The economic boom in early 2000's brought prosperity for everyone around the world and there was no looking back. There was a feeling amongst the financial institutions and the governments that nothing could possibly go wrong but it was not a fairytale and the economic boom period was not to stay forever. Lehman Brothers, the 158 year old and America's fourth largest investment bank went bankrupt in 2008 and marked the beginning of a major global financial crisis. In this essay I would discuss the main causes of the crisis and the steps UK government could take to avoid another crisis.
The growth of developing countries like China and global financial markets had contributed to the huge current account deficit in America. The series of booms and crisis over the years has mainly been due to the increase in financial assets of the rapidly developing countries (Carmassi et al. 2009). China was turning out to be the fastest growing economy with skilled cheap labour. There was a huge increase in income and China invested the surplus money with western banks and money was flooding in the trading and capital markets of the world. This pushed down the interest rates of banks and the Federal Reserve became complacent. Alan Greenspan, the Chairman of America's central bank Federal Reserve at that time, cut the interest rates to 1%. The banks started to innovate as the investment returns reduced with the low interest rates. They borrowed more money which was as good as free money at such a low interest rate and lent it to anyone as it was free. There was a huge increase in complex financial instrument like derivatives with the light touch regulatory system on both sides of the Atlantic. (The love of money video)
The US government supported ownership of homes as it felt it was good for the American economy and families. The house rates were increasing by 10% a year and the property market was booming with easy availability of loans by the banks that had free money to lend. This led to the beginning of sub-prime mortgages. The mortgages were given to people without taking into consideration their job or economic profile. The banks targeted these people with a bad credit history to get higher interest on the loans. The lenders then sold the mortgages to investment banks like Lehman Brothers. These investment banks thought they could collect years of high mortgages from the original borrowers. These banks borrowed more and more money for every dollar it owned, called leverage, to buy the mortgages. Leverage can be calculated by the total credit to GDP ratio and an increase in this ratio is one of the causes for the crisis (Carmassi et al. 2009). Lehman Brother had a leverage ratio of 44:1 by end of 2007 (The love of money video). The investment banks did not consider that while leverage amplifies the profits, it would also multiply the debts if the property rates go down what exactly happened. The investment banks then classified the thousands of mortgages it bought into 3 buckets as safe, medium and risky. The risky mortgages had higher rate of returns as it consisted of borrowers who were more likely to default on their payments. An ‘originate to distribute' model was used where these securitized pools of loans were re-sold to hedge funds and other investors who took more risks (Carmassi et al. 2009). The ratings agencies rated the different mortgages. AAA rating was given to the mortgage which was the safest.
The banks offered Credit default Swaps (CDS), a type of insurance against the borrowers who would default on loans. However these banks provided the insurance without keeping any of its capital aside in case the people default. So they would have no liquidity to service the insurance is if the people defaulted on their payments. The Commodity Futures Trading Commission wanted to regulate CDS as the insurance had no capital behind it but Greenspan rejected the idea as he thought it would take them in the opposite direction of the progress. In 2007 the CDS market expanded to 62 trillion dollars. This system was getting more and more complex and risky. The risks were distributed further and there were brokers, lenders, investment banks and other investors in the chain now, many of them even ignorant of the content of the original loans. In the boom period all of them in the chain made a lot of money and there was a false confidence in the market. This can be asserted by the fact that Lehman Brothers gave out 9 billion dollars to its employees as bonus in 2007.
But then the large number of house owners who had been allured by the initial cheap mortgage rates could not keep up with the payments when the mortgage rates increased and they started defaulting. The investment bankers were now left with empty houses to sell which the defaulters had vacated. There was an increase in supply and reduction in demand of property. This imbalance made the property rates to fall and the banks were left with huge amounts of worthless mortgages which no investors wanted to buy. Now the financial system freezed with the mortgage lenders, investment bankers and other investors all having the worthless securities which they bought after borrowing huge amount of money and it could not be sold now. The system collapsed with Lehman Brothers filing for bankruptcy in September 2008. The banks had now lost confidence. The short term loan charges doubled overnight and flow of dollars stopped with no liquidity across the world. It impacted the global economy. Depositors withdrew money from the money market funds. This was a major setback for big corporations who depend on short term loans for their day to day cash flows. These companies were not able to access their inventory or make the basic payments for their employees. Banks had difficulty raising funds as they did not have enough assets or liquidity. The French President Sarkozy blamed the financial policies of US and England for the turmoil.
The UK government should take a number of steps to prevent the country going through another period of crisis in the future. The Financial Services Authority (FSA) should regulate the financial markets and needs to be tougher. They should have better methods to address issues of insolvency and liquidity. The Commodity Futures Trading Commission (CFTC) should have the power to regulate Credit default swaps. The regulators should understand the amount of intrusion which is necessary to regulate the financial structure of the country. There should be a structure for regulation so that banks can challenge what they are doing even when they are successful. The bank authorities should be careful while lending mortgages. The borrower should be verified for his credibility and his financial position to pay back the loan.
The UK government should work towards strengthening the financial system by introducing regulations that help effective functioning of securitization markets. The FSA should help strengthen the banks' risk management by working with banks to improve stress testing. More consistent methods of liquidity regulations should be adopted while working with international partners. The accounting standards should be regulated to provide transparent information on the basis of valuations and risk management steps. The role of credit rating agencies should be monitored by the authorities. The FSA should work with the banks to make sure that they have a backup plan in case that the sponsor bank fails. There should be a focus on compensation arrangements by the banks for the customers to have confidence in the banks. The Bank of England which was not regulating in any sense during the boom period which led to the crisis situation when asset prices fell should have more power to regulate and improve coordination between authorities. Gordon Brown, the Prime Minister of UK said that Global financial regulations were necessary to put into place (The love of Money video). There should be effective internal and external communications to promote unity for the international financial issues. The FSF and IMF should cooperate to provide any information they have and introduction of early warning scheme towards global financial risks would help prevent another acute crisis (Hall 2009).
Allen Greenspan admitted after the crisis that he was partially wrong for not regulating the mortgages but warned that the global financial crisis happened not just due to lax government policies but because of human nature of greed. He said that a financial crisis would hit next time too unless the human nature for the greed of money changes (The love of money video). In conclusion, the governments of all countries should work closely on financial policies that are best suited for the countries. The basic regulations on the leverage ratio limits for banks and careful lending of mortgages would help prevent a financial crisis in the future.
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