The global economic crisis or the global financial crisis isbelieved to have begun when the housing market of the United Statescollapsed in 2007. The Lehman Brothers, a global bank, went bankruptin September 2008, and it almost led to the collapse of the globalfinancial system (Friedman 23). The crisis was caused by severalfactors that led to the emergence of the crisis and its growth until2009. The US Federal Reserve, central banks and other regulators alsotolerated unscrupulous lending of mortgages to the borrowers. Also,the so-called “savings glut” in Asia especially in China loweredthe world interest rates during the years of stable growth and lowinflation. When all these factors came into play, they fostered asurge of huge debts in the seemingly less risky world economy. In myopinion, I think that the central bankers and other regulators’mistakes by allowing the uncontrolled mortgage lending to borrowers,as well as, tolerating the growth of the crisis were the main causesof the global financial crisis.
The Unscrupulous Financial Institutions
Before the crisis, America saw irresponsible and unsafe mortgagelending to individuals and institutions for few years. The banks ofthe US extended “sub-prime” mortgages to borrowers, who had poorcredit histories and during repayment, they struggled a lot. Thebanks found out that the housing market was at great risk since thehome owners could not repay their loans. Eventually, many borrowersdefaulted in paying back their loans, and the banks was forced torepossess the houses and land but, the repossessed assets were worthless than when they were loaned out. As a result, the banks saw aliquidity crisis associated with difficulties in lending sub-primeloans (Claessens 54). At this time, the housing bubble, which wascharacterized by high house prices, burst leading to the collapse ofthe housing market.
Big banks engineered these risky mortgages and turned them intolow-risk securities that could be traded in the stock markets. Themortgage-backed securities were created to appear safe by pooling themortgages together for investors to buy them. The big banks claimedthat the housing markets in the US cities were independent of eachother, meaning that they would rise and fall differently. Theirarguments proved wrong because the housing market in the US had seenhouse-price falls since 2006. The pooled mortgages were securitizedto create the collateralized debt obligations (CDOs) and then slicedinto tranches based on the level of exposure to default (Forrest 39).Due to low global interest rates, many investors bought the CDOsbecause they appeared to be safer and would provide higher returns oninvestment.
The low interest rates at a global level created an incentive forhedge funds, investors and even banks to seek for more risky assetsthat provided higher returns. At this time, the global economyexperienced low inflation rates and stable growth and it is commonlyreferred to as the Great Moderation, which fostered risk-taking andcomplacency (Claessens 58). The banks exploited the low volatility ofthe world economy by making the interest rates to appear stable. Inthis way, they were able to trigger the investors to take the risk ofborrowing in the capital markets and buy their mortgage-backedsecurities, which were high-yielding and longer-dated.
From Housing to Money Markets
The global financial system was greatly affected when the housingbubble in the US busted. The financial engineering techniques andpooling of mortgages did not secure the trust of investors asplanned. As a result, the mortgage backed securities fell in value asmore investors sought less-risky assets such as government bonds andeven gold. The CDOs became worthless and the big banks haddifficulties in selling dodgy assets at any price since the investorsdid not get the promised protection. They could not use thesesecurities as collateral to seek short-term funding from other banksor the government. The debt created by defaulters in loan payment andthe low-valued dodgy securities led to bankruptcy of many banks(Friedman 25).
The Lehman Brothers Bank went bankrupt in 2008, and significantlyaffected the global financial system. The collapse of the LehmanBrothers marked a series of other dissolutions because the Trust haddissolved a year before, in 2007 (Aizenman & George 356). Thecollapse of several big banks in the US and Europe created a havoc inthe financial market as banks started doubting the financialviability of their counterparties. A British mortgage lender calledthe Northern Rock also collapsed in 2007 as a result of thedifficulties in the global financial system believed to have beencreated by American unscrupulous banks. The effects of the housingmarket on the money market affected European, Chinese and Australianbanks because they had bought the suspect assets and securities(CDOs) engineered by American big banks.
In the attempt to spread the risks through the use of thecredit-default swaps, it turned out that the banks were concentratingit. Credit-default swaps are forms of financial instruments used byinvestors, which could be banks or individuals to insure against theunforeseen loan defaults (Aizenman & George 358). The use ofthese financial instruments led to many people seek for insurancecovers for their assets but, major insurance companies such theAmerican International Group (AIG) extended its liability more thanits capacity (Claessens 69). Banks set aside little capital to absorbthe losses since they had permitted their balance sheets to swell upas shown in the chart below. Although the gambling with borrowedmoney provided more returns, it turned out to be catastrophic whenthe value of their securities rapidly fell in the money markets.
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Failure of the Financial Regulators
Some economists claim that in addition to the banks’ mistakes, thefinancial regulators around the world should be held responsible forfailing to handle the crisis accordingly. The central banks and otherregulators failed to oversee the operations of financial institutionsand did not control the economic imbalances in the world economyparticularly in the money market. It is claimed that the regulatorslet the Lehman Brothers, a global bank, go bankrupt. The Lehman’sbankruptcy created havoc and panic in several markets and suddenly nobanks would lend and nobody would be trusted by others. For example,the non-financial institutions froze their expenditures to hoard cashsince they could not have borrowed from the banks (Forrest 41). Intheir attempt to keep their businesses running, these companiesaffected the real economy.
When the regulators allowed big banks to go bankrupt, the governmentintervened to rescue the big financial institutions in almost everycountry across the world. This happened as the collapse of thehousing and capital markets worsened at a global level. Many banks atthat time faced liquidity issues since they could not secure fundingor sell their assets to the investors to get money. It is claimedthat the regulators didn’t track the performance of the propertyand stock markers even before the crisis. The central bankers helpedto inflate the housing bubble and tolerated the imbalances in theworld current-accounts even before the Lehman Brothers went bankrupt(Zestos 10).
The Federal Reserve did not attempt to curtail the inflated housingbubble that is characterized by high prices of houses. The EuropeanCentral Bank assumed that it had no responsibility in maintainingfinancial stability and thus, failed to restrain the mortgage lendingsince they thought that the imbalances in the current accounts didnot matter in the monetary union (Zestos 13). Although the centralbankers claimed that they were unable to regulate the key markets byraising the interest rates, they could have demanded the banks to setaside more capital or lower the rates of mortgages lending toborrowers. These are some of the regulatory tools they could haveused to curtail the worsening money and housing markets.
The “Savings Glut” or Excess Savings in Asia
The excess savings in Asia especially in China greatly lowered theworld interest rates. During this period of “Great Moderation”the world economy saw stable growth and low rates of inflation, andthis fostered risk taking in the money markets and self-satisfactionin many domestic economies. The “savings glut” in emergingeconomies was characterized by the purchase of bonds from theAmerican government, thereby pushing down the interest rates. TheCentral banks had raised concerns before the crisis warning that theexcess savings from Asia could have affected the American moneymarket (Zestos & Yin 175). For example, Ben Bernanke, the Fed’sChairman highlighted the saving excesses in 2005. The European banksand Chinese institutional investors increasingly bought many unsafeAmerican securities offered in the money market.
The European banks were victims of the saving excesses ofAnglo-Saxon bank and propagated the collapse of the global financialsystem. They created the euro, which in turn prompted the expansionof the financial sector within the euro region and in nearby bankingcenters such as Switzerland and London. Additionally, Europe hadinternal current-account imbalances similar to those of the US andChina (Zestos & Yin 176). These imbalances were funded by creditsfrom the euro-zone, which was also experiencing an increase inhousing prices in countries such as Ireland and Spain. The eurocrisis propagated the financial crisis in some ways as the Europeanbanks were loaded with debts when the housing bubbles in the euroarea busted.
Key Factors that led to the Global Financial Crisis
Up to date, economists still argue whether the low global interestrates were facilitated by the regulators’ mistakes or thesubstantial shifts in the global economy (Friedman 27). The centralbankers’ mistakes led to the collapse of the housing market of theUS and some experts believe that it triggered the global economiccrisis. Those who claim that the shifts in the world economy causedthe crisis support their argument by examining what had happened theprevious years before the crisis. These experts and some politiciansstrongly believe that the unscrupulous lending of mortgages to peopleled to the financial crisis since the housing market had beenperforming poorly since 2006. In my opinion, I would argue that thecentral bankers and big banks’ mistakes caused the global financialcrisis.
The Housing Bubble of the US
As discussed earlier, there was uncontrolled “sub-prime”mortgage lending to people in the US before the crisis (Batten &Szilagyi 70). It seems that if the regulators could have controlledthe amount of mortgage loans lent to individuals in the risky housingmarket they would have prevented its collapse in 2007. If the FederalReserve had curtailed the inflation of the housing bubble in theAmerican cities, it would have been easier to maintain the “GreatModeration” that was indeed healthy for the US and the worldeconomy. It is argued that the banks even led mortgage loans toborrowers with poor credit histories just to reap higher benefitsfrom the booming housing business. I think that the most obviouscause of the financial crisis is the greed portrayed not only by theborrowers but, also the banks that lent the money.
The Unscrupulous Banks
When the banks realized that the borrowers could havedefaulted in paying their mortgages, they created the mortgage-backedsecurities to be traded in the money market (Batten & Szilagyi88). I think that at this point, the big banks increased their ownrisks of failure and at the same time spread the risks to the moneymarket. In their attempts to reclaim the money lost through mortgagelending, they put their assets at greater risks. It seems that if thebanks would have controlled the housing market without touching themoney market, they would have reduced the occurrence of the globalfinancial crisis.
When the financial regulators including the Federal Reservelet the Lehman Brothers Bank go bankrupt, they worsened the moneymarket in the US that spread to China, Europe, and Australia amongother countries around the world (Batten & Szilagyi 90). In myopinion, if Fed had kept proper oversights over giant financialinstitutions in the US, it would have bailed out banks such as theLehman Brothers and contain the crisis in America. They could havedemanded the banks to set aside more capital and avoid inflatingtheir balance sheets to handle the crisis and the incubation stage.However, when the financial regulators allowed banks to use anymethod in reclaimed their bad debts, I strongly believe that thisworsened the crisis spreading it to other money markets around theworld.
The global financial crisis of 2007-2009 that greatly affected theworld economy can be claimed to have been mainly caused by thecollapse of the housing and money markets due to the central bankers’mistakes since they allowed unscrupulous mortgage lending toborrowers. Although some economists still argue that the excesssavings from Asia caused the crisis, the fact that the US banksincluding the Federal Reserve could have regulated the loans lend toborrowers for buying homes long before the crisis rules out thisproposition. The period of “The Great Moderation” that wascharacterized by stable growth and low inflation before the crisisprompted the extraordinary inflation of the housing bubble by USbanks, and the Fed could have prevented this trend. When the bubblebusted, the big banks of the US spread the risk to the money marketby offering dodgy securities to investors. As a result, manyinvestors from the US, China and Europe bought these assets to gethigher returns on investment. After some time the money marketcollapsed leaving the Lehman Brothers bankrupt. It seemed that thecrisis would not have reached to that extent if the financialregulators had kept in check the current-account imbalances inEuropean, Asian and American banks.
Aizenman, John and George, Pasricha, “Selective Swap Arrangementsand the Global Financial Crisis: Analysis and Interpretation.”International Review of Economics and Finance 19(2010):353-365. Print.
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Claessens, Stijn. Financial Crises: Causes, Consequences, andPolicy Responses, New York: Cengage Learning, 2014. Print.
Forrest, Ray. Housing Markets and the Global FinancialCrisis. Cheltenham: Elgar, 2011. Print.
Friedman, Jeff. What Caused the Financial Crisis?Philadelphia: University of Pennsylvania Press, 2011. Print.
Zestos, George and Yin, Ling, “Global economic Convergence.”International Journal of Economic Research 6 (2009): 175-203.Print.
Zestos, George.The Global FinancialCrisis: From US SubprimeMortgages to European Sovereign Debt. London:Routledge, 2015. Print.