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What Caused the Global Financial Crisis?

Introduction

It is ascertained that global financial crisis sent great fear around the banks with banks virtually refusing to lend each other. It had been affirmed that this necessitated the authorities to struggle to increase liquidity into the fiscal markets while corporate bonds witnessed a premium increase by around six percent. This had the effect of stopping the corporate sector from borrowing, development projects were shelved for lack of funding, trade credit was difficult to get and investments of manufactured goods and durables like cars witnessed a sharp drop in volume.

The result of this crisis saw a reduction in economic activities in the economy with developed countries finding themselves on the wrong side. There was a loss of confidence in the US investors that resulted to consumer confidence hitting rock bottom as everybody prepared him/herself for any eventuality. The housing sector was greatly affected as home owners and developers who had taken loans found out that they could not continue with their mortgage payments and hence found themselves with negative equity. Repossessing houses owned by the borrowers by the banks was not worth what was originally borrowed from them. This housing situation acted as an eye opener to politicians who believed that a better financial system was needed to regulate and discourage unprincipled borrowing and lending. Governments responded to salvage their economies by easing both monetary and fiscal policies to allow more trade and financial flows. This response by governments resulted to unemployment rise in the countries due to political efforts to protect local industries from collapsing through introduction of subsidies.

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It is worth pointing out that the global financial crisis first started on the housing market in 2007 and spread steadily across the world destroying the economies of those countries including that of US. This investigative paper will first examine the reasons that led to the crisis and in particular investigate the development and downfall of the housing sector and the significance of financial tools that changed the backdrop of economy.

The research topic is what were the likely causes of this situation and how did different countries respond to salvaged their economies from collapsing. This topic is worth investigating as it will help an individual understand both the short and long term causes of this crisis and basing on the causes, lessons that can be learnt and derived from both so that both governments and companies can prevent future occurrence of this problem.  The paper in the process will seek to address questions revolving around what might have implicated and motivated the occurrence of certain events prior to the crisis of 2008. It will also in addition try to answer the response mechanism that different economies and governments put in place to mitigate the impacts of the crisis to the economy.

Qualitative research technique will be used for this investigation as it will develop concepts that will help expose the occurrences of the study investigation giving emphasis to the different views and notions under study. Qualitative social analysis method may be affected by biases that arise from different political liking, attitudes and different ways of thinking. Bias in this piece of work will be amicably dealt with by consulting variety of sources to get different insights and opinions then a thorough analysis done. For this case both qualitative and quantitative research methods will be used for the study but retained qualitative method as the primary tool. Using both eliminates bias in addition to improving on data evaluation by ensuring that each limitation is balanced by the strength of the other technique. Bias was eliminated as there is greater understanding of issues as the two techniques are used concurrently.

The study provided answers to the research question and topic; poor mortgage arrangement, highly over formulated balance sheets, increased use of credit defaults, poor housing loan schemes are some of the factors that contributed to the crisis.  It was also discovered that the solution to this crisis relied on government regulations and control.

Background of the problem

The problem originated from when homeowners and buyers were convinced that home prices would tremendously continue to increase and that they could capitalize on that opportunity to invest in real estates and homes. This encouraged people to buy more homes that in real sense they could not afford as they equated the homes to the loans that were advanced to them. Banks that were giving out the loans did without proper verifications of the borrower’s credit status or income. Economists eluded that a “bubble” was generated in the housing sector a market condition in which a particular industry or sector receives too much investments more than the others, everyone was now investing in housing units with the notion that home prices would continue to rise.

Literature available in the area acknowledges that a similar bubble was also experienced in the technology sector and with the collapse of this in the year 2000 there was need to invest in another sector. The housing sector bubble was quite unique to other bubbles as the entire economies and sectors were directly involved in this. US households for instance experienced reduced savings as home prices continued to rise. This reached to a point of using savings as equities for home loans, what they normally would save for their own upkeep and consumption. The continued consumer spending in the industry were strictly tied to the housing prices, the entire world heavily invested in the housing sector and when the bubble collapsed in 2006 the entire world economy was affected.

The results of the collapse of the housing boom included the world stock markets declining by 48%, Chinese exports declined by 3% among others countries that experienced different repercussions. This paper will consider both the short and long-term causes of the 2008 financial crisis and, based on these causes, note the lessons we can derive from them, both for government and companies.

Social analysis framework

PEST social analysis framework was used in the research paper, it allowed for the description of the political, economic, social and technological factors that may have been responsible for the crisis (Greenspan, 2007). It is a framework that forms an external part of analyzing problems and factors that are responsible for certain events in the economy, in other words, social problems. In this crisis banks were partly responsible for the collapse of the economy and hence understanding the social world is important for any investment to be commissioned by the banks. Major indicators of economic growth are reduction in poverty levels through investments in projects and sectors that would generate high returns.

As pointed out earlier qualitative technique was the primary method for this investigation. This method has the ability to take into account diverse opinions and experiences arising from data collection. It is vital in describing social events that occur in the day to day life activities, its premise is gaining the understanding of such events and the likely factors contributing to their occurrences. This technique has the potential of developing theories to be used in understanding and gaining insights on the issues under study in different fields including economics. Scholars have argued that this technique borrows much from constructionism epistemology of learning that elaborates that learning is gained through interactions. Global financial crisis was considered as a social problem that in perspective was not desirable to the people and the economies of different countries. It is ascertained that social analysis can address such kind of issues through qualitative research couple with a multivariate analysis of findings and their relationships.

Social analysis methods have been instrumental in gaining insights on issues bordering on injustices and when combined to analysis techniques can help companies or governments to develop strategies and policies to prevent certain problems and crisis like global financial crisis from happening. For instance, after discovering the negative effects of global financial crisis governments came up with regulations to control their economies and prevent them from collapsing.

Causes of the Crisis

Available literatures have indulged in-depth discussions on the likely causes of the financial problem that disrupted the economies of the world. Some have floated reasons like over-investment on housing units, strange securities for loans advanced, small and not approved financial institutions among others.

Household Debt and Consumer Spending

According to available literature this was a key cause of the crisis, it is ascertained that in the beginning of the 1980s the American households started saving less while taking more debts from financial institutions. Between 1996 and 2006 the economy experienced a rising in home prices, the US households began taking mortgages and the notion at that time was that there were reduced risks that were associated with investing in the housing sector. Statistical data available indicate that US households for instance had their personal saving rate at 10.2 percent in 1980, gradually this rate reduced to 1.2 percent in 2000.

At this time consumer spending that was consider a vital driver in domestic growth began reducing as homeowners were using their home equity as savings reducing what was saved for consumer spending. Van Eeden points out that consumer spending was at 62.3 percent of US GDP in 1982, in 2004 the figure rose to 70 percent. This meant that the US households for instance were more vulnerable to economic downturn since the economy was considered fragile especially in the case where the housing prices could come down tremendously. Analysis pointed out that as the housing prices increased the households were able to spend more of their earnings and the economy would continue to grow, on the contrary a decrease in housing prices could tremendously affect the economy through a strong decline.

Scholars have argued that this was a cause and amplifier of crisis and recession, the housing sector was integral to the success of greater economy making it more easy and attractive to invest in. “Economically when housing prices increase there is a considerable reduction in savings and a more increased spending leading to more investments in the economy” (Arnold, 2009). When the rapid reduction in housing prices occurred in 2006 household were forced to reduce their consumptions. It is avowed that multiple recession lead to more reduced consumer spending and in the process affected more industries and hence the economy (Arnold, 2009).  This greatly affected the US economy that later spread to other countries that depended on exports.

Promotion of corporate debt

It has been affirmed that there are two ways of financing a company or a corporation; one is equity coming from stakeholders and the other debt from other people or financial institutions. It is a known fact that in either way the corporation must compensate the shareholders or the debtors for the advanced capital. Financial analysts consider debt to be more attractive to finance the activities of a corporation compared to shareholders equity, equity is more expensive. This therefore encouraged debt taking by corporations as they were motivated by the profits margins that appeared to be low after paying the debts to debtors. Analysts acknowledged that institutions maximized on their return on equity making them have higher leverage ratios in the process (Arnold, 2009).

When investments in the housing sector took off due to the expected lucrative return on investment through increase in housing prices it set a stage for financial crisis. When the housing sector came down crumbling due to reduction in prices many companies and corporations were affected drastically affecting the economy. It was eluded that in the situation that the federal government encouraged debt taking by corporations it was evident that they were preparing a stage for crisis. The US economy was affected, countries that depended much on the economy of the American people also faced the wrath of this biting crisis.

Lost Confidence

“With the economic recession people lost trust and confidence in the financial institutions and their corresponding systems” (Langley, 2015).   People questioned the health of most financial institutions in the US and Europe leading to financial shock. Scholars argue that financial institutions pursued self-interest first a fact that was more detrimental to borrowers and taxpayers. The selfish pursuit made people and companies to lose interest in borrowing. This led to closure of some corporations shrinking the economy further.

Politics of homeownerships

This notion was brought forward by Fannie Mae, Freddie Mac and was commissioned by the Congress as government sponsored enterprise (GSE). The mission of these firms company was to provide a level ground for taxation in the public domain. Their mission was to commission same tax and rules in the financial sector. They were to make it easy for homeowners to secure loans by buying mortgages, putting them together and selling them as backups for mortgage securities. They were able to buy mortgages and sell them making huge profits. It was a fact that being of a GSE status there was belief that they had the federal government as their backup. They were able to buy securities at reduced rates and sold them expensively to the public, by so doing they took mortgage lending off the shoulders of other financial institutions helping them to make more loans. Making more loans increased liquidity by providing constant buyers for loans. The two companies did not just directly contribute to the housing bubble by decreasing the interest rate.

The Clinton presidency also advocated for increased home ownership for those who had low-incomes; this motivated the desire to take more loans to own houses. In 1992, the Congress pushed the two companies to increase mortgage loans that were going to those of low-income; additionally they were given benchmarks and target to meet in ensuring that the low-income households were in positions to own houses. To meet their targets the two firms had to buy widespread amounts of mortgage backed securities, their effects took lending off the balance sheets of banks thereby fuelling the subprime problem in the economy (Langley, 2015).  The political atmosphere necessitated the increase in ownership of homes and when the housing prices came down the crisis evolved.

Low interest rates

It is ascertained that the economy of US experienced recession after the end of the technology bubble in 2000. It is believed that the recession was made even worse by the terrorist attack of September 11 and that affected drastically and even disrupted the financial markets of the economy (McKibbin and Cagliarini, 2009). “When the financial markets resumed Fed had to cut the rate of their funds, Fed controls the lending rates by banks thereby controlling the interest rates imposed on debts”(McKibbin and Cagliarini, 2009).

After the collapse of technology bubble there were a lot of capital for investment and therefore the need for somewhere to invest in. Mortgage-backed securities were chosen and with fed funds being low, lenders had easy time in securing funds to lend. Homebuyers were also able to secure loan with easy terms, investment banks even took advantage of the opportunity to invest in mortgages that had securities as their backups to maximize on their profits. It is believed that fed funds contributed to the bursting of the economy as they caused over-investment in the housing sector (Langley, 2015).

Derivatives

It was eluded that Morgan chase invented credit defaults that could allow companies to evade risky investments, risks could be shifted to third parties and in the process act as insurance. At the time this was considered a bad idea as it increased market efficiency by spreading risks of any eventualities. In 2007, a lot of money was speculative in the market through the spreading of the risk to an extent of not knowing actually who was holding them. When companies like the Lehman brothers started failing protection against the Lehman business had to be paid. To the contrary most firms evaded their own position creating a difficult situation. It was estimated that the Lehman brothers business had an estimated four hundred billion dollars that needed to be settled. Fear engulfed the economy as it was evident that the settlement would be a mess and that the large payouts could destroy other firms that had references to the Lehman’s. The economy was therefore hurt as after settlement only five billions dollars exchanged hands as the speculative funds had to be settled creating the crisis.

Foreign Capital

This was also considered a causing factor to the global crisis, for instance, China’s policy was pegged on encouraging more exports at the expense of domestic consumption. This policy had been considered a success as the revenue had grown from eighty million dollars in 2000 to two hundred and twenty five billion dollars in 2006. This allowed the Chinese economy to accumulate lots of dollar reserves which they again invested in the US economy in form of security holdings. The securities that the Chinese invested in US economy were on a long term basis and were controlled by Fannie Mae and Freddie, the two companies were vital in the housing market and by 2008 the Chinese were directly indulged in the housing boom business. When housing prices came down both the economies of the two countries were heavily affected.

Findings and analysis

The research found out that there was no single cause and that it was interplay of many forces. It has been ascertained that among the forces that were responsible for this included securitized mortgages, involvements of “Fannie Mae and Freddie Mac” companies in the housing business, excess liquidity that were created in the economy and the notion  of driving up the prices of homes to a boom-bust cycle in the economy (Jickling, 2008).  Others include the low rate of savings and economic growth being pegged on consumer spending.

It was also discovered that the Federal government set the stage for a painful economy recession; this was through increasing the desire for home ownership at all costs creating an enabling environment for virgin mortgages to take off. It providing a driving force for companies to invest as in the process laying a foundation stone to the financial crisis witnessed in 2007-2008.

It was also noted that low-slung interest proportions that were charged by Fed provided cheap money and increased the rate of investment in the housing market allowing people to take securitized mortgages. The Chinese capital that found its way in the economy of the US also provided more liquidity for the housing boom business; the government was thus responsible for encouraging risky investments into the economy.

It was discovered that having speculative funds spread to other third parties also contributed to the crisis as it brought great uncertainty in determining who held the mortgages in the economy. All the factors bundled together provided a smooth path for the occurrence of the crisis, when the housing boom came to an abrupt end, housing prices began to come down. The mortgages that were issued were issued to those who were unqualified, fear spread through the market as losses were looming launching the financial crisis that later spread throughout the world economies.

The research also uncovered lessons that were learnt from the events leading to the crisis, it was learnt that people and the government never looked into the underlying concepts. The leveraged balance sheets, speculative funds spread were to be controlled and regulated by the government. It is worth pointing out that regulations can be passed to require large capital reserves to qualify for loans, enforce strict underwriting principles and reduce the use of credit swaps to solve such unforeseen problems in the economy. Another lesson learnt from this is that even if the government has good intentions, the economy stakeholders like the financial institutions can be driven by selfish interests, something that in the end would hurt the economy even further. Such selfish interests develop certain mechanisms to circumnavigate around regulations put in place by the government. Franklin Allen points out that  financial liberalizations is an important factor to consider in situations when assets prices tremendously increases then dramatically come down.

The study also uncovered that the government role in increasing homeownership distorted the market thereby resulting to a disastrous situation, the government must be hesitant in advocating for certain things that may have direct impact on the economy. It was ascertained by financial analysts that the unintended consequences are always bigger and the effect disastrous than the intended one in the long term.  In this regard the regime and the people should study from preceding inaccuracies in the economy to prevent future problems.

The study provided insights on the importance of legal tender regulations, the Chinese and US are drawn to this assertion because both print their own currencies. When countries conduct business the currencies are converted to their own, in the case of China having large reserves of dollars give them certain levels of economic power. Political interests when included in this made the Chinese government to use their dollar reserves in the economy thereby distorting the markets. Strict legal tender laws should be put in place to prevent this situation.

Recommendations

From the study several recommendations are suggested, first, to prevent the occurrence of the crisis in future the Federal Reserve and central banks of different countries should use interest rates to keep stable the money supply in the economy. For instance, the low interest rates offered by Fed after the September 11 terrorist attack provided easy money for the housing sector creating a bubble in the sector (Jickling, 2008).  “When the supply of money is stable in the economy the price levels of assets are also stable preventing booms and bubbles from developing in the economy” (Taylor, 2009).

Second, the two firms that were controlling securitized mortgages in the economy, “Fannie Mae and Freddie Mac” should be privatized as in their current form they are in positions to receive financing at the same rate as the federal governments. Removing their status will force and subject them to the same market prices in the economy ensuring that they have no advantage of over-controlling the sector. In this scenario large amounts of liquidity will be removed and thus preventing market distortion (Langley, 2015). This should be done procedurally after the economy has fully recovered from the damage to prevent upsets in the market.

Third, as a measure to prevent future crisis, governments should not rescue failing companies. “Firms were bailed out during the crisis of 2008-2007 because they were considering themselves too big to fail and that they are very important to the economy of those countries” (OECD, 2009).   This bailing out creates unethical hazard by firms not having well define mechanisms to survive in the economy.

Fourth, the financial industry and system should also come up with incentives that can stimulate long-term investments in the economy. This is evident in the scenario of almost all financial institutions involved themselves with the short term housing boom. A former economist of the IMF pointed that when employees are awarded bonuses yearly then there should be a way to take away such bonuses in case they make losses for that given period. The industry should behave responsibly just like requiring managers to invest in the businesses that they operate.

Conclusion

This paper has explored the causes that led to the predicament that spread to other countries in the world affecting major economies including those of US and China. It was discovered that the major causes were broadly drop in asset prices and reduction in demand and trade among different sectors and countries. It is paramount to simulate the effects of a bursting economy using the housing bubble in the US and Europe to ascertain the rising perceptions of risky businesses by households.

This paper has also described extensively what can be learnt from the crisis and how to mitigate the effects to prevent any future occurrence. Findings for the research have been analyzed adequately to help gain insights on the issue. The analysis has included monetary and fiscal stimulus that might have caused the situation and how future cases should be treated. It is believed that other countries would have reallocated their capital to other investments and thus the situation would have not been as dramatic as witnessed (Brigo etal, 2010).  The world would have escaped the recession had countries like China reappraised and re-evaluated their investment decisions.

The study has authoritatively affirmed arguments by other scholars that the teeming of the “housing bubble” leading to the decline of house prices was responsible for the collapse of the economy.  The study has also made recommendation to prevent future financial crisis by reappraising risks in business and the scale of damage likely to be impacted by the risk. Bold recommendations have also been formulated on areas like controlling interest rates, privatizing mortgage companies and investing in numerous sectors. Investing in multiple sectors is important so that in cases of collapse in one sector the economy can still stay afloat.

References

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