Introduction
The purpose of this research paper is to review the global financial crisis that took place in late 2007. The financial crisis has been termed as the most drastic economic crisis that the world has experienced since the recession of 1930. The recession saw many companies going bankrupt and shutting down as they lacked the financial capacity to continue operating in that economic environment.
The unemployment rate increased drastically as some companies opted to downsize their workers so as to remain in business. The interest rates on mortgages and bank loans also went up as a result of the financial crisis which saw many people being unable to repay their mortgages and bank loans. This resulted in banks in the United States repossessing some of the houses whose loans had default payments.
The financial crisis also saw the downturn of major stock markets around the world such as the New York Stock Exchange, the Japan Stock Exchange and the decline of the European currency and the British Pound. The financial crisis has been considered by most economists to be the worst crisis since the Great Depression as it contributed to the failure of major financial institutions in the U.S. and the decline of consumer wealth which was estimated to be in the hundreds of billions in U.S. dollars.
The crisis also saw the financial commitments that were incurred by most governments around the world that lead to a decline in economic growth and activity. Many reasons and causes of the financial crisis have been offered by financial experts and analysts alike some of which will be outline and highlighted in the following section.
Reasons for the Recent Financial Crisis in the U.S.
The financial crisis of 2007 was triggered by a liquidity fall in the banking system of the United States which can be traced back to the deflation of the stock markets in 2000. The global economy during that year began to decline slowly into a recession and the United States Federal Reserve and U.S. central banks reacted to this by lowering their interest rates drastically so as to limit the amount of economic damage.
The low interest rates being offered by the central banks saw an increase in the number of people borrowing mortgages to buy new houses in the U.S. These low interest rates also encouraged the existing home owners in the country to continue refinancing their mortgages at a much lower rate (International Labor Office, 2009).
Financial innovations were developed that would be used to ensure that mortgage brokers earned commissions based on the number of homeowners they brought to mortgage lenders. What these financial innovations failed to factor in was how the new home buyers would repay their mortgages.
The traditional method of mortgage and loan repayment was that banks financed the housing loans through the customer’s deposits which placed a limit in the amount they could lend. However new financial innovations in the industry saw business models being used to expand the funds needed to lend for mortgages and housing loans.
Mortgage lenders immediately began to sell the home loans they got from borrowers to investment banks. The investment banks in return converted the mortgages into mortgage backed securities (MBS) that would be sold to investors who were willing to pay for high yielding products at a low interest rate. The Mortgage backed securities enabled financial institutions around the world to invest in the U.S. real estate industry (Davies, 2010).
The mortgage backed securities continued to increase in the housing and financial sector during 2006 as more and more people continued to access housing loans, mortgage loans and credit card loans. Financial lending and borrowing institutions as well as banks in America were recording huge profits in 2006 as a result of the increased mortgage lending and borrowing activities.
As the credit, mortgage and real estate industry in the United States continued to grow dramatically, the quality of mortgages that were being offered to new home buyers began to deteriorate. Home owners who were making mortgage payments to banks and mortgage lenders became over burdened due to this deterioration.
The first sign that the financial industry in America was going to face a decline was a warning from a bank in Europe in early 2007 that had recorded huge losses from an acquisition of an American sub-prime lender. Four months later, two hedge funds that belonged to an investment bank closed as a result of being exposed to the housing market. Another European bank froze its investment fund withdrawals in August 2007 setting off a panic amongst Europeans.
Such events lead to the beginning of the financial crisis. Major financial institutions that had invested heavily in the real estate business began to record significant losses on their investments. The declining housing prices also resulted in homes being more worthless than their mortgage loans. This decline in prices provided banks and lending institutions with the incentive to foreclose on the mortgage loans and houses (International Monetary Fund, 2010).
The collapse of the housing market caused the value of the mortgage backed securities to go down drastically causing extensive damage to major financial institutions around the world.
The decline in credit availability and the increasing insolvency of most banks in America impacted on the global stock markets resulting in huge investment losses on securities. Worldwide economies began to experience a slow growth as credit activities slowed down drasticically, a situation that initiated the decline of international trade around the world.
Financial experts around the world argued that credit rating agencies had failed to predict the kind of financial risk that would be incurred from the mortgage backed securities and collateral credit payments. Major governments around the world were also criticized for failing to adjust their financial regulations in response to the growing mortgage and credit industry (Steverman & Bogoslaw, 2008).
Impact of the Crisis on Financial Markets and Institutions
A major contributing factor to the global recession was attributed to the widespread use of leverage by most financial institutions so that they could increase their profits. The major financial institutions that make up the financial market include the banking industry, the insurance industry and financial intermediaries such as insurance brokers and mortgage lenders. New York’s Wall Street is viewed to be the epicenter of the global financial market.
Most of the major stock markets in the world are mostly influenced by changes that take place in the New York Stock Exchange market. Wall Street has experienced major growth in the past two decades with banks and financial institutions situated in Wall Street becoming major financial players in the United States and around the world (ILO, 2009).
During the period of low interest rates, most European banks experienced asset growths of 18 percent while their total loans expanded by 6 percent. Between 1996 and 2005 the European and American insurance industry doubled in size with the EU’s financial sector employing more that 5 million people in 2006.
The banking industry in Europe employed 75 percent of the labor market which was an indication of how well the financial market was performing (ILO, 2009). The financial crisis however changed all of this. The employment level went down drastically as most financial institutions were faced with either bankruptcy or huge losses that amounted to $1 trillion dollars. These losses were mostly attributed to the bad loans and the declining rate of the mortgage backed securities.
One of the first casualties of the financial crisis was a medium sized bank in the UK known as the Northern Rock Bank. The bank was experiencing a high leverage on its loans and mortgages a situation that forced it to borrow security from the Bank of England.
This created a lot of investor panic in the UK in 2007 which saw the bank being sold to the public. Northern Rock’s financial problems were seen to be the first of the ensuing financial crisis that would impact heavily on other financial institutions. Between 2007 and 2008, 100 mortgage lenders in the UK faced bankruptcy and foreclosure as a result of the declining mortgage and credit rates.
Major financial institutions that were affected by the crisis included Washington Mutual, Lehman Brothers, AIG, JP Morgan Chase, Countrywide Financial and Freddie Mac. Some of these companies underwent bankruptcy and foreclosure during the critical stage of the recession while others reported huge losses. Withdrawals from money markets were estimated to amount to 144.5 billion U.S. dollars in one week during the low interest period when compared to the previous withdrawal amount of $7.1 billion dollars.
Such high withdrawals interrupted the ability of these companies to replace their short term debt appropriately. “The U.S. government responded to the high withdrawals by extending insurance to the money markets and to the Federal Reserve Bank to ensure for the purchase of commercial paper” (International Labor Organization, 2009).
Bailout Plan to the Financial Crisis
The U.S economic bailout plan which was also known as the emergency Economic Stabilization Act was developed in 2008 to counter the financial crisis. The bailout plan was proposed to resolve the cash flow problem that had affected many financial institutions around the world. The Act gave the United States Secretary of Treasury $700 billion dollars to purchase assets and mortgage backed securities from the banks and financial institutions that were facing financial problems.
The purpose of the bailout plan was to initiate a recovery of the declining U.S. economy and reverse the adverse effects of the financial market on the global economy. The plan was meant to provide liquidity to the already bankrupt or almost bankrupt institutions by giving them financial funding. In return the institutions would meet a set of short term obligations set out by the government that would be used to qualify these corporations for financial assistance (Recession, 2010).
The bailout plan was meant to ensure that the banks and financial institutions facing bankruptcy had their cash flow problems fixed enabling them to survive until the financial crisis was resolved. The institutions that were offered the bailout money were mostly those that had a sufficient amount of assets.
The cost of carrying out a bailout involved turning over the control of the company to the government in return for financial aid. Many people in the United States were pessimistic about the Economic Recovery Act because it meant the government buying out the whole financial sector in the country. This meant that the financial market would be more socialized rather than being capitalist. Investors and money holders were also concerned that the plan would fail to cushion their interests once the banks faced closure (Jackson, 2010).
Financial analysts argued that the government should have let the American banks to face foreclosure as the current financial system had the ability to fix itself without the government’s intervention. They argued that there was no point in spending billions of dollars in fixing a system that had led to the financial crisis in the first place.
There have been varied opinions on whether the bailout plan will succeed in reviving the U.S. economy as well as that of the global economy. Some analysts believe that the money can jumpstart most of the falling banks in America while others have argued that the billions of government funds channeled into saving these financial institutions will lead to future economic problems (Recession, 2010).
Such criticisms emerged after banks that got the money to bailout them out paid seniors managers running the institutions almost $1.6 billion in 2007. The $1.6 billion was paid out to the top managers as either stock option, bonuses and other extravagant benefits such as club memberships an others.
Such extravagant use of the bailout money was due to the autonomous nature of the bailout plan that had a no strings attached effect to the receiving institutions. Some banks used a portion of the bailout money to recapitalize their bank subsidiaries while other banks used the money to purchase smaller and weaker banks in the American banking system (Coates & Scharfstein, 2009).
Conclusion
The research paper has focused on the major reasons that caused the global recession in 2007 to date and how the impact of this crisis on the financial market. The financial sector around the world is underwent a major restructuring as a result of the global recession.
Economies around the world are still recovering from the impacts of the crisis that have left many people jobless and without any homes. The unemployment levels are still high as most companies try to recover from the recession. The effects of the bailout plan proposed to recover the economy are yet to be felt by most banks and financial institutions in the U.S. Financial analysts and experts have noted that if the current liquidity continues, there could e an extended recession which could be worse.
References
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Davies, H., (2010). The financial crisis: who is to blame? Cambridge. UK: Polity Press.
International Labour Organization (ILO) (2009). Impact of the financial crisis on finance sector workers. Geneva: International Labour Organization.
International Monetary Fund (2010). IMF loss estimates. Web.
Jackson, J.K., (2010). Financial crisis: impact on and response by the European Union, Congressional Research Service. Pennsylvania, US: Diane Publishing Recession. (2010). U.S. financial bailout plan. Web.
Steverman, B., & Bogoslaw, D., (2008). The financial crisis blame game. Web.