08 Oct 2009

Sample Essay: Financial Crisis

The united states of america is undergoing  a major financial crisis in history that has affected both it’s economy and that of the world .It is mainly characterized by a contracted liquidity that has occurred in the global credit markets and  the banking system. There are several factors that have led to the world economy being ruined. They include the reduction in  housing market,  undertaking lending and borrowing activities that are risky   and excessive individual and corporate debt levels. There are various stages that the crisis has passed through and major weaknesses have been exposed both in the global financial system and  the regulatory framework.

The USA financial crisic  began in 2005 to 2006 by the bursting of housing bubble .

Many years before this, there was a decline in lending standards and  loan incentives had increased whereby borrowers were encouraged by the initial terms and  long-term routes taken in the rise of housing prices. They assumed  difficult mortgages which they believed  they could refinance quickly at a more favorable terms. Refinancing became more difficult when the interest rates began to rise and the housing prices  began to go down. This occurred in many states in the united states.This  resulted in an increase in defaults and foreclosure activity, the initial terms expired and the prices of the homes did not rise as it was expected. The adjustable rates mortgages interests went higher. The global financial crisis in 2007 and 2008 was triggered by the foreclosures which accelerated  in the late 2006.

Causes of the crisis

There are a number of factors that  led to the crisis. These factors include: boom and burst in the housing market,policies of central bank, government policies, excessive underwriting  of high risk mortgages, flawed oversight by mortgage brokers, inaccurate credit ratings, securitization practice, High risk loans and excessive housing speculation

Boom and Bust in the housing market

The crisis was caused by a surplus inloanable funds and easy credit that was created by a combination of low interest rates and large capital inflows from other countries. A major factor that contributed to the increament in rates of home ownership and demand for housing is the subprime borrowing. The rate increased from 64 percent to 69.2 percent.Between 1997 and 2006,the home prices in the united states of america increased by 124 percent.  Most of the homeowners in turn used the increased property value in refinancing their homes with interest rate that was  much  lower. Most home owners went further and took a second mortgage against the value added on the first mortgage and used the funds for consumer spending. In 2007 the united states’ house hold debt rose to 130 percent versus the 100 percent that was earlier in the decade.

Surplus inventory of homes came from excessive building activities that was carried out during the boom period and caused a decline in home prices beginning in 2006 summer.  A combination of easy credit and the assumption of  appreciation of housing prices led to many subprime borrowers obtaining adjustable rate mortgages which they could not manage to pay after  the initial period of incentives.  Refinancing  became difficult when the housing prices began depreciating in most parts of the united states. This led to inability of many homeowners to refinance their loans and began to default on the loans as the loan rates became higher . As of march 2008, approximately 8.8 million homeowners had  zero or negative equity. This was almost 10.8 percent of  homeowners whose homes are said to be worth less than their mortgage.

The supply of housing inventory available had been increased by the increasing foreclosure rates and the unwillingness of homeowners  to sell their homes at a reduced market prices. In 2007 in comparison to the year before, new home sales volume went down by 26.4 percent while the unsold new homes inventory stood at 9.8 percent  by January 2008 based on the sales volume of December 2007 which was the highest level since 1981. There was a record of four million unsold homes  meant for sale. Of the 10 million unsold houses,  2.9 million homes were vacant. The increased supply of home inventory led to downward pressure on prices which resulted in majority of the homeowners being at risk of default and foreclosure. Currently the prices are  seen to be gradually falling and are  expected to continue declining until the reduction of inventory of surplus homes into a more typical level.

Excessive housing speculation

Speculation is considered as a contributing factor in real estate crisis.  In the year 2006,22 percent of homes were purchased and14 percent remain vacant while in the year 2006,28 percent of homes were purchased while 12 percent remained vacant.

This means that approximately 40 percent of home purchases were not primarily residential. Initially the homes were not treated as investments like stocks but the behavior changed during the housing boom.

High risk loans

There are several factors that have prompted the lenders to impose an increased array of higher risk loans to high risk borrowers. The Clinton administration was forced to offer loans to minorities so that they could owwn homes. There was a study carried out by the federal reserve that indicated that the average difference in mortgages interest rates between the subprime and prime mortgages went down from 2.8 percent to 1.3 percent. This means that the risk premium  required by the lenders to give out the subprime loan declined.

The first example in addition to the borrowers is that the lenders have offered increasingly high risk loan options and incentives that include no income, no job and no assets loans. Secondly there is the interest-only adjustable-rate mortgage which has allowed the homeowners to pay only the interest during the initial period. Thirdly there is payment optional loan which allows the homeowner to pay a variable amount but any interest that is not paid is added to the principle. The banks then made efforts to ensure that they no longer have income information about some borrowers but the question was if this had helped them get the profits in money, economic benefit or even fraudulent gain.

Securitization practice

Securitization is one of the causes of the crisis and it is a structured finance process. This is where assets receivables are acquired and classified into tools and then offered as collateral for  investments of the third party. There has been an increase in the subprime mortgage share from 54 percent to 75 percent. It was then stated that the securitization of  home loans that was offered to the people with poor credit was to be blame for the current global credit prices.

Inaccurate credit ratings

The credit rating agencies are pressurized to give ratings of investment grade to transactions of securitization which are based on subprime mortgage loans. From the year 2007 and 2008 the rating agencies dropped the credit ratings on $1.9 trillion mortgage backed securities. This forced the financial institutions to lower the value of their MBS. As a result of this,these institutions are required to  acquire some additional capital so as to maintain stable capital ratios. If the sale of new stock shares are involved, the value of shares  existing is reduced, which means that the ratings downgrade puts pressure on MBS and the stock prices  to lower.

Flawed oversight by mortgage brokers

There is no direct correlation between performance of the loan and the income. It was claimed by the mortgage bankers association chairman that the brokers profited out of the home loan boom but did not work hard to examine whether the homeowners could repay the loan.

Excessive underwriting  of high risk mortgages

The underwriters  determine if the lending risk is acceptable to a particular borrower under some parameters. They consider risks and terms that fall under credit, capacity and collateral. The automated underwriting generated 40 percent of all subprime loans in 2007.  Great willingness to rely on shortcuts made the underwriters to approve borrowers  under a system that is less automated  resulted to the meltdown of the subprime mortgage.

Government policies

There are some critics who says that the current regulatory system is outdated. In September 2008 , president George W. Bush stated the that there will be time to update the financial regulatory structures after the current crisis is over. He also said that failure of one company jeopardizes the whole financial system. He goes further and states that the security and exchange commission have finally conceded that self regulation of the investment banks have largely contributed to the crisis. Another economist criticized the repeal of the glass-steagall act to have contributed to the meltdown of subprime.

Policies of central bank

The central banks is concerned with managing the inflation rate and avoiding recessions. They lend at last resort so as to ensure liquidity and hence they are not involved so much in avoiding the asset bubbles. They have decided to react after the burst of the bubbles so that they can minimize collateral impact on the economy.

The lowering of interest rates earlier in the decade  was done by the federal reserve  and this was a contributing factor to the rise in home prices. This was done to diminish the blow of the collapse of the dot-com bubble and finally combat the deflation risk. All that central bank believed was that the interest rates will be lowered due to the low rate of inflation. However, the inflation figures of federal reserve were flawed. The president and the CEO of the federal reserve bank of Dallas stated that the interest rate policy of federal reserve was misguided during this time by low inflation data hence contributing to the housing bubble.

Effects of the crisis

Decline in homeowners net worth. The reduction of the housing prices leads to the consumers fail to qualify in borrowing much against the equity of their homes which occur mainly due to consumer spending which then lowers the pressure on economic growth. There is also the decline in minority home ownership.  The level of foreclosure is disproportional in some minority neighborhoods especially the african americans populations. Immigrants either legal or illegal are at a high risk  of loosing their jobs. A number of factors that comes from subprime mortgages have brought about problems in the market commercial real estate. Some of the borrowers are now turning to arson as a way to escape the mortgages that they can’t pay. There is also a slash of over 65400 jobs in the united states.

The crisis could possibly lead to collapse of many businesses and consumer loans which may lead to bank failures in europe and a slow down in the world economy.According to international business times,the UN secretary general Ban Ki-moon has expressed deep concern on the financial crisis in the united state which has had a great inpact on the world economy since it is the largest donor country and has a major role in fighting poverty.Due to this,the poor country will continue to suffer in the hands of poverty as the united states will be spending a lot of money in trying to fix it’s financial crisis.

The current USA financial crisis has a major impact on the politic of the country especially with the general election being around the corner.The crisis might be used as a campaigh tools by the two major contestants for presidency.The crisis is seen as a failure of  President Bush economic  policies which resulted to overspending of tax payers money and so it might be used as a campaigh tool against the republic party presidential candidate John McCain who is believed to share the same policies with president bush..According to several polls conducted based on economic perspective ,Senator barrack Obama has a slight lead against John McCain and this may be attributed to the current financial mess which many people believe that it can be fixed by senator Barrack Obama.

President George  Bush  tried to come up with a plan for a bail out package worth $700 billion in order to buy the mortgages so as to save financial institutions from collapse but it was rejected by the house of representatives whereby 228 voted against the motion while 205 members voted for the motion.This was a major political blow to George W Bush presidency as most of the republicans voted against the motion.

Work cited

http://hubpages.com/hub/A-Simple-Explanation-of-The-subprime-Financial-Crisis-Part-1

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