Business In context 3
This assignment will be outlining and explaining how the housing market in the United States and Britain along with subprime mortgages contributed to the global economic crises it will be also explaining the how the role of securitisation and collaterised debt obligations go out of control and triggered off what we know now as the global financial crisis or “credit crunch”. I will be mentioning the many contributing factors that triggered of and eventually made the financial economy spiral out of control.
London was the world financial centre meaning that the words currency was linked to the pound, but in 1931 Britain was forced off the gold standard; the gold standard was a system which is a financial method that involved the exchange of paper notes into fixed quantities of gold. When Britain was no longer on the gold standard the great depression soon followed and the worth of the £ declined. After the Second World War Britain was no longer dominating the world's finance and the worlds currency was now linked to the dollar and the United States from there became the world's new financial centre. However America was falling into debt because China lent out huge amounts of money to prosperous America to provide for its spending habits. America spent the money on Chinese made goods, sending the dollars back to China which was lent back to America (The Economist Oct. 24th 2009). The free market meant that there were no government interventions which encouraged deregulation. Deregulation is the exclusion of government rules and regulations that hold back the procedure of market forces making it a “free market” (Economics, 2006).
From the period between 1997 and 2007 banks started to give out loans to the riskiest category of people for mortgages, this is also known a subprime lending. Consumers were able to get loan from the bank without being appropriately assessed. The number of homeowners in Britain and United States was increasing rapidly during his period of time it was very easy to obtain a loan from the bank because there was a lot of liquidity flowing in banks due to high risk investors. Booming mortgage markets fuelled by increasing home prices and low interest rates attracted investors and consumers/borrowers. Securitization was a device that was made to help make loans “more secure” reducing risk by combining debt instruments in a group then issue new securities backed by the group; a constructed finance method that gives out risk by collecting debt instruments in a group, then issue new backed loans by the group (financial-dictionary.com). In the past, people who applied for mortgages had to reveal their financial information. Banks were really cautious with their loans because it could have a negative reflection on the bank's lending reserves. Banks were not in a position to lend out money to every potential customer (Faber, 2009). A system was put into place to purchase mortgages from lenders, releasing up the bank's capital to extend credit to qualified borrowers. This was known as the Federal National Mortgage Association (FNMA). However the Federal Home Loan Corporation (FHLC) would pay money for mortgages from lenders and collect them up. The Federal Home Loan Corporation would then put up for sale the mortgages as mortgage back securitization to the open market. This made available an increase amount of money available for banks to lengthen credit to extra borrowers who would like to buy homes.
Global investors, driven by the U.S strong currency opened a continuous money valve for investment into these securitized mechanisms. With all this free flowing global investment, banks began offering a selection of subprime mortgage products to borrowers and did not go behind the guiding principle set by The Federal National Mortgage Association and Federal Home Loan Corporation. These subprime lending strategies provided an opening of occasion to corrupt investors who were driven by greed consequently there were mortgage frauds and loans were handed out without appropriate background checks. Mortgage backed securities was shown as a liability on the cash flow of housing properties. Larry Finch a banker, separated sets of these mortgage backed securities into risk stages called tranches (Zandi, 2009). Derivatives and collaterised debt obligations had different levels of risk and investors were paid out according to the level of risk they had been willing to take. These derivatives and collaterised debt obligations could be backed by mortgages. Everyone became interested in investing in these security instruments known as derivatives or collaterised debt obligations. Collaterised debt obligations are beneficial backed security backed by receivables on loans, bonds or other debt. Banks package and sell their receivables on debt to investors in order to reduce the risk of loss due to failure of payment. Income on collaterised debt obligations are paid in tranches (www.financial-dictionary.com). There was no significant lending risks for derivatives to the banks, the risks were transferred to global investors who were informed that the level of risk for investing in mortgage backed securities were a step or two higher than investing in treasury bonds (Zandi,2009). Global investors were in no doubt in the U.S and British housing market.
The graph shows the amount of subprime loans that were distributed by various different financial organisations during the period of 2000 to 2006 in the United states, there were not only commercial banks but private smaller institutions tried to make large profits from risky investments. These companies thought that the housing market will help them reap large amounts of profits but they did not forecast the outcome accurately.
This graphs shows the mortgage issued from 1999-2008 in the United Kingdom it shows that the amount of new homeowners in 2004 decreased almost by half but then boomed again during the end of 2006 right up until the summer of 2007. In comparison to the United States it seems as though there was more loaning in the United States due to its size probably. But both the U.K and the U.s was giving out masses of loans to consumers for home ownership.
However in 2007 gaps began developing in parts of the world's financial markets. There was a short stumble in the Chinese stock market the global stocks and bonds had increased in price and financial guaranties were starting to experience bond defaults. The cracks could not be ignored so by summer 2007 the financial shock of the subprime failure echoed globally (Zandi, 2009). Banks were finding it complex to raise back the funds to cover their debts and so they began selling houses that they repossessed from homeowners who were unable to keep up with the repayments due to the increase of interest rates, and they began tightening their lending guidelines to consumers therefore previously eligible borrowers were no longer qualified. Not only was the subprime loans very difficult to get a hold of but the prime loans were in addition trapped in the mesh. In 2007 lending lines of credit began to turn down and banks were going out of business. Homeowners lost their homes, repossession increased by 3 per cent in 2009 according to the guardian (12th November 2009).
Finally another contributing factor to the global financial crises from the years of 2007 to 2009 was shadow banking. The shadow banking system was associated significantly being a part of the cause to the financial crises. Timothy Geithner who was the head person in charge of the NY Federal Reserve Bank during that period of time gave blame of the freezing of credit markets on a “run” on the individuals in the shadow banking system by their corresponding persons in June 2008. The fast rise of reliance of banks and non bank financial organisations on the use of these off balance sheet devices to fund investment plans had made them very important to the credit markets strengthening the financial system as a whole regardless of their presence in the shadows, outside of the regulatory manipulation of governing commercial banking activity. In addition the devices were in a weak position because money that was borrowed short-term in liquid markets was used to purchase long-term loans. This meant that gaps began to form and long term assets had to be sold at very low prices to cover the debts and close up the forming gaps.
Paul Krugman described the “run” as the core cause of the financial crises; he went on to say that shadow banking expanded to compete and even take over conventional banking in importance, politicians and government officials should have realised that they were creating an unstable financial economic environment. They should haves responded by extending regulations and financial and financial protection to cover new organisations (Paul Krugman, 2009).
From the research that I have made known in this assignment I have come to the conclusion that the current global economic crises was set off when banks began to lend out loans to people who would not normally be eligible under the necessary requirements to obtain loans. In 2006 according to the wall street journal 61% of borrowers that were receiving subprime mortgages had a credit scores high enough to qualify for normal standard conventional loans. More people were taking out loans because interest rates were so low so more consumers starting investing in home ownership. The consumer group that these loans were being given to have not been properly assessed and when interest rates began to rise consumers were unable to make the repayments forcing bank to take over the houses which forced the banks to sell these houses at low prices this was so the bank could pay off their debts quickly. There was an increase of money available because more global investors were willing to take risks but when interest began to rise homeowners were unable to keep up with the repayments resulting in the banks repossessing houses. But the banks could no longer work efficiently and became stricter on how they give out their money and the economy is slowly getting to a move steady state. According to FT.com there is a comparative calm to the global financial crises. The United Kingdom is the only European
Union member with a raise in GDP of 1.1 per cent and economists forecast that it will rise to 1.9 per cent for the next year 2010. Banks have printed an extra £25bn, they believe that bringing in money into the economy will give confidence to banks to trim down borrowing costs which is known as interest rates and improve economic activity (Daily Mail, Friday 6th November 2009).