Financial Crisis BY kstnghl 523 The Over-weighted Factors The Subprime Crisis was cause by multiple factors, some more impactful than others. In the aftermath, there was enough blame to be spread all around, but some institutions and firms did not deserve the level of blame they received. The amount of blame placed on the Gaussian copula function is unjustified. Some states took heat with regard to laws passed to protect home buyers in times of default. The Federal Reserve was quickly pointed out for not recognizing a housing bubble and keeping interest rates too low.
Some theories presented by Caballero on why the financial crisis occurred consist of irregularities that he failed to explain. Caballero writes that causes of the financial crisis are linked to a global imbalance or shortage of safe debt instruments, and that this shortage of safe debt instruments presented the private sector to produce these securities (8). Caballero cannot say a shortage of safe assets caused the financial crisis, since it was the private sector that was the culprit behind the crisis with the instruments they engineered.
A shortage of safe debt instruments did create opportunity for the rivate sector, but this shortage is not what drove the private sector to take on significant risks. The private sector could have actually helped bridge the gap of shortages by actually producing safe instruments by only issuing prime mortgages and practicing good risk management, but they were driven by other forces such as greed to capture market shares of investors. To imply that a shortage of safe assets drove banks to create high risk securities is absurd.
Using economics theory, since the demand for safe debt instruments was far greater than the supply, therefore, the xcess demand should drive the interest rates on these securities close to zero. This was not the case, as interest rates stayed fairly stable up until the crisis hit. If the demand for safe debt instruments was as strong as Caballero implied, then interest rates should have fallen until the market was satisfied, or until a fraction of investors were unhappy with the new returns and turned to riskier assets with higher returns.
How developing nations were affected: The prudential regulation and supervision recommended to developing countries was largely ignored in the developed nations. No country, however, is spared from he consequences of the downturn. The impact on developing countries is even greater. The current financial crisis affects developing countries in two possible ways. First way is that there could be financial contagion and spillovers for stock markets in emerging markets. The Russian stock market had to stop trading twice.
The other way is that the economic downturn in developed countries may also have significant impact on developing countries. The channels of impact on developing countries include Trade and trade prices, Remittance, foreign direct investment. Remittances to developing countries will decline. There will be fewer economic migrants coming to developed countries when they are in a recession, so fewer remittances and also probably lower volumes of remittances per migrant. Another factor that the crisis affected developing nations was Commercial lending.
Banks under pressure in Investors are, increasingly, factoring in the risk of some emerging market countries defaulting on their debt, following the financial collapse of Iceland. This would limit investment in such countries as Argentina, Iceland, Pakistan and Ukraine. While the effects will vary from country to country, the economic impacts could include, weaker xport revenues, further pressures on current accounts and balance of payment and lower investment and growth rates. There could are also social effects such as lower growth translating into higher poverty, more crime, weaker health systems.
Possible policy responses From the current macro economic and social challenges posed by the global financial crisis requires a better understanding of appropriate policy responses. There needs to be a better understanding of what can provide financial stability. There also, needs to be an understanding of whether and how developing countries can minimize financial contagion. Developing countries will also need to manage the implications of the current economic slowdown. The Important Factors The housing bubble is at the core of what caused the financial crisis.
Consistent increases in real estate prices since the 1970s made it very hard to believe that prices would fall. The trend was too hard to be ignored by the market. Banks were more lenient with their lending practices because they assumed that house prices would continue to increase. What they failed to take into account is the possibility that prices might fall. They did not notice that even though house prices ad been increasing, it was not in proportion to income, and that means that home buyers had gradually become more risky.
The housing bubble was fueled further with low interest rates, which increased the demand for mortgages. This increased demand for houses created opportunity for developers who increased the supply for houses. Both the demand and supply of real estate expanded, causing the bubble to inflate until it popped. During the time leading up to the crisis, there was a change in the financial structure. This change in the financial structure had a profound effect on lending practices. This structural change began with the expansion of 6SEs (Fannie Mae and Freddie Mac) that increased their purchases of mortgages.
The system had changed in such a way that banks no longer had to hold mortgages until maturity; instead, they can sell them to 6SEs and other private firms. This had a profound effect on the banking system. Banks no longer made their profits from interest payments, but from selling off mortgages issued. This relieved banks any risk taking they took before, when they held mortgages and increased the incentives for banks to issue as many loans as possible in order to maximize profits. Banks’ internal controls changed and created incentives for brokers to act in malicious ways in order to issue loans.
Such behavior led to an increase in moral hazard, both on the part of lender and borrower. Brokers would tweak numbers to approve more mortgages and geta higher commission, while borrowers falsified or were encouraged to falsify information in order to be approved. of complex securities. This allowed financial markets to expand greatly with the invention of Collateral Debt Obligations (CDOs) and Credit Default Swaps (CDS). These securities were complicated, and it was extremely difficult to assess the risks elated to them.
Due to this, most investors, and even the Federal Government, relied on ratings given by rating agencies. The rating agencies were wrong in their risk assessment; they failed to impose strong enough tests on the securities they rated such as the event of falling house prices. The underlying problem came from the structure of these securities where the issuer tranches lower class securities to make higher rated securities. To simplify, it is basically taking different forms of trash and creating art sculptures and raising the price; at the end of the day, however, the art sculpture will still be garbage.