Global Financial Crisis: Causes and Effect

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Introduction

The financial crisis that began in 2007 spread and gathered intensity in 2008, despite the efforts of central banks and regulators to restore calm. By early 2009, the financial system and the global economy appeared to be locked in a descending spiral, and the primary focus of policy became the prevention of a prolonged downturn on the order of the Great Depression.

The volume and variety of negative financial news, and the seeming impotence of policy responses, has raised new questions about the origins of financial crises and the market mechanisms by which they are contained or propagated. Just as the economic impact of financial market failures in the 1930s remains an active academic subject, it is likely that the causes of the current crisis will be debated for decades to come.

Financial Crisis
The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults.

Major causes of Financial Crisis
Imprudent Mortgage Lending: Against a backdrop of abundant credit, low interest rates, and rising house prices, lending standards were relaxed to the point that many people were able to buy houses they couldn’t afford. When prices began to fall and loans started going bad, there was a severe shock to the financial system.

Housing Bubble: With its easy money policies, the Federal Reserve allowed housing prices to rise to unsustainable levels. The crisis was triggered by the bubble bursting, as it was bound to do.

Global Imbalances: Global financial flows have been characterized in recent years by an unsustainable pattern: some countries (China, Japan, and Germany) run large surpluses every year, while others run deficits. The U.S. external deficits have been mirrored by internal deficits in the household and government sectors. U.S. borrowing cannot continue indefinitely; the resulting stress underlies current financial disruptions.

Securitization: Securitization fostered the “originate-to-distribute” model, which reduced lenders’ incentives to be prudent, especially in the face of vast investor demand for subprime loans packaged as AAA bonds. Ownership of mortgage-backed securities was widely dispersed, causing repercussions throughout the global system when subprime loans went bad in 2007.

Lack of Transparency and Accountability in Mortgage Finance: Throughout the housing finance value chain, many participants contributed to the creation of bad mortgages and the selling of bad securities, apparently feeling secure that they would not be held accountable for their actions. A lender could sell exotic mortgages to home-owners, apparently without fear of repercussions if those mortgages failed. Similarly, a trader could sell toxic securities to investors, apparently without fear of personal responsibility if those contracts failed. And so it was for brokers, realtors, individuals in rating agencies, and other market participants, each maximizing his or her own gain and passing problems on down the line until the system itself collapsed. Because of the lack of participant accountability, the originate-to distribute model of mortgage finance, with its once great promise of managing risk, became itself a massive generator of risk.”

Rating Agencies: The credit rating agencies gave AAA ratings to numerous issues of subprime mortgage-backed securities, many of which were subsequently downgraded to junk status. Critics cite poor economic models, conflicts of interest, and lack of effective regulation as reasons for the rating agencies’ failure. Another factor is the...
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