The 2007-2008 Global Financial Crisis

The global financial crisis of the year 2007-2008 was a complex, multifaceted process. The crisis was an interplay of both macroeconomic and micro-level factors. During this period, there was a proliferation of new financial instruments, which were not accurate in predicting the value of many economic systems. The Global crisis was largely unforeseen and was termed the largest after the great depression of 1930. Though the economic crisis spread globally, it owes its origin to the United States financial environment (Orlowski, 2008).

The housing market in the United States was the origin of the crisis. Unregulated borrowing allowed workers to borrow heavily in order to invest in housing. With the increasing gap in income and wealth, many of the households could not meet their mortgage obligations. This caused values of loaned homes to plummet. Banks repossessed the homes, which held less value than the original loan. As a consequence, the banks suffered a liquidity crisis that made it hard to obtain or give out loans. Many banks caught in the crisis required additional equity to maintain customer confidence amidst decreasing net worth. As a result, liquidity disappeared. Central banks reacted by reducing interest rates and encouraging borrowing in an attempt to elevate liquidity. Investors pumped borrowed funds into financial markets causing the stock markets to become volatile. As a response, securities holders gripped their finances tightly for fear of the future (Obstfeld, Cho & Mason, 2012, p. 81).

Securitization helped propagate the financial crisis to other areas due to increased borrowing between central banks in an effort to boost liquidity. Usually, households bought mortgages at fixed or variable rates of interest governed by the risk of defaulting or credit history. The mortgage lenders would then relieve the risk of defaulters by selling out the mortgages to mortgage bankers. The innovative process allowed the mortgage banker to profit from the sale of the mortgages to investment bankers. Investment bankers, in return, collected mortgages, pooled them together and underwrote them creating a form of security, which they could in turn sell to investors as an asset. These securities, which consisted of thousands of mortgages, were termed as Mortgage-backed securities (MBS). The securities reduced the total risk of defaulting and ensured cash returns, forming lucrative investments. At the same time, banks needed to manage their risks. They developed a Credit Default Swap (CDS), a financial derivative, which they used to insure holders of Mortgage-backed securities in exchange for a fraction of returns from the security portfolios. Owing to poor regulation of the newfound market, large insurance firms such as American International Group (AIG) processed excessive CDSs.

In addition, mortgage lenders realized that the issuers of these securities could handle huge amounts of mortgages. They, therefore, lend more to mortgage seekers. Major financial institutions engaged actively in buying and selling MBS. Unfortunately, the models did not consider what would happen if many mortgage holders default simultaneously. Regulatory bodies also failed in detecting risks in the system with financial institutions raising their leverage ratios to as high as 50. The offer of large profits stimulated dispensation of risky loans causing securitized loans to grow from 50.4 % in 2001 to a peak of 81.2% in 2005. Owing to increasing inequalities between labor and wages, a great number of people with high risk loans defaulted. The collateralized debt obligation (CDO) fuelled by the loans received severe downgrading. Institutions keen to retain a constant leverage quickly sold off massive numbers of assets. The financial losses induced fear of further defaults leading to an upsurge in interbank lending rates. As a result of complexities in calculating risk, banks were reluctant to offer loans to other institutions. The banks could no longer offer security to firms whose collateral was MBS and CDOs. This was a brutal blow to Lehman and AIG. As a consequence, short-term lending by money markets froze (Morrow, 2011).

It is evident that the securitization model, and the ‘originate to distribute’ bank model were the main causes of the financial crisis. At the same time, there was a failure by regulation bodies to come up with sound policies to govern the market. The slack regulatory environment allowed financial institutions to invest in intangible assets. Propagators of the securitization models also failed in conducting thorough analysis to simulate effect on financial status in the event of households defaulting on loans. The rising inequality gap in wealth and income contributed greatly to the crisis. Owing to low profitability of the real economy, the wealthy population increased funds in the high risk investment sectors. Such funds ended up in real estate and securities. Declining levels of real income caused workers to borrow money against their houses as an effort to maintain their living standards. Mortgage purveyors easily convinced households to borrow money against their homes to cater for their bills. The rates of interest were irresistible to many, amidst the declining earnings, paving the way to the development of an asset bubble (Morrow, 2011).

References

Morrow, R 2011, A Critical Analysis of the U.S. Causes of the Global Financial Crisis of 2007-2008, Web.

Obstfeld, M, Cho, D & Mason, A 2012, Global economic crisis: impacts, transmission and recovery, Edward Elgar Pub, Northampton.

Orlowski, T. L 2008, Stages of the 2007/2008 Global Financial Crisis: Is There a Wandering Asset-Price Bubble? Economics Discussion Papers, No 2008-43, Kiel Institute for the World Economy. Web.