Proposal for the Analysis of “Global Financial Crisis-2007”
During our lifetime we have seen many small and big recessions in different financial markets across the globe. The biggest of them all in last eighty years is definitely the Global Financial Crisis of 2007 which is also known as Subprime Financial Crisis. It being by far the most discussed economic topic of our times, lots of things have been said about why it happened and how it could have been averted. Still we are struggling to get out of the deep rooted impact it left upon the global economy.
The Global Financial Crisis did not just happen overnight. It started almost a decade back. From the turn of the century different events like Dotcom Bubble recession, Fed Interest rate cuts, lack of governing in the finance and securities market slowly but surely paved the path for the big crisis in 2007. The events that happened before and during the crisis in 2007 and 2008 would help in identifying the main stakeholders who were to be blamed and how we could have averted the global meltdown.
Firstly, the main purpose of this essay will be to identify the events that triggered the Financial Crisis, in chronological order. Secondly, it will try to scrutinize if US bankers and Policy Makers are the ones to be blamed only for this financial crisis of 2007. Lastly, it will also analyze if US Government or financial institutions could have taken measures to prevent this financial meltdown.
The topic is so vast and so overwhelming that it is almost impossible to bring out all the aspects in one single paper. However, I have gone through numerous research papers by IMF, EU Union finance bodies , US Federal Bank and independent economic bodies to understand the various sides of the crisis before coming to any conclusion upon the above three points.
In early 2007 one British bank called Northern Rock approached Bank of England for a loan to keep itself afloat because of its poor liquidity issues. Wall Street bankers vehemently opposing the demand let that bank sink. What followed afterwards is the biggest financial meltdown in last 80 years, also known as the subprime financial crisis of 2007-08.
Subprime financial crisis of 2007 was looming large in the world economy from the turn of the 21st century but the golden side of the booming economy made us completely overlook the fundamental flaws that were carrying the economy overboard. The Great Depression of 1930’s was much worse in terms of affecting the common men. However, owing to the world economy not being so closely connected the effect of Great Depression was limited mostly to Europe only.
The second most gigantic financial meltdown known as the subprime financial crisis of 2007 had characteristics markedly different from the “Great Depression” of 1930’s. By the time it hit the world, the macroeconomic conditions had changed a lot and the governing parameters of the world economy have shifted from isolated silos to a completely connected behemoth. The economy was so connected by the turn of the century that any economic bubble in any part of the world was certain to impact others. Although the financial crisis mainly started in US but soon it has its presence felt across the European nations and most of the developing countries of the world.
Economic Crisis 2007: The Beginning
The roots of the Financial Crisis of 2007 dates back to late 90’s when many big financial scandals rocked the business world shaking the confidence of the investors. Scandals like Enron, Nortel that crushed the confidence of common men in financial market and corporate houses were followed by the depression in Dotcom market in 2000 that turned worse after the attack on World Trade Center in September 2001. The market liquidity evaporated because of the recession.
In US, Federal Bank started cutting the prime lending rate in the market so that the liquidity in the market bounces back and the impacts of recession is minimized. From a decent lending rate of 5.25% in early part of 2000, it came down to 1.75% by the end of December 2001 which kept the liquidity in the market in good shape and soon the fear of short-lived recession was behind world economy. The Dotcom bubble burst though short-lived presented a nice gift to the people of US, the cheap availability of loan. The short lived Dotcom depression of 2000 was soon history but Federal Bank kept the lending rate to very low level for quick recovery from the after effects of the depression. The interest rate for home loan became so low that all Americans started dreaming of owning a house. In the wake of Dotcom bubble burst, willing home buyers met restless bankers. People started buying houses at cheap loan rate and bankers started fulfilling an average American’s dream of owning a house. Housing boom started in early 2002. The demand for houses started going up very fast, so did the requirement for money to buy those houses. Bankers in this house buying frenzy lost their fundamental credit rating parameters and started lending to subprime borrowers.
A hypothetical scenario of McDonalds will explain the trigger points of the crisis in more clear terms. Suppose I am a poor man (read subprime borrower), hungry and without money. McDonalds (read lenders) told me about an offer availing which I don’t need to pay anything immediately after I have a burger there. The payment could be made later without any extra charge for the delay. In such scenario two things generally happen. Firstly, in the absence of that offer, I probably would have eaten one burger by using whatever little money I have. However, with no monetary obligation now, I will be tempted to eat more than one burger. So in the process I will be tempted to go beyond by monetary capacity. Secondly, when others like me will hear about the McDonald’s offer, they will also come to avail the same.
After some time with the help of this special offer McDonalds will sell millions of burgers without even getting a single penny in return. However, their company balance sheet will show the possibility of earning millions of dollars from customers like me who are committed to pay at a later date. This is exactly what happened during the housing boom.
During 2003 the Fed rate hit almost all time low of 1% and this made the already cheap rate of loan even cheaper. Between 2002 and 2004 bankers gave loans worth billions of dollars to millions of people irrespective of their subprime ratings. It went from bad to worse when these subprime loans were soon securitized, bundled and sold to other financial institutions by Freddie Mae and Fannie Mac, and even by the big private banks. The nail in the coffin was hammered when the Securities and Exchange Commission relaxed the net capital requirement for five big investment banks making it even easier for them to offer loans to any Tom, Dick and Harry.
The Actual Fall
In the beginning of 2006 in US, availability of houses exceeded the demand. As a result, the housing price began to plummet. In a stable economy housing loans are safe bets. In case of subprime bad borrowers failing to pay the loan, the bank can seize the property and get its money back by selling the house. But that theory was no longer valid in the US market because by 2006 the house price had dropped sharply with subprime borrowers defaulting and the banks were unable to get any money out of selling the houses. The market was saturated, so there were no new buyers and the price of the houses plummeted from the actual price at which they were sold. To make matters worse, lot of borrowers who had taken a loan in 2003 or in 2004 at a rate of 1.5% now had to repay the loan at the rate of almost 6%. They started defaulting. Lot of cases of small subprime lenders filing bankruptcy surfaced in the first couple of months of 2007 leading to the downslide.
Even in the mid-2007, bankers believed that they can solve this subprime puzzle and as a matter of fact some of the big players started closing some of the subprime hedge funds and securities. However, they were only creating sand embankment to protect a financial tsunami.
7th August 2007 is the day when BNP Paribas with its announcement of no withdrawals from the three subprime hedge funds opened the flood gate and within next few days almost hundreds of billion dollars of bad debt was declared due to complete evaporation of liquidity from the market. This in turn affected the job market causing millions become jobless. Millions of previous homeowners were either gasping for loan repayment or already lost their homes to the bank.
Quick Fixes and After Effects
The unemployment rate went up causing economic slowdown in every sector. In next couple of months even some of the non-financial organizations started filing bankruptcy because of sudden drop in revenue and lack of working capital. To keep the liquidity in the economy intact different governments came out with different approaches. US government announced a $700 billion stimulus to bring back the economy to normal and beef up the employment. However, the impact of the financial crisis was so deep and huge that it will take many years for the economy to normalize. Austerity became a norm for many of the economies just to cut down the cost and keep the trade deficit within control.
Generally, when a depression or recession hit any economy the following events take place making the matter go worse.
As soon as the depression starts consumers get into panic and immediately cut their spending habits. In every mature economy almost ¾ of the economic actions derive from the expenditure of consumers. Hence even a small change in the spending pattern slows down the economy even further. 2007 recession was no exception in this matter.
Government needs to act swiftly to reduce the effects of recession by injecting monetary stimulus in the economy to revive dying businesses. Owing to many companies going bankrupt government revenue stream dries up. To reduce the deficit between spending and earning, government often cuts down on normal budget affecting different sectors, like research and development funds, healthcare, defense and direct and indirect employment by the government. US government in the process of making the financial crisis somewhat manageable injected $700 billion to the economy which put the country’s debt to all time high, forcing the government to take many austerity measures.
Stock market plummeted after the financial debacle causing huge erosion in the available net worth for companies. In fact some of the companies were so badly affected that they had to shut the business down.
Whom to Blame and Who Could Have Averted This?
This was too big an incident to get away without blame game. The finger pointing started immediately after the subprime crisis came into the scene. There has to be lot of parties to have done things wrong for a prolonged period of time for this big tsunami to shape up.
Lenders are definitely the prime culprits in creating the whole mess. It was upon the lenders whether or not to give loans to subprime borrowers no matter what the loan rate is in the market. They could have easily averted this crisis by refusing loans to subprime borrowers.
By 2005 most of the lenders started realizing that subprime lending was taking liquidity out of the system, but still they didn’t take any preventive action. Rather they started making more complex financial products out of those subprime loans by trading them, thus making more institutions susceptible to subprime loan.
Rating agencies were another party which could have alarmed the government about the subprime lending by downgrading the rating of securities but they conveniently forgot to do that. This might have happened due to some unsaid cartel between the lenders and the rating agencies.
Central banks and the governments too cannot be spared from taking the responsibility. They had the knowhow, expertise and power to restrict anyone in the system. They not only did nothing to stop it but accelerated the process from time to time by wrong policymaking, like low Fed rates in 2003 followed by relaxed capital requirement for certain banks. They could have easily made the financial lending and borrowing process more stringent. Then lenders would have been more cautious while giving loans to subprime borrowers.
It is very easy to point fingers now but identifying the novel and difficult financial products that were created out of a simple subprime loan and sold in the market were not easy. These complex financial products also made it difficult for regulators of the economy to recognize the crisis until very late.
Last but not the least the borrowers along with the lenders played a very risky game. They bought homes going beyond their affordability, hoping for a price appreciation that would have gone in their favor but sadly, that never happened.
So we see that the main events which triggered the financial crisis actually started way back in the 90’s with some financial scandals that were immediately followed by Dotcom recession causing financial investors losing faith in the market. Those two events forced Federal bank to reduce the rate of interest to an all-time low to keep the liquidity in US market intact. This helped the economy to bounce back fast but Federal Bank having forgot to raise the prime lending rate back to normal when it was over caused a huge housing bubble in economic market leading to the ultimate financial disaster of 2007.
Considering lenders/bankers to be the main culprits in this whole mess with policy makers and the government playing no part to prevent this debacle by bringing some stringent financial regulations in loan market, knowingly or unknowingly these two parties paved the road for crisis.
Everything about the Financial Crisis was not bad. At least it taught all of us that even the strongest of economies can face deepest economic trouble if the policies and parameters are not controlled effectively with the changing economic environment. It also made consumers, government, policy makers and business houses careful about their future moves and hopefully, better macroeconomic rules will be introduced into the market. Consumers being the worst sufferers of this financial crisis hope for such economic recessions never to be repeated again. Stricter governing bodies can stop some of the risk factors from the market but the macroeconomic parameters and dynamics change over time. It will not be easy to predict the behavior and interaction of the always changing macroeconomic dynamics in future but hopefully next time we, the consumers, will be better prepared.
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