Financial Crisis

Free «Financial Crisis» Essay Sample

Root Cause Analysis

To begin with, it is vital to understand the deep meaning of the financial crisis of 2007-2009. This period also refers to the Global Financial crisis and it is considered to be the worst crisis since the 1930’s Great Depression. The catastrophe caused collapse of reputable financial institutions that were rescued by bank bailouts through the national governments. However, despite the efforts of governments to rescue organizations from the predicament, stock markets collapsed globally. The housing sector suffered from the crisis, which resulted in evictions and extended lack of employment. The crisis resulted in failure of chief occupations, reduction of economic activities leading to a recession, and a decline of consumer wealth that is estimated to amount to trillion of U.S. dollars.

The active stage of financial crisis manifests as a liquidity emergency in 2007 leading to complete withdrawals of three hedge funds (Elliot, 2012). Similarly, the root cause connects the first stage of the crisis to the disintegration of the housing market (Brewer, 2008). The supporting reason for this claim is the support forwarded by the sector to the health docket and the banking segment. Slightly before the onset of the catastrophe, significant macroeconomic imbalances evidence the fluctuations in the real property markets. Thus, individuals must appreciate the nature of such imbalances to comprehend the chief cause of the crisis. For instance, about 70% of the U.S. gross domestic product came from the unsustainable household consumption for the last two decades of 2007 (CDBEA, 2007).

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The government policy of increasing ownership rates loosened the lending standards and consequently resulted in the promotion of excessive consumption. Unfortunately, such a change in a policy led to a remarkable decline in the overall saving rates.  There is also evidence of the supply of cheap credit from abroad and home that led to the calamity. Additionally, there was a rise in financial intermediation with the inclusion of derivative products having novel structures. The government with the private sector also played role in the crisis formation by running considerable budget deficits and enormous current account shortfalls (Elliot, 2012).

The predicament thus attributes to two reasons.  The first one is the squandering lending that paved way for people to purchase overpriced property that they couldn’t afford. The second factor is the availability of the extreme land employment regulation that assisted in driving prices up in the majority of markets (Wendell, 2008).

However, it is vital to acknowledge that extravagant lending cannot act alone to bring about severe effects. Thus, disorderly lending had a direct link to the disproportionate land-use parameter. Several metropolitan markets promoted restrictions on land usage, such as setting urban growth boundaries, thus making huge areas excluded from development. House prices hence rose to extraordinary levels and consequently led to sternly elevated exposures to mortgage (Wendell, 2008). Alternatively, the traditionally synchronized markets only experienced meek amplification of housing prices. Such increases were beneficial to the economy bringing the expectations about the possibility of mitigating fiscal losses if the nation and the global market sustained markets in a similar way.

Why the Financial Crises Affect Us So Badly?

The financial turmoil affects us so terribly due to a number of reasons. The first reason relates to the bad loans created by banks. Secondly, the ratings agencies became reluctant on their responsibilities and hence never did their duties according to the guidelines. The other reason rests on the misguided incentives by the government that encouraged reckless lending of bank and a monetary policy that maintained a very low interest rate standing for long. Lastly, the calamity destroyed a huge amount of financial assets held by the entire U.S households (Tyler et al., 2013).

Role of the Central Bank

Apparent links of crises to changes in the functions and mandate of the Central Bank (CB) can be derived from the analysis. A good example of the link between the CB and the crisis relates to the blame put on the Central Bank for its inaction in the period of worsening of the 1930’s Great Depression (Stark, 2011). After the despair, the monetary policy operated under the fiscal authorities for nearly two decades.  Therefore, the Central Bank took the mandate to safeguard and stabilize prices in cases of high inflation or in cases of feeble monetary regimes failure.

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Despite the fact that the turmoil partly de-constructed the macroeconomic framework, it never eroded all the features. One of such facets lies in the increasing emphasis on the independent nature of the Central Bank. The institution acts on its accord and does not rely on external forces (Stark, 2011). The other section of the macroeconomic structure is the constancy of centrality for the monetary policy.

The Central Bank’s role of financial stability calls for drafting of monetary policies not only during crisis but also in normal times. The turmoil provided a proof that the Central Bank is the first port to contact in the occurrence of systematic pecuniary crises. The predicaments not only increase economic costs significantly, but also threaten the mechanisms for transmission of monetary plan and the balance sheets of the CB. It is thus legitimate and abiding for CB to prevent such predicaments (Jaime, 2011).

CBs require sufficient direct supremacy of influence in the promotion of financial stability and monetary guidelines. These powers should enable them to get institutional arrangements for shaping and controlling other bodies with authority over similar tools (Jaime, 2011). They hence have a role and capacity for participating in regulatory design and macro-prudential policy.

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Mortgage Lending Collapse

The causes of the calamity interrelate with housing finance. Therefore, one should comprehend the evolution in the mortgage market and the journey to its collapse. The bazaar changes from the traditional model to the novel “originate to distribute” model. The old model, for instance, advocated for holding a 30-year mortgage with a fixed rate. The holding would find facilitation through the usage of loans and savings to fund long-term assets with short-term liabilities. However, this formula collapsed with the disintegration of the thrift industry (BLC, 2009). The fresh model separated mortgage origination from mortgage risks and offered products with attractive terms, such as flexible maturity dates.

The innovative form adapted loan securitization, where banks transferred loans and other assets from their balance sheets to avenues that provided interests to investors. The method paved way for depositories to free their capital for additional assets and loans. The risk of lending was hence transferred from the banks to the shareholders. Securitization also afforded supplementary source of income to institutions in the lending business.

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Unfortunately, the novel mortgage finance collapsed. The busting of the housing bubble indicated the uncertainty in the credit market.  The bubble identifies with the speedy boost in real housing valuations to the extent where they accomplish unsustainable points and then drop. The speculative bubbles refer to the methodical, unrelenting, and escalating divergences of definite costs from their elementary values (Brook & Katsaris, 2005).  Another cause of the subsiding is the failure of the Government Supported Enterprises (GSE) that piloted the drying up of the securitization markets. 

Why the Housing Markets Become Bubble?

The housing market became bubble due to some dynamics. The bubble germinated from the harmless demand rise for real estate. The increase in demand subsequently led to a rise in the prices of households. The increase in cost subjected a speculative belief to individuals that the prices would keep rising and hence majority of residents rushed to purchase homes. The buyers were not only the genuine would-be homeowners but also businessmen who bought speculating real estate to resell at higher prices. This massive rise in the demand was thus the main reason for the housing markets become bubble.

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Unbalance of the Global Financial 

The distortion in the global financial arena affected the credit system. Erroneous credit pricing based on assumptions and mathematical hazardous models contributed to the prevalent mispricing of assets and risks internationally. Suggestion supports a fact that a continued liquidity crisis would propagate an extensive recession (Goodman, 2008). It brought the largest shakeout in the universal banking sector since the meltdown in the saving-and-loan (Cho & Binyamin, 2008). The calamity brought failure fever to all economies, where the hopes for recovery were lost. Governments were forced to act to counter the unbalance. The need to systematically inject capital into the economy arose.

Prevention from Another Crisis

Economists say that even after several years from the worldwide financial emergency, another may occur. The catastrophe may rekindle as the government still controls the mortgage-finance companies, Fannie Mae and Freddie Mac. The politicization of the matter makes it difficult for the government to contract them to controllable sizes due to the huge profits generated by these firms. Surprisingly, ninety percent of the loans receive guarantees from the State. Lacks of disclosure on the money holding in the mutual funds markets also pose a risk of another calamity (Coy, 2013).

The government and the Wall Street may prevent the occurrence of a similar turmoil. Facing out Fannie and Freddie would be a big step by the State to prevent a possible reoccurrence of the disaster. The administration could also make reforms in the money market commerce. The value of net assets should accommodate some funds to float as opposed to the fixed $1 per share. The funds will hence act as bonds and notify investors about the uninsured investments (McCoy, 2013). The Wall Street could prevent the crisis by ensuring that they bind bonds with diverse risk characteristics as a securitization measure. Wall Street must not issue bonds with similar risk status, but when they do, they should take responsibility and buy back the defective products (Weinreich, 2012).

The financial crisis requires preventive measure to be undertaken in order to avoid unimaginable monetary loss and possible bankruptcy of the industry. The company has initiated a systematic risk oversight to mitigate effects of a possible recap. Erecting an integrated focus and strengthening the umbrella supervision for any financial decision are essential for safeguarding the business.

Why Should We Prevent Crisis?

The crisis requires avoidance like a plague. The first reason why we should avoid the catastrophe lies in the pecuniary reduction of people’s living standards. In addition, the reduction in the net worth of households leads to worsening off of the society (Warnock, 2010). Total wealth also faces significant decline due to reduction of human capital and national level of consumption. Moreover, the crisis requires prevention since it brought high costs of joblessness, lost income and awful psychological consequences for the fear of the unknown.

Do We Have Financial Security to Keep Us Safe?”

We are fortunate to financial security to keep us safe. The previous predicament made us launch prevention strategies. The first tactic that aims at shielding us is the reform of the financial regulatory system. Updating our regulatory system ensures that the current financial innovations find fresh governing governance that would avoid another disastrous event. The current process of eliminating bailouts also serves as security since it covers taxpayer’s interests.

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In conclusion, the discussion on the global financial is vital to all company employees. The executive leadership of every organization should take the initiative and educate their staff about the topic to design ways of safeguarding the firm against this external negative force.  The worker will hence learn that the root causes of the calamity associate with the spendthrift lending and land development regulations. In addition, the report highlights the roles of the central bank and eventually displays methods of preventing a possible recap of the catastrophe.