Question

1) List and discuss the various reasons that contributed to the financial crisis that occurred in 2008.

2) ) Is the stock market "out of control?" How can the poor benefit from this financial institution?

Note :- Please avoid Plagiarism / copy paste

Answer 1

Greetings for the day,

There were various causes for the financial crisis that occurred in 2008:

SUB-PRIME MORTGAGE:

G-20 summit (2008) viewed that the current global economic crisis has originated due to sub-prime mortgage in the USA in 2007. With the easy availability of credit at low-interest rates, real estate prices in the US had been rising rapidly since the late 1990s and investment in housing had assured financial return. Kunt et al., (2002) reported that US home-ownership rates rose over the period 1997-2005 for all regions, all age groups, all racial groups, and all income groups. Banks went out of their way to lend to sub-prime borrowers who had no collateral assets. Low-income individuals who took out risky sub-prime mortgages were often unaware of the known risks inherent in such mortgages.

REPACKAGING OF LOANS:

The mortgage market crisis that originated in the US was a complex matter involving a whole range of instruments of the financial market that transcended the boundaries of sub-prime mortgage. An interesting aspect of the crisis emanated from the fact that the banks/ lenders or the mortgage originators that sold sub-prime housing loans did not hold onto them.

They sold them to other banks and investors through a process called securitization.

EXCESSIVE LEVERAGE:

Global economic outlook (2008) reported that the final problem came from excessive leverage. Investors bought mortgage-backed securities by borrowing. Some Wall Street Banks had borrowed 40 times more than they were worth. In 1975, the Securities Exchange Commission (SEC) established a net capital rule that required the investment banks who traded securities for customers as well as their account, to limit their leverage to 12 times. However, in 2004 the Securities and Exchange Commission (SEC) allowed the five largest investment banks – Merrill Lynch, Bear Stearns, Lehman Brothers, Goldman Sachs and Morgan Stanley – to more than double the leverage they were allowed to keep on their balance sheets, i.e. to lower their capital adequacy requirements.

MISMATCH BETWEEN FINANCIAL INNOVATION AND REGULATION:

It is not surprising that governments everywhere seek to regulate financial institutions to avoid crisis and to make sure a country’s financial system efficiently promotes economic growth and opportunity. Striking a balance between freedom and restraint is imperative. Conway (2009)

Reported that financial innovation inevitably exacerbates risks, while a tightly regulated financial system hampers growth. When regulation is either too aggressive or too lax, it damages the very institutions it is meant to protect.

FAIR VALUE ACCOUNTING RULES:

Fair value accounting rules require banks and others to value their assets at current market prices. The broad aim of fair value accounting is to enable investors, financial system participants, and regulators to better understand the risk profile of securities to better assess their position. To achieve this, financial statements must, in the case of instruments for which it is economically relevant, be sensitive to price signals from markets, which reflect transaction values. Investors and regulators hold that the fair value accounting standard should not be weakened because it is a key component of accurate and fully transparent.

The requirements of fair value accounting ensured that what began initially as a sub-prime crisis morphed into a general credit deterioration touching prime mortgages and causing their credit downgrades and system-wide markdowns.

FAILURE OF GLOBAL CORPORATE GOVERNANCE:

The financial system of the USA has changed dramatically since the 1930s. Many of America's big banks moved out of the "lending" business and into the "moving business". They focused on buying assets, repackaging them, and selling them while establishing a record of incompetence in assessing risk and screening for credit-worthiness. Hundreds of billions have been spent to preserve these dysfunctional institutions. Singh (2008) told that nothing has been done even to address their perverse incentive structures, which encourage short-sighted behaviour and excessive risk-taking. Prudential oversight was lax, allowing poor lending standards, the proliferation of non-transparent securitization structures, poor risk management throughout the securitization chain, and the build-up of excessive leverage by financial institutions.

TYPICAL CHARACTERISTICS OF US FINANCIAL SYSTEM FAILURE OF GLOBAL CORPORATE GOVERNANCE:

One of the reasons for the current crisis in the advanced industrial countries related to the failures in corporate governance that led to non-transparent incentive schemes that encouraged bad accounting practices. Rajadhyaksha (2008) studied that there is an inadequate representation and in some cases no representation of emerging markets and less developed countries in the governance of the international economic institutions and standard-setting bodies, like the Basle Committee on Banking Regulation.

The IMF has observed and stated in The Hindu, (March 11, 2009) that market discipline still works and that the focus of new regulations should not be on eliminating risk but on improving market discipline and addressing the tendency of market participants to under-estimate the systemic effects of their collective actions. On the contrary, it has often put pressure on the developing countries to pursue such macro-economic policies that are not only disadvantageous to the developing countries but also contribute to greater global financial instability.

VIII. COMPLEX INTERPLAY OF MULTIPLE FACTORS:

It may be said with a measure of certainty that the global economic crisis is not alone due to the subprime mortgage. There are a host of factors that led to a crisis of such enormous magnitude. The declaration made by the G-20member states at a special summit on the global economic crisis held on 15th November 2008 in Washington, D.C. identified the root causes of the current crisis and put these in a perspective. During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence.

2. Is the stock market "out of control?" How can the poor benefit from this financial institution?

The stock market crash 2008 was one of the biggest drops since today. The chain reaction of events that took place during the period wiped off the retirement savings of most Americans and reduces the saving of many households and affect the economy adversely.

The major crash occurred due to the major fall of dow jones to 777.8 in a single day trading and the rejection of bank bailout bill by the congress. But the signs were visible from the time before the crash hit the market.

As compared to the previous stock market crash i.e. 1929 and black Monday 1987 this stock market crash was the worst in which dow jones falls to its maximum value.

The financial chaos rise due to stock market crash 2008 led to:

1. Massive job loss
2. Mortgage default
3. The downfall of investment firms
4. The bankruptcy of many automakers

In all, the crisis of the stock market pushed the World Bank towards the edge of collapse.

But the main question is how the stock market crash that we have already seen in the above reasons for the crisis.

Impact of the financial crisis on poverty:

The poverty impact of the crisis in a developed country will depend on how it affects both average consumption and the distribution of consumption relative to the mean. The World Bank has made projections for average consumption at country level, which can be compared to the Bank’s pre-crisis projections to assess the expected impact of the crisis. We use the World Bank’s latest growth projections for 2009 and 2010 (as of mid-April 2009) as the “post-crisis” growth rates while the counterfactual (pre-crisis) projections for those done by the Bank in December 2007 for 2009 and 2010. We have used the growth projections for private consumption per capita. Consumption is more appropriate than GDP for predicting the short-term impacts on poverty since the shock to GDP is unlikely to be passed on fully to consumption in the short term.

For each country, we project the distribution in levels forward to estimate the poverty impacts of the crisis given the pre-crisis and post-crisis growth rates, keeping the relative distribution unchanged from the latest available household survey. This is done at the country level, for each of over 100 countries, allowing for different initial conditions. The country-level results are then aggregated to obtain the overall impact.