Foundation of scholarship and research 2010-11

RECENT CREDIT PROBLEMS IN THE FINANCIAL MARKET

Introduction The recent financial crisis has been very interesting on illustrating what globalization is all about and how different economies and business have inter-linkages world wide. I believe this topic is extremely relevant and timely because of its effect in the world economy in general. However, due to the limitation of the essay and broadness of the subject, I will concentrate my attention on the financial market of the United States of America. As the financial crisis itself has started in America back in 2007 and triggered a massive economic recession that spread to other economies of the world. The financial crisis which started in 2007 is considered by many economists to be the worst financial crisis since the Great Depression of the 1930s.1 It was triggered by a liquidity shortfall in the United States banking system, and has resulted in the collapse of large financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world. In many ways, the housing market has suffered enormously, resulting in numerous evictions, foreclosures and prolonged vacancies. (Bexley & Herberman, 2009). The crisis contributed to the failure of key businesses, declines in consumer wealth estimated in the trillions of US dollars, substantial financial commitments incurred by governments, and a significant decline in economic activity. Although there have been aftershocks, the financial crisis officially ended in late 2008 and mid 2009. 2 Many causes for the financial crisis have been suggested, with varying weight assigned by an expert, which is discussed below. Both market-based and regulatory solutions have been implemented and are under consideration. Main Body This section will discuss in depth the extent of the credit problem in the United States, major contributors and causes of the problem. In addition, it will look at the current measures being undertaken by the government as well as partner institutions, like banks and investment companies, in addressing this problem. This section also samples some of the sentiments or ideas that have been expressed by economists about the problem.

Reuters (February 27 2009) David Pendery, Three Top Economists Agree 2009 Worst Financial Crisis Since Great Depression; Risks Increase if Right Steps are Not Taken. Available at: http://www.reuters.com/article/2009/02/27/idUS193520+27-Feb-2009+BW20090227 (Accessed: 30 March 2011)

Chan, S. (2011)Financial Crisis was Avoidable. New York Times, January 25, 2011, p.3.

Aida Awel

000683777

Foundation of scholarship and research 2010-11 Cause and effect of the credit crisis The initial trigger for the causes of the crisis dates back to 1982 onward with the steady decreasing interest rates backed by the US Federal Reserve and large inflows of foreign funds which created easy credit conditions for a number of years prior to the crisis, fueling a housing construction boom and encouraging debt-financed consumption. The combination of easy credit and money inflow contributed to the United States housing bubble. Loans of various types (e.g., mortgage, credit card, and auto) were easy to obtain and consumers assumed an unprecedented debt load.3 As part of the housing and credit booms, the number of financial agreements called mortgage-backed securities (MBS) and collateralized debt obligation (CDO), which derived their value from mortgage payments and housing prices, greatly increased. Such financial innovation attracted institutions and investors around the world to invest in the U.S. housing market. Major global financial institutions that had borrowed and invested heavily in subprime MBS reported significant losses as housing prices declined. Defaults and losses on other loan types also increased significantly as the crisis expanded from the housing market to other parts of the economy.4 Federal Reserve Chairman Ben Bernanke explained that between 1996 and 2004, the USA current account deficit increased by $650 billion, from 1.5% to 5.8% of GDP. Financing these deficits required the USA to borrow large sums from abroad, much of it from countries running trade surpluses, mainly the emerging economies in Asia and oilexporting nations.5 One of the most significant causes of the crisis has been linked to the housing bubble in the United States, which started between 2005 and 2006. This effect led to plunging in the values of securities that were tied to the real estate pricing which subsequently led to the damaging of many financial institutions across the world. The impact of this entire problem heightened in the late 2008 and early 2009 where the issues
3

Board of Governors of the Federal Reserve System (2009) Four Questions about the Financial Crisis. Available at: http://www.federalreserve.gov/newsevents/speech/bernanke20090414a.htm (Accessed: 25 March 2011)

International Monetary Fund (2010) Loss Estimates. Available at: http://www.imf.org/external/pubs/ft/weo/2009/01/pdf/exesum.pdf (Accessed: 02 April 2011)

Governor Ben S. Bernanke, The Federal reserve Board (2005) The Global Saving Glut and the U.S. Current Account Deficit, Available at: http://www.federalreserve.gov/boarddocs/speeches/2005/20050414/default.htm (Accessed: 27 February 2009)

Aida Awel

000683777

Foundation of scholarship and research 2010-11 such as declines in credit availability, bank solvency, and low investor confidence had an impact on global stock market, where securities suffered large losses. Generally, international trade at that time declined sharply as the lending institutions tightened their credit lending procedures. (Bexley & Herberman, 2009) The blame on the causes of the financial crisis has been centered on the investors and credit rating agencies that have been blamed for not pricing accurately the risk involved with mortgage-related financial products, which they dealt with. One other issue was the unrefined bailouts, monetary policies, and fiscal stimuli, by the governments and central banks, which were unprecedented. These actions contributed significantly to the credit problems in the financial markets that are still being experienced today. (Bexley & Herberman, 2009). National Debt There is a need to urgently address the problem with debt financing in the United States. As mentioned above, the increasing debt could instill detrimental effects to the United States economy that is slowly recovering following the 2008 credit crunch that rocked the entire global economy (Financial Markets Highlights-May 2008: 2008). Currently, the GDP growth in the United States is growing at a very slow rate and lack of credit availability in the market is a significant contributor. Addressing the credit problem in the United States has become a priority of the government as economists continue to sound an alarm over the federal fiscal sustainability of the nation. One of the biggest problems that the United States economy could face is the fact that a different currency could replace the dollar as the global reserve currency this is because, the United States would definitely face higher interest rates in order to attract capital, which in turn has an effect of reducing the overall economic growth in the longterm. In May 2009, The Economist wrote: having spent a fortune bailing out their banks, Western governments will have to pay a price in terms of higher taxes to meet the interest on that debt. In the case of countries (Like Britain and America) that have trade as well as budget deficits, those high taxes will be needed to meet the claims of foreign creditors. Given the political implications of such of austerity, the temptation will be to default by stealth, by letting their currencies to depreciate. Investors are increasingly alive to this danger (The Economist, 2009) Contributing factors As explained above a number of factors are responsible for causing the current credit crisis in the United States, American housing bubble being the most significant one. There are other contributing factors as well, one being that policymakers did not immediately recognize the increasingly important role played by financial institutions such as investment banks and hedge funds, also known as the shadow banking system. In June 2008 speech, Timothy Geithner Secretary of the United States Treasury placed

Aida Awel

000683777

Foundation of scholarship and research 2010-11 significant blame for the freezing of credit markets on a "run" on the entities in the "parallel" banking system, also called the shadow banking system. These entities became critical to the credit markets underpinning the financial system, but were not subject to the same regulatory controls. The rising debt in the United States is a significant factor aiding the current credit problem. In 2010, the United States treasury statistics showed that 95% of the annual GDP, which is close to $13.723 Trillion, represented the Total Public Debt outstanding. Out of this, about $9.14 Trillion, which is approximately 66%, represented the Debt Held by the Public. The reminder of 34% of the GDP represented the intergovernmental debt (Carson, 2010). The gross debt is expected to increase to about 100.6% by 2012 up from 70.2% of the GDP reported in 2008: these are the estimates of the Congressional Budget Office (Auerbach & Gale, 2010). The U.S. Financial Crisis Inquiry Commission reported its findings in January 2011. It concluded that "the crisis was avoidable and was caused by: Widespread failures in financial regulation, including the Federal Reserves failure to stem the tide of toxic mortgages; Dramatic breakdowns in corporate governance including too many financial firms acting recklessly and taking on too much risk; An explosive mix of excessive borrowing and risk by households and Wall Street that put the financial system on a collision course with crisis; Key policy makers ill prepared for the crisis, lacking a full understanding of the financial system they oversaw; and systemic breaches in accountability and ethics at all levels." 6 U.S. households and financial institutions became increasingly indebted or overleveraged during the years preceding the crisis. This increased their vulnerability to the collapse of the housing bubble and worsened the ensuing economic downturn. From 2004-07, the top five U.S. investment banks each significantly increased their financial leverage, which increased their vulnerability to a financial shock. These five institutions reported over $4.1 trillion in debt for fiscal year 2007, about 30% of USA nominal GDP for 2007.Leham Brothers was liquidated, Bear Stearns and Merill Lynch were sold at fire-sale prices, and Goldman Sachs and Morgan Stanley became commercial banks, subjecting them to more stringent regulation. With the exception of Lehman, these companies required or received government support.7 Rapid increases in a number of commodity prices followed the collapse in the housing bubble. The price of oil nearly tripled from $50 to $147 from early 2007 to 2008, before plunging as the financial crisis began to take hold in late 2008. The destabilizing

Financial Crisis Inquiry Commission-Press Release-27 January 2011, FCIC Report-Conclusion ExcerptJanuary 2011.
7

The Economist,(2008 )The End of the Affair 28 November 2008, Available at: http://www.economist.com/world/unitedstates/displaystory.cfm?story_id=12637090 .(Accessed: 27 February 2009)

Aida Awel

000683777

Foundation of scholarship and research 2010-11 effects of this price variance have been proposed as a contributory factor in the financial crisis.8 Mortgage Market The Mortgage debt-GDP ratio in the United States grew from 46%, which was experienced in the mid 1990s to a staggering 73% in 2008. The household debt alone was estimated at $7.4 trillion in 2005, which was a growth of 60% compared to $705 billion in 1974, this further increased to a whopping $14.5 trillion by the mid of 2008 (Bexley & Herberman, 2009). A few homeowners decided to refinance their mortgages at that time given the idea that the interest rates were lower while others financed their consumer spending through acquisition of second mortgages, which were secured by the price appreciation experienced at that time. Eventually, there was close to 127% household debt in the United States in relation to or as a percentage of annual disposable personal income in 2007 and this was an increase from 77% recorder in the year 1990. The highest percentage of mortgages that had been taken by homeowners were the adjustable-rate mortgages because of the belief in which the people held that the housing prices that were being experienced would indeed continue to increase or appreciate (Whitney, 2007). Problems started when homeowners defaulted after their grace period experienced and this meant they had to pay higher prices for the mortgage; most of them, as mentioned above, tried to refinance them after the grace period but this became very difficult for many owners because prices begun declining at that time in many parts of the United Sates. This was between the years 2006-2007 and later the problem escalated in 2008 when Lehman Brothers filled chapter 11 for bankruptcy while companies such as American International Group or AIG experienced dire financial difficulties (Whitney, 2007). Testimony given to the Financial Crisis Inquiry Commission by Richard M. Bowen, III on events during his tenure as Citi's Business Chief Underwriter for Correspondent Lending in the Consumer Lending Group (where he was responsible for over 220 professional underwriters) suggests that by the final years of the US housing bubble (20062007), the collapse of mortgage underwriting standards was endemic. His testimony states that by 2007, 80% of mortgages purchased by Citi from some 1,600

The Daily Telegraph (26 May 2008) Edmund Conway George Soros: rocketing oil price is a

bubble. Available at:

http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/2790539/George-Sorosrocketing-oil-price-is-a-bubble.html. (Accessed: 1May 2010)

Aida Awel

000683777

Foundation of scholarship and research 2010-11 mortgage companies were "defective" (were not underwritten to policy, or did not contain all policy-required documents)9. As well as easy credit conditions, there is evidence that both government and competitive pressures contributed to an increase in the amount of subprime lending during the years preceding the crisis10. Some, like American Enterprise Institute fellow Peter J. Wallison, believe the roots of the crisis can be traced directly to sub-prime lending by Fannie Mae and Freddie Mac, which are government sponsored entities. On September 30, 1999, The New York Times reported that the Clinton Administration pushed for more lending to low and moderate income borrowers, while the mortgage industry sought guarantees for sub-prime loans.11 Government polices also failed significantly to control the problem. The current increase of credit problems in the financial markets has been directly linked to the failure by the government to regulate as well as deregulate the mortgage market. Alan Greenspan and the Securities and Exchange Commission (SEC) both agreed that the government indeed failed to regulate investments banks and therefore allowing them to undertake their own self-regulation, which was fraudulent. They made their remarks when giving their testimony to the House of Congress following the crisis. Homeownership has been the goal of almost every president including Reagan, Roosevelt, Clinton, as well as George W. Bush. This, according to analysts, could be the reason why the government failed to develop proper and efficient legislations to curb the vice over the years (Bexley & Herberman, 2009). The crisis effect globally The crisis rapidly developed and spread into a global economic shock, resulting in a number of European bank failures, declines in various stock indexes, and large reductions in the market value of equities and commodities.12 At the end of October 2008 a currency crisis developed, with investors transferring vast capital resources into
9

Hearing on Subprime Lending & Securitization & Government Sponsored Enterprises, 7 April 2010, Available at: http://www.fcic.gov/hearings/pdfs/2010-0407-Bowen.pdf. (Accessed: 29 October 2010)

10

The New York Times (02 October 2008) Stephen Labaton, The Reckoning Agencys 04 Rule Let Banks Pile Up New Debt, Available at: http://www.nytimes.com/2008/10/03/business/03sec.html

11

Peter J Wallison, (9 December 2008) American Enterprise Institute for Pblic Policy Research, What Got Us Here? Available at: http://www.aei.org/article/29047. . (Accessed: 1May 2010)

12

Norris, Floyd (October 24, 2008). United Panic. The New York Times. Available at: http://norris.blogs.nytimes.com/2008/10/24/united-panic. (Accessed: 24 October 2008)

Aida Awel

000683777

Foundation of scholarship and research 2010-11 stronger currencies such as the yen, the dollar and the Swiss franc, leading many emergent economies to seek aid from the International Monetary Fund. The economic crisis in Iceland involved all three of the country's major banks. Relative to the size of its economy, Icelands banking collapse is the largest suffered by any country in economic history.13 The Brookings Institution reported in June 2009 that U.S. consumption accounted for more than a third of the growth in global consumption between 2000 and 2007. "The US economy has been spending too much and borrowing too much for years and the rest of the world depended on the U.S. consumer as a source of global demand." With a recession in the U.S. and the increased savings rate of U.S. consumers, declines in growth elsewhere have been dramatic. For the first quarter of 2009, the annualized rate of decline in GDP was 14.4% in Germany, 15.2% in Japan, 7.4% in the UK, 18% in Latvia, 9.8% in the Euro area and 21.5% for Mexico. 14 Some developing countries that had seen strong economic growth saw significant slowdowns. For example, growth forecasts in Cambodia show a fall from more than 10% in 2007 to close to zero in 2009, and Kenya was estimated to achieve only 3-4% growth in 2009, down from 7% in 2007. According to the research by the Overseas Development Institute, reductions in growth can be attributed to falls in trade, commodity prices, investment and remittances sent from migrant workers (which reached a record $251 billion in 2007, but have fallen in many countries since). This has stark implications and has led to a dramatic rise in the number of households living below the poverty line, be it 300,000 in Bangladesh or 230,000 in Ghana.15 Estimated loss The International Monetary Fund estimated that large U.S. and European banks lost more than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009. These losses were expected to top $2.8 trillion from 2007-10. U.S. banks losses were forecast to hit $1 trillion and European bank losses were expected to

UBS AG. Fears of recession loom. Daily roundup for October 9, 2008. (Accessed: 17 October 2008). "short by historical standards"
14

13

Evans-Pritchard, Ambrose (July 25, 2007).Dollar tumbles as huge credit crunch looms. The Daily Telegraph (London: Telegraph Media Group Limited). Available at: http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/07/25/cnusecon125.xml. (Accessed 15 October 2008
15

Landler, Mark (October 23, 2008). West is in Talks on Credit to Aid Poorer Nations. The New York Times. Available at: http://www.nytimes.com/2008/10/24/business/worldbusiness/24emerge.html

Aida Awel

000683777

Foundation of scholarship and research 2010-11 reach $1.6 trillion. The IMF estimated that U.S. banks were about 60% through their losses, but British and eurozone banks only 40%16.

Measures that have been taken to contain the credit crisis so far The economic stimulus package was introduced by the United States government in 2008 and it was worth $168 billion. The American Recovery and Reinvestment Act of 2009 were also signed into law by President Barrack Obama in 2009 and a further $787 billion stimulus package. This package contained a broad spectrum of tax cuts and spending (Shah, 2010). The United States government has also worked through the Troubled Assets Relief Program (TARP) to help in averting the credit problems in the nation. Key advisers and President Barrack Obama introduced a number of regulatory proposals in June 2009 (Shah, 2010). These proposals addressed the bank financial cushions, executive pay, consumer protection, enhanced authority on Federal Reserve, and expanded control of the shadow banking system (The Economist, 2009). To offset this decline in consumption and lending capacity, the U.S. government and U.S. Federal Reserve have committed $13.9 trillion, of which $6.8 trillion has been invested or spent, as of June 2009. In effect, the Fed has gone from being the "lender of last resort" to the "lender of only resort" for a significant portion of the economy. In some cases the Fed can now be considered the "buyer of last resort." This credit freeze brought the global financial system to the brink of collapse. The response of the U.S. Federal Reserve, the European Central Bank, and other central banks was immediate and dramatic. During the last quarter of 2008, these central banks purchased US$2.5 trillion of government debt and troubled private assets from banks. This was the largest liquidity injection into the credit market, and the largest monetary policy action, in world history. The governments of European nations and the USA also raised the capital of their national banking systems by $1.5 trillion, by purchasing newly issued preferred stock in their major banks.17 Conclusion

16

Reuters (5 November 2009) Fact Box- US, European banks write down credit looses Available at: http://www.reuters.com/article/2009/11/05/banks-writedowns-losses-dCNL554155620091105?rpc=44 (Accessed: 1 May 2010).

17

BBC News, (14 February 2009) BBC Stimulus Package 2009. Available at: http://news.bbc.co.uk/1/hi/business/7889897.stm. (Accessed: 27 February 2009).

Aida Awel

000683777

Foundation of scholarship and research 2010-11 The root cause of the crisis is clear, too much dependence on credit for far too long. Too much money and artificially low interest rates always and inevitably lead to speculation and mal-investment. The credit problem has led to rapid increases in prices of food commodities across the globe. Oil prices have also escalated and this has been due to financial speculations especially from the point of view of major giant economies like the United States, which is currently crippling with debt problems and trade deficits within its economy. Mortgage defaulting especially during the crisis continues to bite the investment banks as well as the financial institutions in general. Generally, the recent credit problems have significant effects in all spheres of the economy through hampering significant development that a country can have. However, it is important to note that third world countries suffered less and most of the economies are stable despite the credit crisis that continues to bite developed economies. In summary, it is essential to understand the cause of the current credit problem in the financial markets. It is evident that the problem was mainly started by the mortgage market crisis, which started in 2006. The increasing debt-GDP ratio is also another problem that is escalating the credit problem. Lack of availability of credit is a problem that is affecting the performance and day-to-day operations of financial markets; if this problem is not checked detrimental effects like currency devolution and trade devaluation will almost certainly be the reason. The GDP growth rates across the globe continue to decline; the United States debtGDP ratio has continued to increase over the years and it is expected to increase further by the year 2019. Increases in public debt affect the United States dollar as the global reserve currency and the worst-case scenario would be the replacement of the United States dollar by another stable currency (Bexley & Herberman, 2009).

Aida Awel

000683777

Foundation of scholarship and research 2010-11 Reference List Ambrose, E. (2007) Dollar tumbles as huge credit crunch looms. The Daily Telegraph (London: Telegraph Media Group Limited) July 25 2007. Available at: http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/07/25/cnusecon125.x ml. (Accessed 15 October 2008) Auerbach, A. J., & Gale, W. G. (2010) The Federal Budget Outlook, Chapter 11. Available at: http://www.taxpolicycenter.org/UploadedPDF/1001450_chapter11.pdf (Accessed: 15 November 2010) BBC News, (2009) BBC Stimulus Package 2009, 14 February 2009. Available at: http://news.bbc.co.uk/1/hi/business/7889897.stm. (Accessed: 27 February 2009). Bexley, B. J., James, F. J., & Herberman, J. (2009) Financial Crisis and its issues Research in Business and Economics Journal, pp.1-7. Board of Governors of the Federal Reserve System (2009) Four Questions about the Financial Crisis. Available at: http://www.federalreserve.gov/newsevents/speech/bernanke20090414a.htm (Accessed: 25 March 2011) Conway, E. (2008), George Soros: rocketing oil price is a bubble The Daily Telegraph, 26 May 2008. Available at: http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/2790539/GeorgeSoros-rocketing-oil-price-is-a-bubble.html. (Accessed: 1 May 2010) The Economist (2008 ) The End of the Affair 28 November 2008, Available at: http://www.economist.com/world/unitedstates/displaystory.cfm?story_id=12637090 .(Accessed: 27 February 2009) The Economist. (2009) A new global system is coming into existence from The Economist, May 14 2009. Available at: http://www.economist.com/node/13653915?story_id=13653915&source=hptextfeature (Accessed: 14 November 2010) Financial Market Highlights (2008). Available at: http://www.oecd.org/dataoecd/55/51/40850026.pdf (Accessed: 17 November 2010) Governor Bernanke, B. (2005) The Global Saving Glut and the U.S. Current Account Deficit The Federal reserve Board. Available at: http://www.federalreserve.gov/boarddocs/speeches/2005/20050414/default.htm (Accessed: 27 February 2009)

Aida Awel

10

000683777

Foundation of scholarship and research 2010-11 International Monetary Fund (2010) Loss Estimates. Available at: http://www.imf.org/external/pubs/ft/weo/2009/01/pdf/exesum.pdf (Accessed: 02 April 2011) Labaton, S. (2008) The Reckoning Agencys 04 Rule Let Banks Pile Up New Debt, The New York Times, 02 October 2008. Available at: http://www.nytimes.com/2008/10/03/business/03sec.html Landler, M. (2008). West is in Talks on Credit to Aid Poorer Nations. The New York Times, October 23 2008. Available at: http://www.nytimes.com/2008/10/24/business/worldbusiness/24emerge.html Norris, F. (2008). United Panic. The New York Times, October 24, 2008 . Available at: http://norris.blogs.nytimes.com/2008/10/24/united-panic. (Accessed: 24 October 2008) Pendery, D (2009) Three Top Economists Agree 2009 Worst Financial Crisis Since Great Depression; Risks Increase if Right Steps are Not Taken Reuters, 27 February 2009) Available at: http://www.reuters.com/article/2009/02/27/idUS193520+27-Feb2009+BW20090227 Reuters (2009) Fact Box- US, European banks write down credit looses, 5 November 2009. Available at: http://www.reuters.com/article/2009/11/05/banks-writedowns-lossesdCNL554155620091105?rpc=44 (Accessed: 1 May 2010). Shah, A. (2010, September 30) Global Financial Crisis Available at: http://www.globalissues.org/article/768/global-financial-crisis (Accessed: 18 November 2010) Wallison, P. J. (2008) What Got Us Here? American Enterprise Institute for Public Policy Research, 9 December 2008. Available at: http://www.aei.org/article/29047 (Accessed: 1May 2010) Whitney, M. (2007) United States Housing Market Crash to result in the Second Great Depression The Market Oracle, 23 February 2007. Available at: http://www.marketoracle.co.uk/Article383.html (Accessed: 18 November 2010)

Aida Awel

11

000683777