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Global financial crisis has been experienced for a while, but it started to show its effects in the mid 2007 into the year 2008. It is often referred to as the Global Financial Crisis, Great Recession, or the Credit Crunch and is considered by economists as the worst financial crisis since the Great Depression in the 1930s.

The crisis has resulted in stock markets falling around the world, many financial institutions have collapsed and/or have been bought out and even the world’s wealthy governments had to bail out their financial systems (Diya 2).

The housing market has also been affected in many areas, thus resulting in many evictions, foreclosures and lack of employment. Free Plagiarism Checker For Teachers

As those responsible for the global financial crisis are being bailed out, the effects are felt by everyone. The crisis has contributed to failure of many important businesses, falls in consumer wealth and a significant reduction in economic activity resulting in the severe global recession in 2008 (Gordon 1).

As the housing disintegration progressed, credit tightened and international trade declined, thereby slowing many economies worldwide.

This has seen many governments responding with fiscal stimulus, bail outs and monetary policy expansion (Diya 2). Arguments put forward suggest that credit rating agencies and investors were unable to accurately evaluate the risk associated with mortgage related financial markets, and policy makers were unable to identify the role of financial institutions, such as investments and hedge funds (Diya 5).

Therefore, this paper will critically evaluate the global financial crises around the globe.

Background

The global crisis was triggered by the global housing bubble disintegration, which hit its highest level in 2006, after the U.S. lowered security values connected to the real estate and as a result, damaging financial institutions globally. Speculation led to more home owners seeking loans from banks, as housing prices began to rise.

The price of a typical American house had increased by 124% on average between 1997 and 2006 (Justin 4). The appreciating prices and lower interest rates triggered an increase in mortgage, though income generating projects were not able to grow at the same rate.

Banks encouraged home owners to take on loans persuading that they would be able to pay them back quickly without overlooking the interest rates. The interest rates began to rise in the mid 2007, leading to a decline in the housing prices significantly.

The speculative bubble was difficult to sustain by 2003 and 2008, the decline in the average U.S. housing prices was over 20% (Justin 5).

Refinancing became increasingly hard, thus resulting to a rise in the number of foreclosed homes. Lowering of interest rates, backed by the U.S. Federal Reserve from 2000 to 2003 from 6.5 % to 1 % provided simple credit conditions which led to increased borrowing.

Free Plagiarism Checker For Teachers These easy credit conditions prior to the crisis fuelled the housing construction boom and encouraged debt financed consumption. The U.S. was experiencing high and rising current account deficit, which pressurized lowering of interest rates as the U.S. required borrowing money from the outside countries (Justin 6). The situation created a demand of different financial assets, rising of their prices and reduced interest rates.

In addition, the easy credit conditions allowed borrowers with low credit histories and higher chances of defaulting to increase. This sub-prime lending has been viewed as one of the causes of the debt crisis.

Free Plagiarism Checker For Teachers Mortgage frauds have been confirmed and predatory lending has also been viewed as the cause of this financial crisis (New York Times 1).

Further, it has been argued that the regulatory framework was not able to keep up with the pace of financial advancements. Some laws were bypassed and their enforcement weakened in parts of the financial system.

As the housing bubble expanded, the U.S. households and financial institutions became increasingly indebted as a result of over-leverage contributing to its collapse.

The use of adjustable rate mortgage, mortgage backed securities, credit default swaps, collateralized debt obligations and other complicated, modern financial innovations were expanding, thus becoming leading causes of the debt crisis (Simkovic 4).

Financial agreements called mortgage-backed securities and collateralized debt obligations, which passed on their value from the payments of mortgage and prices of housing that increased rapidly. These financial innovations enabled investors and institutions around the world to invest in the U.S. housing market.

However, the market participants failed to precisely evaluate the risks associated with such financial innovations. They were not able to assess its impacts to the economy and the overall financial system (Gordon 6). Decline in the housing prices left the major global financial institutions that had borrowed to invest in the subprime MBS counting significant losses.

Free Plagiarism Checker For Teachers These great losses left many banks with very little funds to continue with their operations. The declining prices also resulted in houses valued going low compared with the mortgage, thus giving a financial incentive to enter foreclosure.

Free Plagiarism Checker For Teachers This foreclosure has been ongoing and it continues to drain wealth from consumers and the strength of banking institutions continues to be eroded (Justin 2).

Other parts of the economy have also been affected by defaults and losses of loans have significantly rose with the expansion of the crisis from the housing market. Below is a table reflecting the financial performance from 2006 to 2009.

The TED spread (in red) stimulated rapidly during the financial crisis, thus reflecting a rise in perceived credit risk. Other than housing and credit bubbles growth, various factors contributed to the increased financial inflation.

These caused the financial system to expand and become increasingly fragile, a process called financialization. The regulatory framework was not able to keep up with the pace of financial developments (Briggo, Pallavicinni and Torresetti 3).

Deregulation had been emphasized by the U.S. Government policy to encourage business, and this resulted in less disclosure of information concerning new businesses, as the banks were involved in. Less oversight of the financial institutions was also observed. Laws were bypassed, and their enforcement weakened in parts of the financial system.

Policy makers were unable to identify the role of financial institutions such as investments and hedge funds also referred to as the shadow banking system. Even though, these institutions were a source of credit to the U.S., as they were not subject to the same laws governing commercial banks.

They assumed large debt burdens by providing loans, but they lacked a financial support to deal with the large loan defaults and losses (Gordon 7). Free Plagiarism Checker For Teachers Economic activity was slowed and the lending ability of financial institutions was greatly impacted by these losses.

Central banks had to provide funds to restore faith in stock markets and encourage lending, which were integral in funding business operations. The government had to rescue the situation by implementing economic stimulus programs resulting to added financial commitments (Diya 5).

Subprime Lending

Subprime refers to the credit quality of certain borrowers who have weak credit histories and higher risk of default than the prime borrowers. Free Plagiarism Checker For Teachers High competition between lenders for market share and revenue and the short supply of creditworthy borrowers caused mortgage lender to provide risky mortgages to less credit worthy borrowers (Gordon 8).

Easy credit conditions allowed borrowers with weak credit histories and greater risk of defaulting to increase. As well as easy credit conditions, these competitive pressures contributed to the increase of subprime lending during the years prior to the crisis.

Government Sponsored Enterprises (GSEs) relaxed their regulations in order to keep up the competition with the private banks and together with the major U.S. banks played an important role in the expansion of lending. This sub-prime lending has been viewed as one of the causes of the debt crisis (Gordon 4).

Further, it has been argued that the regulatory framework was not able to keep up with the pace of these financial advancements. Some laws were bypassed and their enforcement weakened in parts of the financial system.

Expansion of the Housing Bubble

The global housing bubble disintegration peaked in 2006 in the U.S., thus lowering the values of securities tied to real estate, and as a result, damaging the financial institutions globally. The price of a typical American house had increased by 124% on average between 1997 and 2006.

Free Plagiarism Checker For Teachers The appreciating prices and lower interest rates triggered an increase in mortgage though income generating projects, which were not able to grow at the same rate. The speculative bubble was difficult to sustain by 2003 and 2008, the decline in the average U.S. housing prices was over 20% (Justin 7).

Free Plagiarism Checker For Teachers This decline in the housing prices led to great losses being reported by the major financial institutions that and invested heavily in the U.S. Investors’ confidence was damaged, thus impacting stock markets greatly (Briggo, Pallavicinni and Torresetti 9).

The strength of the banking institutions was eroded, credits tightened and international trade declined. Large losses in securities were reported in the late 2008 and early 2009 (Gordon 5).

Easy Credit Conditions

Lowering of interest rates in the U.S. from 2000 to 2003 from 6.5 % to 1 % provided simple credit conditions, thus leading to increased borrowing. The situation created a demand of different financial assets, rising of their prices and reduced interest rates.

The U.S. was experiencing high and rising current account deficit which pressurized, thus lowering the interest rates as the U.S. required borrowing money from the outside countries (Simkovic 8). An inflow of foreign funds was needed to allow it to balance its current and capital account.

Foreign investors were ready to lend either because of high interest rates (as high as 40% in China) or because of high oil prices. Foreign governments provided funds by buying the U.S.A Treasury bonds, and thereby, avoiding much of the impact of the crisis.

Predatory Lending

The practice of lenders enticing borrowers to get into unsecure loans for inappropriate purposes has been seen as a contributing factor to the financial crisis. The most common method used was the advertising of loans at low interest and later charging borrowers higher (Gordon 4).

Free Plagiarism Checker For Teachers The consumers would be put into an Adjustable Rate Mortgage (ARMs), where the interests charged would be higher than the interests paid, though the advertisement might state that the interest charged would be 1% or 1.5%. This resulted to negative amortization which borrowers might not realize until after completion of the transactions.

Deregulation

Regulatory framework was not able to keep up with the pace of financial advancements, such as the importance of shadow banking. Some laws and regulations were bypassed or changed and oversight in enforcement was absent in parts of the financial system (Gordon 10).

Free Plagiarism Checker For Teachers Restrictions on bank financial activities were not emphasized, thus allowing banks to rush into real estate lending and other activities even when the economy soared.

Over-Leveraging

In the period preceding the crisis, the financial institutions became highly leveraged, thus increasing their risky investments and reducing their abilities to deal with losses. Financial instruments like off balance sheet securitization and derivatives were used to make it hard for creditors and regulators to oversee and reduce the levels of financial risks (Simkovic 6).

This contributed to the need for the government bail outs, as the institutions were not properly organized in bankruptcy. Free Plagiarism Checker For Teachers As the housing bubble expanded, the U.S. households and financial institutions became increasingly indebted as a result of over-leverage. Their vulnerability to the collapse of the housing bubble was increased and worsened after the economic downturn.

Financial Innovations