Financial Crisis in America
Primary causes of financial crisis in America
The immediate cause of the United States of America crisis is seen to be triggered by the burst of the housing bubble which went to its peak during the end of year 2006. This was subsequently accompanied by the high rates of default for those who had taken mortgage services failing to pay back after the bubble burst. The situation was so severe when the adjustable rate mortgage and the subprime rates increased thereafter leaving many people unable to meet their mortgage obligations. Initially, the mortgage industry in the American industry was structured in a manner that, easy initial terms encouraged people to assume mortgage services with a long term hope of raising housing prices in the future with a hope of refinancing these mortgage services at the future with more favorable terms (Erhan and Demirlap, 67).
This was not to be when the housing prices began to increase in 2007 accompanied by a steady rise of interest rates in the economy. This scenario made it impossible for many Americans to finance back their mortgage services. These situations in the economy witnessed an ever high ARM rates with housing prices remaining low characterized by foreclosures. The declining housing prices created a situation of worth less in the home sector more than the mortgage loan resulting to massive foreclosures. This activity of foreclosures in the housing industry picked in 2007 and it attributed to be the primary cause of the financial crisis not only in America but across the world through the integrated economic systems in the international market. The foreclosure behavior that was gaining momentum in America resulted to erosion of financial institutions' strength especially the banking sector and draining consumers off their wealth (Cecchetti, 45).
The situation was fueled long before the actual crisis in 2007, America from early as 2002 experienced massive capital inflows from Asian countries and other major the oil producing countries. This coupled with low rates of interests in American economy since 2002 up to 2004 facilitated easy access to credit facilities. This condition fueled both housing and credit bubbles in the economy. This witnessed unprecedented loan load because of its easy accessibility from mortgage, auto and credit card loans. There was a great increase of mortgage backed securities which resulted from a special financial agreement which boomed the housing and credit markets as well. With these kinds of innovations and incentives in the housing sector, American economy especially the housing sector was open for investment by foreign institutions and individual investors from across the world (Erhan and Demirlap, 73).
Defaults on loans and huge losses reported increased not only in the housing sector but also spilled to other sectors in the economy. The crisis was increased by the inaction position that was assumed by the monetary authorities in America by their actions not to recognize the paramount roles played financial institutions such as shadow banking systems and the investment banks. These institutions had assumed the role of commercial banks in issuance of credit facilities and depository roles. Due to huge loan default, the financial institutions were impacted adversely in their role to advance credit facilities consequently slowing down economic activities. These predicaments forced the Federal Reserve to take action and inject funds in the economy to encourage spending to stimulate economic activities and restore confidence in the stock market especially for the commercial papers which forms an integral part in funding business activities and operations (IMF, 23).
The situation went to worse to a point that the government came in to the rescue of huge businesses by providing bail outs to key financial institutions providing substantial financial assistance to these institutions.
Source: (Erhan and Demirlap, 2008)
This diagram illustrates the course that events took to unveil to the crisis that is experienced in the United States of America. It stared in the housing sector and spread to the financial sector causing the Federal Reserve and the government's intervention.
Financial market impacts of the crisis
In February 2007, the financial market began to demonstrate the effects of financial crisis in the economy. The events unfolded when the world's largest bank the HSBC wrote a total of US $ 10.5 billion as holdings of subprime related with MBS recording the first and huge subprime loss to be accounted and announced. The peak of the crisis was towards the end of 2007 when over one hundred mortgage companies either suspended their operations or shut down operations while others were sold out. The situation was so worse that the management of these financial institutions had to take tremendous measure; to this end the Chief Executive Officer of Citigroup and Merrill Lynch had to resign towards the end of 2007. Many financial institutions especially in the banking sector announced their intentions for mergers while others engaged in negotiation to find merging partners. Year 2007 witnessed massive exodus of capital from mortgage related bonds and other shaky equities towards store of value equities causing panic in the financial sector (Cecchetti, 54).
Commodities super - cycle has sky - rocketed fuel and food commodity prices resulting from the speculations in the financial market concerning future commodity trading which consequently resulted to collapse of the financial derivatives market. The economy was as adversely affected as a result of decline in profits to approximately US $ 646 million in 2007 for the America's 8533 depository institution which is insured by the FDIC. Due to bank failures, money market started shrinking drastically experienced huge capital outflow and this sector had been instrumental n the provision of liquidity in the economy when financial institutions begun experiencing difficulties. The whole American economy lost trillions of dollars due to capital outflows from the economy worsening the situation due to inadequate credit in the economy consequently reducing spending levels (IMF, 26).
US Commercial paper trading
This figure demonstrates how the economy was detrimentally affected to a point that the stock market activities declined as shown by the decline of trading of commercial papers from 2006 all through to 2007. In fact the declining trend does not seem to stop in the near future unless drastic measures are employed by the government and monetary authorities. This is just one example that demonstrates how spending declined in the economy due to over speculation in the market.
The role of key participants in the economy
The United States of America forms an economic background that is regarded as the most stable in the world. This status was achieved through hard word and dedication of all the stakeholders who devoted their resources to build America economy. For this objective to be achieved, the federal reserve play a paramount role in the building and sustaining economic gains that have been realized so far. Apart from the Federal Reserve, the governments participatory in the economic activities is unequivocal to enhance that economic agents are regulated and rules , regulations and the code of conduct are upheld. The government also plays a major role in the economic growth and development through fiscal and monetary policy. Other important plays are the financial intermediaries which involves commercial banks and other non bank financial institutions (Cecchetti, 64).
When the economic crisis began to take roots in the American economy, all these agents in the economy greatly contributed to the worsening of the crisis. Federal reserves authorities never took initiative to regulate the level of interest rates in the market. This lead to a situation where interest rates were to low levels encouraging people to purchase more than they can afford on credit deepening the crisis. Commercial banks and other financial institutions never considered the creditworthiness of individuals and corporate entities while advancing credit which consequently resulted to defaults leading huge economic losses. The government on its side took drastic and unsound macroeconomic measures to avert the crisis which produced counter – productive effects in the economy worsening the situation. Furthermore, the government's implementation of rescue plans and stimulus packages were biased towards some agents in the economy which further aggravated the crisis to un - manageable levels (IMF, 21).
In order to avert the affects of the crisis, the government would have implemented a sound and prudent macroeconomic policy in form of a fiscal stimulus package instead of providing bailouts to affected economic agents. This prudent fiscal package would have increased spending from the household and small economic agents in the economy. The increased spending would have triggered stagnant and slowing economic activities which could have increased effective demand in the economy. This increased effective demand in turn causes companies to resume production and because there is need for liquidity in the market, commercial banks and other financial institutions would have revived their activities. This process would have been effective through the multiplier effect and incomes of both households and other economic agents boosted unlike through use of bailouts to companies implemented which stagnated or even deepened the crisis (World Bank, 12).
Impact on Oklahoma State Bank in Vinita, OK
Oklahoma state bank was also not left untouched by the financial crisis that cut across the whole international financial market and more severely in the United States of America. The bank is located at 120 West Canadian Street, Vinita, OK 74301 in the United States of America. The bank has a total asset base of US $ 83.3 million and an equity capital of up to US $ 8.4 million. Besides it has a total of US $ 69.1 million as deposits held in the domestic offices with an assets return of about 1.13 per cent representing US $ 0.9 million. Its return on equity amounts to 12.18 per cent representing a figure of about US $ 1.0 million. The bank also holds a net income of US $ 1 million with a US $ 941.5 million as pretax profits representing a total of 1.13 per cent (Farqs.org, n. pg).
The bank is a financial corporation and holding that offers financial products and services to financial institutions, industrial customers and commercial customers. Their main area of operation includes consumer banking, commercial banking as well as wealth management. In the segment of commercial banking, they offer treasury and cash management services, lending and customer risk management services to small scale businesses and enterprises, larger commercial customers and to middle market operators. Consumer banking section includes provision of services like deposit services, lending in retail terms, indirect automobile lending and the mortgage banking activities. Lastly the wealth management segment offers services like brokerage and trading, fiduciary services, investment advisory services as well as private banking (IMF, 29).
It includes all the development and improvements that concerned with buildings, wells, fences and other site improvements fixed on land and are immovable. Real estate has increasingly become a major trading area for many investors which have included businesses as well as the financial institutions like banks and non – banking financial institutions. Under the umbrella of financial institutions, it is referred to as commercial real estate. To venture into this field of investment, it requires a significant large proportion of resources in terms of finances. The Oklahoma state bank in Vinita engaged its practicing activities in the real estate business and the whole trading area that the bank had influence had introduced this type services to their clients. In order for transactions of real estate to be complete, several people are involved and required to facilitate these transactions for proper business dealings (Farqs.org, n. pg).
Examples of real estate businesses includes; appraisals which include the professional valuation services, development composing of all the activities to improve the land for use either by constructing structure or replacing the existing ones. Brokerages are also involved which account for the fees charge earned by the mediator in charge of facilitating the transactions involved in transfer o property between two parties. Other important components include property management, net lease, relocation services, real estate marketing, and corporate real estates. All these demonstrate the heavy and large investments required to practice business in real estate management. However, following the 2007 / 2008 financial and economic crisis in the world especially in America, businesses were greatly affected (Farqs.org, n. pg).
This sector has major areas of specialization which are the residential real estate and the mortgage in real estates. As described above, this sector was hard affected by the crisis, the collapse of Freddie Mac and Fannie Mae; the largest mortgage companies in the US had detrimental effects to the real estate sector. The sector was at risk since the overall construction and development was overhauled due to the inadequate finances in the market. The subsequent collapse of world biggest mortgage companies was a set back to the development of real estate sector not only to the US but also across the world. However the greatest loss was experienced in the US industry. Values in real estate started to increase following revisions done on the US interest rate regimes where the rate of interest started to increase following a decade of almost close to zero levels (Farqs.org, n. pg).
This situation had encouraged massive development of real estate without consideration of all the necessary requirements and the required capital base. Real estate boomed prior to the financial crisis forming an asset bubble in the sector. Year 2007 witnessed the climax of the bubble inflation and subsequent burst of the bubble. The prices of real estates and real estate development increased drastically forcing many developer quit the market. There were reduced levels of real estate development from then onwards characterized by increased housing prices and tough economic situations. Many people were almost losing their properties and millions homeless due to the turn of events in the real estate market. These events followed stagnation in the further development processes in the real estate sector. The crisis has been recorded to greatly affect the real estate sector more than any other sector of the economy especially in the US market. The increased cost of housing and other real estate led to many people losing their houses as demonstrated below (Erhan and Demirlap, 89).
Increase in the cost of real estates
A demonstrates the effects of increased cost of housing as it happened after the financial crisis during the short run period. The construction cost increased when mortgage interest rates increased also for instance from CCo to CC1. This causes developers in the real estate to be selective in their ventures while others will exit the industry due to high costs. This consequently decreases the quantity for housing from (HSo to HS1) as demonstrates above just like it happened in the US. The reduction in quantity levels consequently reduces supply levels from SHo to SH1 due to depreciation of the existing housing and the result is increased prices for housing like depicted in the above diagram from Ro to R1. This increased prices in housing due to tough conditions in the real estate management, results to many people inaccessible to own a housing accelerating housing crisis (Farqs.org, n. pg).
Residential housing and commercial real estate
Residential real estate is a property which is utilized for household occupation and is composed of less than four units; this includes single family houses, duplexes, triplexes and fourplexes. On the other hand, commercial real estate is the properties used for business purposes and consists of more than four units. These include warehouses, storage facilities, office buildings and industrial facilities. The financing aspect also provides a clear distinction between these two investment fields. While residential properties are completely and almost financed through credit and owners resources, commercial properties on the other hand are primarily judged from the incomes they generate therefore creating a less credit degree for the owner. In consideration of the investment perspective, residential real estate can only accommodate one tenant who if he moves, the owner is left with 1oo per cent mortgage on the property unlike commercial real estate where there is multiple tenants. This implies that the owner would not assume 100 per cent mortgage even if one tenant vacates (Cecchetti, 67).
National real estate
This represents a nationwide program by the federal government to improve the housing industry across the country. This program is managed by the national real estate information services (NREIS). This body is mandated to support both residential and commercial real estate mortgages, therefore, its main aim is to support financially and performs regulatory duties to all other forms of real estate. National real estate's products and services in the market are comprised of real estate appraisals, alternative valuation products, title insurance and property reports, settlement and closing services, default and property preservation services, commercial real estate services and flood and tax certifications (World Bank, 17).
The financial crisis was far much reaching and its effects were detrimental to all sectors of the economy to an extent of altering the operations of many institutions. The asset quality of many institutions were greatly affected to an extent that, they could no longer be used as collateral to secure a loan to expand business activities. The assets that were presented as collateral for other stakeholders to secure loans from the institution were no longer worth the amount that owed the institution. Generally there was widespread asset quality erosion by the financial crisis situation. These predicaments forced many institutions to tighten their capital regulatory measures. No investment was endorsed after the crisis due to shrinking of the capital base of not only the institution but also several companies across the country. In view to mitigate the effects of the crisis, all the interest rates that were advanced to clients were placed under new charge offs and interest rate regimes. The bank also exercised conservative practices in new lending process due to the trends that was experienced after the crisis of loan defaults by more than half of the total disbursed loans. The existing non performing loans were dealt with through the revaluation process where their rates of interest were revised downwards. This was to encourage the holders to improve on their payment modes and responses (Woodford, 34).
This crisis resulted to a financial crunch, the spending powers of the clients greatly declined as well as investment levels. Many loans were classified as defaults while other were non performing, this adversely affected the liquidity state of the bank with less activities in the market where the investment practices could not carried out due to low liquidity levels. Although there was reduced competition in the banks trading area, there was still substantial amount of competition that was posed by the non bank financial institutions which were not dealing with liquid monetary terms directly. Therefore the reduced activity level of the bank was not only due to financial crisis alone, but also due to the competition which was staged by these non bank financial institutions which were less affected by the crisis. The deposits of the bank decreased by over 25 per cent immediately after the crisis due to reduced activity level in the market. The reduction in spending from the general public greatly reduced the activity level of the banks since they were fewer deposits (World Bank, 21).
Oklahoma state bank was hard hit and adversely affected by the crisis in the American economy. To mitigate against the detrimental effects of the crisis, the bank adopted three strategic and fundamental initiatives. First there was the introduction of diversified business mix in the operations of the bank's activities. This was to safeguard the bank from any macroeconomic uncertainty as the crisis continued. Through implementation of this initiative, the bank was targeting to establish good foundation to deal with potential turbulence in the market as well as the low interest rates predicted for the future. Secondly, the bank established a credit risk management with high diversification to be in a position to stand and perform business even during credit cycles. This was to safeguard the bank during macro challenges that drives provisions high in financial market (Federal Reserve System, n, pg).
Lastly, the bank established an asset efficiency strategy through balance sheet strength for regulatory purposes to fulfill higher capital requirements, increased funding and operating costs and harmonize its activities with state intervention measures. These initiatives have been attributed to the continued success of the bank especially during these shocks in the economy. These plans were employed by the bank greatly assisted the institution to deal with the adverse effects of the crisis. Other banks employed strategic initiatives that directly affected the clients like adjustment of interest rates which are still not operational since the public are still struggling to increase their spending. These strategies adopted by other banks did not mitigate the problem since public was left with little spending power unlike the strategy adopted by Oklahoma which indirectly affected the clients (World Bank, 22).
Financial regulation reforms
These are the financial regulatory proposed reforms that were proposed by the congress to prevent further worsening of the crisis and avert occurrence of future problems by introducing regulations and laws governing operations in the financial market.
Systematic risk regulation
This regulation was supposed to deal with the financial institutions that were considered immune to any crisis. The regulation was to be composed of two assessment strategies in the risk systematic risk regulation. This regulation was to deal with the ‘too big to fail' institutions and the ‘too interconnected to fail' institutions. These institutions sometimes do carry out market practices without any regulations due to these conceptions. Therefore this regulation was proposed to regulate and govern these institutions. Government intervention is proposed in the affairs of these institutions which enjoyed the laissaz faire conditions in the market like the Freddie Mac and Fannie Mae mortgage companies which were considered ‘too big to fail' and ‘too interconnected to fail' but they were the major cause of the crisis. Therefore, congress decided to propose measures that will deal with these institutions (Federal Reserve System, n, pg).
The congress proposed the law to safeguard against the consumer protection and laws to facilitate lack of customer exploitation by firms and businesses especially big firms. The laws proposed that consumers are supposed to receive all the relevant information which is truthful and reliable free to access. They also proposed that the consumer experience fair competition in the market place. The purpose for this law is to safeguard the consumer interests from exploitation by big businesses which lacked in the US mortgage industry where the government did not have enough regulatory mechanisms exposing millions of Americans from losing their houses as a result of inability to repay their loans. The law proposes that businesses should disclose all the relevant information while dealing with the customers, for instance any hidden charges (Federal Reserve System, n, pg).
Regulation of derivatives
Derivatives represent an agreement that is designed for one party to pay or receive an amount of money that will be determined by changes in interest rate at a future date or determined by future asset price, credit trading or even currency exchange rate. Therefore derivatives can be generally referred to as bets. The derivates were attributed to the major cause of collapse of many industries across the world. For instance the giant insurance company in the world; American International Group (A.I.G), disclosed in 2008 that it had incurred huge losses trading in C.D.S's derivatives bets where municipalities and companies defaulted on their bond obligations. Therefore the derivative regulation proposed by congress seeks to mandate two bodies; the New York Stock Exchange and the Chicago Mercantile Exchange to conduct speculative trading to avoid a repeat of the worst ever situation. Trading derivatives in this proposal would first be evaluated by a private governing body before proceeding to the Commodity Futures Trading Commission for further evaluation before passing through the Securities and Exchange Commission for approval (Federal Reserve System, n, pg).
Farqs.org, Oklahoma State Bank in Vinita, Oklahoma (OK), Retrieved on February 1st 2010 from: http://www.faqs.org/banks/Oklahoma-State-Bank-15611-Vinita-Oklahoma.html#top, 2009
Erhan, Artuc and Demirlap, Sevla. Discount window borrowing after 2003: the explicit reduction in implicit costs, Working Paper 0708, New York, NY, 2007
Cecchetti, Stephen. Money, banking, and financial markets, New York, NY: McGraw Hill Irvin, 2008
Federal Reserve System group on alternative instruments for system operations: Am alternative for open market and discount window operations. Retrieved on February 1st 2010 from: http://www.federalreserve.gov/boarddocs/surveys/soma/alt_instrmnts.pdf, Washington. WG: 2009
IMF, World economic outlook update, rapid weakening prospects call for new policy stimulus. Washington. DC: Routledge, 2008
World Bank, Global economic prospects, commodities at the cross road. Washington. DC: Princeton University Press, 2009
Woodford, Michael. Interest and prices: Foundations of a theory of monetary policy, New Jersey. NJ: Princeton University Press, 2009