The Great Recession Essay Example

Factors That Contributed To the 2008 Global Financial Crisis

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Factors That Contributed To the 2008 Global Financial Crisis

The main factors that contributed to the crisis are as follows:

1. Expansive Monetary Policy

The principal framework for failures in credit flows resulted from the price bubble in the US housing boom. From 2001, the Federal Bank was slow to tighten the monetary policy and this set the stage for housing price boom. By proselytizing the benefits associated with home ownership, the government stimulated the demand for new houses (Financial Crisis Enquiry Commission 2011). Moreover, lenders of different investment securities offered risky loan options, as well as, a wide range of borrowing incentives. This caused loan securities to decline substantially during the boom period, which peaked from 2005-2007. In other cases, the use of automated loan approval systems necessitated huge loans to be made without appropriate documentation and approval. Subsequent failure of borrowers to honor their loans resulted in severe debts, which set the financial crisis in motion (Dicken, 2007).

2. Flawed Financial Innovations

The other factor which contributed to the crisis was the rapid manipulation of certain investment instruments such as derivatives and securitizations. The manipulations were done before financial markets could note irregularities in the design of those instruments. The flaws made it difficult to determine the prices of the instruments (Ross, 2009). Additional banking innovations, most notably the practices of the derivative industry worsened the mortgage lending problems by shifting risks in directions that became complex to understand. The securitization of mortgage loans quickly spread from the mortgage industry to other loans such as the credit card receivables, student loans and commercial paper issuance. Packaging of mortgage loans for resale as financial securities was a threat to both mortgage borrowers and investors and halted upward trends in the financial market (Zandi, 2008).

3. The Collapse of Trading

Another factor that led to the financial crisis was the collapse of market for certain financial instruments. One such instrument was the auction-rate security, a long-term investment security whose interest rate is set periodically during auctions. The auction-rate security was introduced in 1984 as an alternative debt security for borrowers with long-term financing needs. By 2007, outstanding auction rate securities were worth more than $330 billion (Niall, 2008). This caused the auctions of these securities to fail and consequently, there were fewer bidders than the number of outstanding securities. These securities were consequently priced at a penalty rate-meaning that investors could not redeem their money and the issuers had to pay at higher rates to borrow (Niall, 2008). Financial institutions that had conducted the auctions were forced to commit capital to prevent subsequent failure of the auctions. However, as the banks experienced credit losses due to the collapse of the subprime mortgage market, they could not commit their money to prevent the auctions from failing. As a result, the market for auction-rate securities collapsed.

How a Bursting Bubble In the US Subprime Housing Market Developed Into A Global Credit Crisis

In US, housing market suffered significantly due to the fact that lots of home owners who had obtained sub-prime loans were unable to service them or to make their mortgage repayments (CANSTER 2012). These owners found themselves with negative equity due to fall of home values. This forced banks to reclaim houses and lands due to high number of borrowers defaulting on loans. However, the values of those properties were of lesser values in market than when the loans were being obtained. This led banks to have a liquidity crisis making it difficult for them to give and get loans due to fall out from the sub-prime lending bubble burst usually known as credit crunch (CANSTER 2012).

Nevertheless, despite collapse of housing being blamed for causing global financial crisis, some experts have continued to study further, what led to events. Furthermore, the crisis in the United States’ financial system quickly spread to other countries because several foreign companies had bought collateralized debt in the US (Niall, 2008). Many of the subprime mortgage loans in the US were sold into financial institutions around the world. As an example, banks in Britain and Iceland had exposure to the mortgage loans and when defaults occurred, the banks lost a lot of money. The other factor that facilitated the spread of the crisis to other counties was the international linking of financial systems. When some banks began to incur losses, they became reluctant to lend money to other banks. The decline in bank lending resulted in serious falls in aggregate demand and hence the global credit crunch. To some extent, global trade contributed to the crisis also. As the United States economy entered a recession, the demand for its export fell. As such many countries experienced declines in international trade. The decline contributed to the global recession (FCEC, 2011).

References

CANSTER 2012, Global Financial Crisis — What caused it and how the world responded,

viewed 29^th Dicken, P 2007. ‘
April 2012 from, http://www.canstar.com.au/global-financial-crisis/Making the World a Better Place’, in Global Shift, 5th edn Financial Crisis Enquiry Commission 2011.
., The Guilford Press, New York, pp. 524-554. Final Report (2011), viewed 29^th April 2012 from, http://www.fcic.gov/report

Niall, F 2008. The Ascent of Money, New York, Penguin.

Ross, G 2009. The Great Crash of 2008, Melbourne, Melbourne University Press.

Zandi, M 2008. Financial Shock, London, Financial Times Press.