financial vulnerability that made the Great Depression possible—and they should have responded by extending regulations and the financial safety net to cover these new institutions. He referred to this lack of controls as “malign neglect.” Where I disagree with Mr. Krugman is when he says that it was neglect, I feel it was all carefully planned to largely benefit only a few people in the U.S. risking the rest of the world. The New York State Comptroller’s Office mentioned that in 2006, Wall Street executives took home bonuses totaling $23.9 billion.

(The Inside Job)Credit rating agencies were compensated heavily for rating debt securities by those issuing the securities. Then, Henry Paulson (former CEO of Goldman Sachs) was made President George W. Bush’s Treasury Secretary. While the other banks continued to fall, Goldman Sachs was given $10 billion in TARP funds and $12.9 billion in payments via AIG, while remaining highly profitable and paying enormous bonuses. The SEC who is supposed to monitor and regulate such actions knowingly stayed silent because their officials were also compensated for keeping their eyes shut.

The Housing Bubble in the U.S. & Eurozone

The most prominent factor leading to the crisis was the housing sector, in the US and the Eurozone. (Wikipedia, Causes of the 2007–2012 global financial crisis, 2012) During the years leading to the crisis, i.e. between 1997 and 2006, the price of the typical American house increased by 124%. This housing bubble resulted in quite a few homeowners refinancing their homes at lower interest rates, or financing consumer spending by taking out second mortgages secured by the price appreciation.

By September 2008, average U.S. housing prices had declined by over 20% from their mid-2006 peak (also shown in the graph). Easy credit, and a belief that house prices would continue to appreciate, had encouraged many subprime borrowers to obtain adjustable-rate mortgages. These mortgages enticed borrowers with a below market interest rate for some predetermined period, followed by market interest rates for the remainder of the mortgage’s term. Borrowers who could not make the higher payments once the initial grace period ended would try to refinance their mortgages. The ugliest part of refinancing surfaced when house prices started declining. Borrowers who found themselves unable to escape higher monthly payments by refinancing began to default.

NINJA Loans ; Speculative Purchases

People with no income, no jobs and assets were given home loans and mortgages, knowing that almost all of them will be unable to pay back (a.k.a subprime lending). (Liebowitz, 2009) The chart below shows the intensity of this game during 2008. Subprime mortgages spiked to nearly 20% and remained there through the 2005-2006 peak of the United States housing bubble. Also, in 2006, 22% of homes purchased (1.65 million units) were for investment purposes, with an additional 14% (1.07 million units) purchased as vacation homes.

Chinese mercantilism

China maintained an artificially weak currency to make Chinese goods relatively cheaper for foreign countries to purchase, thereby keeping its vast workforce occupied and encouraging exports to the U.S. One byproduct was a large accumulation of U.S. dollars by the Chinese government, which were then invested in U.S. government securities and those of Fannie Mae and Freddie Mac, providing additional funds for lending that contributed to the housing bubble. China’s currency should have appreciated relative to the U.S. dollar beginning around 2001.

And Then the Bubble Burst!

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. The household debt as a percentage of annual disposable personal income was 127% at the end of 2007, versus 77% in 1990. Loans started going bad in enormous numbers to the extent that people lost their houses AND their money.

Role of Credit Rating Agencies

Credit rating agencies decided on the ratings, not on the basis of the position or return expected but on the level of compensation they would get from the bank. These high ratings enabled risky investments to be sold to investors, thereby financing the housing boom. During that time, one major rating agency had its stock increase six-fold and its earnings grew by 900%.

Role of Regulators

Regulators stopped doing what they had been appointed to do. They allowed excessive leverage; failed to criticize the large institutions’ business models and also, did not regulate derivatives.

Net Capital Rule Relaxed

In 2004, the Securities and Exchange Commission relaxed the net capital rule, which enabled investment banks to substantially increase the level of debt they were taking on, fueling the growth in mortgage-backed securities supporting subprime mortgages.

No Regulation of Shadow Banking System

Financial institutions in the shadow banking system were not subject to the same regulation as depository banks, allowing them to assume additional debt obligations relative to their financial cushion or capital base. Any institution performing the act of a bank is supposed to be regulated and that was overlooked.

Allowance to meddle with accounting rules

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 weakness of the capital base of the firm or degree of leverage or risk taken. Off-balance sheet entities were also used by Enron as part of the scandal that brought down that company in 2001.

Self-regulation of derivatives

The U.S. Congress allowed the self-regulation of the derivatives market. Derivatives such as credit default swaps were used to hedge or speculate against particular credit risks. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47 trillion. (Loomis, 2009)

Removal of the Glass Steagall Act

(Eichengreen, 2012) In the days of fixed commissions, investment banks could make a comfortable living booking stock trades. Deregulation meant competition and thinner margins. Elimination of Glass-Steagall then allowed commercial banks to encroach on the investment banks’ other traditional preserves. In response, investment banks branched into new businesses like originating and distributing complex derivative securities. They borrowed money and put it to work to sustain their profitability. This gave rise to the first causes of the crisis: the originate-and-distribute model of securitization and the extensive use of leverage.

Corporate risk-taking and leverage

Leverage ratios of investment banks increased significantly during 2003–07. Debt taken on by financial institutions increased from 63.8% of U.S. gross domestic product in 1997 to 113.8% in 2007. This increased the vulnerability of investment banks to a financial shock. Five top institutions reported over $4.1 trillion in debt for fiscal year 2007, about 30% of USA nominal GDP for 2007. Lehman Brothers was liquidated, Bear Stearns and Merrill Lynch were sold at fire-sale prices, and Goldman Sachs and Morgan Stanley became commercial banks, subjecting themselves to more stringent regulation. Fannie Mae and Freddie Mac, 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.

Different names, one purpose (of investment portfolios)

One such investment portfolio was adjustable-rate mortgage; the bundling of subprime mortgages into mortgage-backed securities or collateralized debt obligations for sale to investors, a type of securitization; and a form of credit insurance called credit default swaps. The CDO in particular enabled financial institutions to obtain investor funds to finance subprime and other lending, extending or increasing the housing bubble and generating large fees. Approximately $1.6 trillion in CDO’s were originated between 2003 and 2007. The pricing model for CDOs clearly did not reflect the level of risk they introduced into the system.

Another example relates to AIG, which insured obligations of various financial institutions through the usage of credit default swaps. The basic CDS transaction involved AIG receiving a premium in exchange for a promise to pay money to party A in the event party B defaulted. However, AIG did not have the financial strength to support its many CDS commitments. This is analogous to allowing many persons to buy insurance on the same house. Speculators that bought CDS insurance were betting that significant defaults would occur, while the sellers (such as AIG) bet they would not.

Mark-to-Market Accounting

Accounting rules require companies to adjust the value of such securities to market value, as opposed to the original price paid. Firms could use their own judgment in valuing assets. Many large financial institutions recognized significant losses during 2007 and 2008, as a result of marking-down MBS asset prices to market value. For some institutions, this also triggered a margin call, where lenders that had provided the funds using the MBS as collateral had contractual rights to get their money back. The combination of losses and margin calls resulted in further forced sales of MBS and emergency efforts to obtain liquidity. Writing down the assets presented both liquidity and solvency challenges.