The financial crisis that hit the globe late in 2007, grossly affected the financial markets stability across the globe. As governments made attempts to salvage the crisis, it became apparent that financial institutions were amongst the most hits. According to the IMF report, the stock markets in the developed nations declined by between 50-75%, the USA and UK included (International Monetary Fund 2009). Other than this, mortgage holders default their payments putting the banks at a very tricky position. The US alone is believed to have lost up to 416.2 trillion worth of equity in 2008. Several investment banks collapsed while the high street banks had to be rescued through government sponsored packages amounting to more than $1 trillion. Several months, up to July, 2008, the sudden decline in the house prices resulted into a loss of up to $2.4 trillion, offsetting the bank’s balance sheets (Foster & Magdoff 2009). A case in hand to show the actual impact of the financial crisis is Bear Stearns whose share prices declined by up to 80% prior to its acquisition by JP Morgan, a rival bank.
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The current stock market’s crush can simply be designed as taking the path of what happened in the 2008 banking crisis, and an indication of what is yet to go through. The crippling of the financial system in the US and the UK in the period beginning late 2007 was a product of crippling loans. Understanding how the development of the prices of shares, corporate bonds and loans relate to the 2007 financial crisis requires some level of understanding of the subprime lending facilities that played a major contributory role in the financial crisis. The lending and mortgage system in the U.S. and the U.K. world has gone through the significant changes during previous decades – the old system where banks used balance-sheet money to lend has been replaced with a system where mortgages are securitized, i.e. transformed into financial instruments, and sold to investors (Greenlaw, Jan, Anil, & Hyun 2008). The process of securitizing mortgages includes a long chain of intermediaries and the risk of the mortgages, thus becomes transferred far away from the actual source. To provide safety, the mortgage instruments were hedged with either credit derivatives or by companies specialized in insuring financial instruments, e.g. monoline insurers, further increasing the distance between the asset (e.g. mortgage) and the investor.
At the beginning of the 21th century, rates of interest in the United States and the United Kingdom were substantially reduced and as a result, loans, credits facilities as well as mortgages facilities were easily accessible. With the citizens borrowing at very low costs, the real estate business blossomed and continued to flourish in the period between 1996 and 2006. (Morris& Hyun 2009). It is this rapid growth in subprime lending as access to montage market that various experts believe to have triggered the sudden downturn in 2007 (Demynyak & Hemert 2008). However, unlike the US, where subprime lending was occasioned by specialized mortgage brokers and investment banks which were unregulated, in the UK, subprime lending was mainly occasioned by regulated deposit taking banks (Shin 2009).
According to the Economist magazine, it was the increase in the supply of credit that enabled the rapid growth of these aggressive lending instruments (Foster & Magdoff 2009). Since 2003, different variations of ARMs has accounted for two-thirds of all loans in the United States. In 2004, non-prime mortgages continued to grow intensively. A particular ramp up in the number of negative amortization loans and ARMs was offered in the subprime market. This loosening in lending standards resulted in mortgages with higher relative probability of defaults (Foster & Magdoff 2009). For example, data released by the Mortgage Bankers Association reveals that in the 3rd quarter of 2007, 43% of the adjustable rate mortgages extended to subprime borrowers started the foreclosure process. In early February of 2008, Fitch Ratings predicted that 48% of subprime loans fully securitized by major financial institutions in 2006 will go into default. In 2006, the subprime mortgages reached 20.1% of the total mortgage market in the U.S. from 7.4% four years earlier.
With signs of catastrophe beginning to show at the beginning of 2007, households begun defaulting their mortgages, and as a result, the investment bank had to alter strategies. Most of the crisis then revolved around financial liberation as well as substantial expansion of credit(Foster & Magdoff, 2009). This was subsequent by This is often accompanied by an exchange rate crisis as governments choose between lowering interest rates to ease the banking crisis or raising interest rates to defend the currency. Finally, a significant fall in output occurs and the recession lasts for an average.
The situation highlighted deeper into the mortgage market, mortgage and asset derived instruments, money market instruments utilized in funding, as well as institutional setting surrounding the products, as well as markets. The worldwide financial system is large in size, as well as complexity and description of the system in entirety is an effort too big for context of this paper. In the United States, the lender of the last resort to the banks is the Federal Reserve Discount Window which could be used by commercial banks only prior to 2008. It enables banks to borrow against collateral that the market will not finance (Foster & Magdoff, 2009). Up and until 2008, due to regulation deficiencies, commercial banks were none-eligible for conventional discount loans in the United States. However, on March 16, 2008 the Federal Reserve attempted to establish the discount window for investment banks, as well as brokers and hence, put in place the Primary Dealer Credit Facility (Foote, Gerardi, & Willen, 2008; Adrian & Hyun, 2008). This facility allows the borrowers to pledge a substantially broad set of collateral which may include “investment-grade corporate securities, municipal securities, mortgage-backed securities and asset-backed securities for which a price is available” (Federal Reserve Bank of New York, 2008). Whenever banks are caught up in financial problems and face a lack of liquidity to meet their withdrawals as well as contractual obligations, they are allowed to borrow from the central bank (Adrian & Hyun, 2007).
As described in this paper, the U.S. house prices increased dramatically during the late 1990’s and the beginning of the 2000’s, and along with this phenomenon the amount of mortgages originated increased heavily – the amount of mortgages originated reached $3,945 billion in the peak year of 2003, an increase by approximately 400% in 9 years(Foster & Magdoff, 2009; Adrian & Hyun, 2008). The subprime share of the total origination increased as well in 1994 the subprime share of all mortgage originations was 4.5%, during the years 2004-2006 the subprime share was between 18.2% and 21.3% (Adrian & Hyun, 2009). The increase in subprime mortgage originations might very well have been a contributing factor to the rising house prices (as new borrowers entered the housing market), and the relatively high risk of subprime mortgages implies that the overall risk of the mortgage market increased with the subprime share (Goodhart 2008). The U.S. home-ownership rate reached all-time-high in 2004, at 69.2%.
The mortgage-related issuance in the U.S. bond markets followed the increase in the total mortgage origination during the peak year of 2003 the mortgage-related issuance reached $3,166 billion, thus accounting for 80% of total origination (Packer, Stever, & Upper 2007). During the years 2004-2007 the share of total mortgage-related issuance made by non-agency firms (i.e. other than GSEs) were at historically high levels of between 28% and 43% – i.e. private actors constituted a larger part of the market than usual. The CDO issuance reached its peak in 2006 at $521 billion (an increase of 92% compared to the previous year), a number that two years later (in 2008) had decreased to $61 billion (Bank of England 2008). These numbers imply that there was a surge for CDOs prior to the crisis. The implied surge is enhanced by the fact that the total amount of ABSs and mortgage-related debt outstanding in the U.S. reached $11,569 billion in 2008, an increase of 300% since 1996 (these numbers should not be confused with the peak in mortgage-related issuance that occurred in 2003 (Buiter 2008).
With the plummeting of property values in 2006 and 2007, subprime mortgage payers defaulted their repayments posing an unanticipated liquidity risk. This failure stimulated a chain of reactions characterized by a substantial decline in cash flows from the mortgages. It is important to note that this decline was a clear danger signal ahead, as the mortgages held important cash which could be used to pay off derivative instrument obligation (Crockett 2000; Boyce 2008). With the plummeting in property value and also the subsequent effect on mortgage payments, the values of the mortgage supported derivate instruments similarly fell as investing parties attempted to liquidate their positions within these instruments in a relatively illiquid market (Foster & Magdoff 2009). Threats emerged from two forms here: firstly, is the provision allowing investors to recall their investment anytime, and secondly, is the illiquid nature of the market at the time that the first threat became a reality.
As it is evidenced in Bear Stearns case, a conventional Liquidity often starts with a negative event which can take on various forms, as well as shapes. The consequential coverage, as well as publicity amounts to pressure on not merely the share price, but similarly the asset portfolio reflected on the institution’s balance sheet as various players in the market take defensive cover by disposing off their individual inventories or even aggressive bets through short selling of the securities subject to scrutiny. In the process, the rating agencies will most likely downgrade the issues leading to a reduction or even cancellation of the counterparty lines. Even in instances where the lines are not cancelled, provided the write down in value is displayed by the market, calls for margin as well as collateral are likely to come in and add to the already existing liquidity pressure (Peston 2008).
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