Theoretical Transitional Mechanism Of The Financial Crisis

Published Date: 02 Nov 2017

Introduction:

The financial crisis of 2007 - present is a crisis triggered by a liquidity deficit in the United States banking system. It has resulted in the collapse of large financial institutions, the "bail out" of banks by national governments and downturns in stock markets around the world. In many areas, the housing market has also suffered, resulting in several evictions, foreclosures and expanded vacancies. It is considered by many economists to be the worst financial crisis since the Great depression of the 1930. (Pendery, 2009)

It contributed to the failure of key businesses, declines in consumer wealth estimated in the trillions of U.S. dollars, considerable financial commitments incurred by governments, and a significant decline in economic activity (Baily & Elliott, 2009). The collapse of the global housing bubble; which is a type of economic bubble that occurs periodically in the local or global real estate market that is characterized by rapid increases in valuations of real property such as housing until they reach indefensible levels relative to incomes and other economic elements, followed by a reduction in price levels, which peaked in the U.S. in 2006, caused the values of securities attached to real estate pricing to fall thereafter, damaging financial institutions globally. ("This American Life": Giant Pool of Money wins Peabody, 2009).

Questions regarding bank solvency, declines in credit availability, and damaged investor confidence had an impact on global stock markets, where securities suffered large losses during late 2008 and early 2009. Economies worldwide slowed during this period as credit constricted and international trade declined (Prego, 2009). Critics argued that credit rating agencies and investors failed to accurately price the risk involved with mortgage -related financial products, and that governments did not adjust their regulatory practices to address 21st century financial markets (Declaration of the Summit on Financial Markets and the World Economy , 2008).

The main reasons of the crisis:

The immediate cause or trigger of the crisis was the bursting of the United States housing bubble which peaked in approximately 2005–2006. High default rates on "subprime" (which is making loans that are in the riskiest category of consumer loans and are typically sold in a separate market from prime loans); and adjustable rate mortgages (ARM) (which is a mortgage loan where the interest rate on the note is periodically adjusted based on a variety of indices) began to increase quickly thereafter. An increase in loan packaging, marketing and incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms. However, once interest rates began to rise and housing prices started to drop moderately in 2006–2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated, and ARM interest rates reset higher (WALLACH, 2007).

Low interest rates and large inflows of foreign funds created easy credit conditions for a number of years prior to the crisis, fueling a housing construction boom and encouraging debt-financed consumption (Bush's, 2008). While the housing and credit bubbles built, a series of factors caused the financial system to both expand and become increasingly fragile, a process called finacialization which is a term sometimes used in discussions of financial capitalism which developed over several decades. Policymakers did not recognize the increasingly important role played by financial institutions such as investment banks and hedge funds, also known as the shadow banking system.

All of the previously mentioned reasons in addition to the growth of the housing bubble, easy credit conditions that took place in between the years from 2000 to 2003 where the lower interest rates encourage borrowing when the Federal Reserve lowered the federal fund rate target from 6.5% to 1.0% (Board, 2008). As well as the sub-prime lending, predatory lending which is a practice of unscrupulous lenders, to enter into "unsafe" or "unsound" secured loans for inappropriate purposes (John D. Hawke, 2000). Financial innovation and complexity which is an ongoing development of financial products designed to achieve particular client objectives, such as offsetting a particular risk exposure. Incorrect pricing of risk which refers to incremental compensation required by investors for taking on additional risk, which may be measured by interest rates or fees. Finally commodity bubble price bubble was created following the collapse in the housing bubble i.e: the price of oil.

Figure 1 [1] 

Figure 2 [2] 

The theoretical transitional mechanism of the crisis on various markets and various sectors in the economy:

The crisis had a tremendous worldwide effect on the global financial institutions and not only the U.S. The International Monetary Fund estimated that large U.S. and European banks lost more than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009. These losses are expected to top $2.8 trillion from 2007-10. U.S. banks losses were forecast to hit $1 trillion and European bank losses will reach $1.6 trillion. The IMF estimated that U.S. banks were about 60 percent through their losses, but British and euro-zone banks only 40 percent (Cutler, Slater, & Comlay, 2009).

Initially the companies affected were those directly involved in home construction and mortgage lending such as Northern Rock and Countrywide Financial, as they could no longer obtain financing through the credit markets. Over 100 mortgage lenders went bankrupt during 2007 and 2008. The crisis hit its peak in September and October 2008. Several major institutions failed, were acquired under duress, or were subject to government takeover. These included Lehman Brother, Merrill Lynch, Fannie Mae, Freddie Mach, Washington Mutual, Wachovia, and AIG. (Altman, January/February 2009).

As a logical sequence wealth was affected as well. There is a direct relationship between declines in wealth, and declines in consumption and business investment, which along with government spending represent the economic engine. Between June 2007 and November 2008, Americans lost an estimated average of more than a quarter of their collective net worth. By early November 2008, a broad U.S. stock index the S&P 500 was down 45 percent from its 2007 high. Housing prices had dropped 20% from their 2006 peak, with futures markets signaling a 30-35% potential drop. Total retirement assets, Americans' second-largest household asset, dropped by 22 %, from $10.3 trillion in 2006 to $8 trillion in mid-2008. During the same period, savings and investment assets lost $1.2 trillion and pension assets lost $1.3 trillion. Taken together, these losses total a staggering $8.3 trillion. (Altman, January/February 2009).

The status of the business cycle before, during, and after the 2008/2009 crisis

Economic cycle widely known as business cycle is economy-wide fluctuations in production or economic activity over several months or years. These fluctuations occur around a long-term growth trend, and typically involve shifts over time between periods of relatively rapid economic growth commonly known as expansions or booms and periods of relative stagnation or decline or recession.

The following figure shows the European Union business cycle. Figure 3 is a combination between economic sentiment and real GDP growth which shows that before the financial crisis the business cycle in the EU area was experiencing an expansion that started in 2005 that started out of a small trough; the boom reached its peak in 2007 which was the beginning of the financial crisis where after that a declining trend started to take place during that financial crisis. By the beginning of 2009 business cycle started to boom once again the steady upward trend in the ESI suggests that the year on year GDP growth will have continued to recover in the fourth quarter of 2009 but, because of its low starting level, will still have been negative which mean that the market started to reveal from its defects that caused the financial crisis.

Figure 3 source: European Commission