What are the endogenous developments in the financial system that have led to the 2007-09 financial crisis?

The Endogenous Developments in the Financial System that Led to the 2007-9 Financial Crisis

Introduction

The Financial crisis that occurred in the year 2008-09 was one of the worst economic collapse experienced in the history of the world, with many countries, including the U.S. economy experienced a significant loss in the stock market. There was a remarkable fall in the stock market, and unemployment cases skyrocketed. According to da Silva and associates in comparison, the causes of the 1929 great recession share some similarities with the 2008-09 crisis in that both involve too much dept in asset markets like the housing markets and reckless development speculations (da Silva et al., 2016). The factors that led to this financial crisis are not exclusively external. Still, the leading causes of the economic collapse were some internal developments projected to build up the financial system and the economy. In this paper, various developments and their relevant case studies are discussed in detail.

Deregulation of the financial sector and the Hedge fund trading

 Deregulation of the financial industry Banks engagement in the Hedge fund trading was an internal development which led to the 2009 crisis. Hedge funds offer investor advantages and boost risk distribution and financial market stability. Hedge funds also provide financial markets with liquidity and stability and help sharply devalued asset prices. General hedge funds aim to reduce systemic risk. Also, hedge funds raise the risk. Their use of leverage helps them to control more securities than if they purchased for a long time. They used sophisticated derivatives to make investments by borrowing money. A good market produced higher returns and more significant losses in a bad one (Orhangazi, 2015).

In the year 2001, the fed funds rate was lowered to 1.5% by the Federal Reserve. This was a plan to help in fighting the recession. This lowering of the rates attracted many investors who sort through hedge funds to gain higher returns. With the apparent improvement in the nation’s economy in the year 2003-04, there was a lot of money inflow into the hedge funds, and more risky investments were made to help bank managers compete favourably in the then competitive market. In this period profitability was assured, and the financial institutions increased their use of exotic derivatives. Mortgage-backed securities arose, and they constituted of bundle Mortgages and were very profitable. The house markets were therefore flooded by many who initially could not afford conventional mortgages. The increase in the demand for these mortgage-backed securities increased the underlying mortgages, and the banks by using their respective customers’ deposits heavily invested in the hedge funds. Other large banks ended up creating their hedge funds. (Francis, Jackson, & Owyang, 2020).

 The red light began to be more marked when Congress revoked the Glass-Steagall Act in 1999. The policies which were passed into the law allowed the banks to have a greater level of their authority in their risk in their activities without any government interventions (Carpenter, Murphy, & Murphy, 2016). This led to the deregulation of the financial institutions which formed the bedrock of the genesis of the financial crisis of 2008-09. After the bill’s passage, the banks then had the freedom of engaging into any derivatives and activities at their will. Thus, after that, the banks exerted a lot of pressure on their mortgage departments, and loans were lent to everyone without the realization of possible loan defaulters. By the year 2004, the hedge fund’s volatility effect made the industry unstable (Shelby, 2017). The same year also there was an increase of rates by the Federal Reserve to fight inflation.

The increase was further hyped in the following years, and by the year 2006, the rates had risen to 5.25%. These increments in the rates resulted in a corresponding decrease in the demands for housing. The homeowners realized that their homes became worth less than the initial investment prices. Thus, many house owners realized the rise in the interest-only loans and could not pay the loans; hence, they defaulted. The banks also could not find sales for their derivates, and they went ahead to make use of their collateral for loans thus the banks became reluctant to lend each other (Dell’Ariccia, Laeven, & Suarez, 2017).

According to Thakor, the following year many of the multi-billion-dollar hedge funds began to went down crumpling. There are some banks which were brought down as a result of their hedge funds. Like Bear Stearns in the year 2007, they suffered the fate of their hedge funds’ fall. By the year 2008, Bear couldn’t raise sufficient capital to survive. The same reason that led to the fall of bears was that Lehman Brothers was rendered bankrupt in the same year in September 2008. They couldn’t find buyers for their investment derivatives. As a result of the failure of these banks Dow Jones Industrial Average to crumpled. The worst part came when the banks could not offer loans to each other due to the fear of further defaults (Thakor, 2015).

Financial securitization developments

Another internal financial development that led to the 2008-09 crisis is the mortgage debts’ securitization. Securitization is a mechanism by which a corporation clubs it’s various financial assets/debts to construct a consolidated financial instrument issued to investors. One of his corporation’s financial products was the Collateralized dept obligation (CDOs), which are products supported by pooling of loans, and assets that are after that sold to investors. The other was Mortgage-backed security, another financial Product like the CDOs under financial securitization development. The mortgage-backed security effectively converts the bank into an intermediary between the homebuyer and the investment industry. A bank will offer its clients mortgages and then sell them on for inclusion in an MBS at a discount. The bank reports the sale on its balance sheet as a plus and loses nothing if the homebuyer defaults down the road at any point (di Patti, & Sette, 2016).

 Thus, the banks were in an apparent secure situation in which all was a win-win phenomenon. In exchange, investors receive interest in such securities. The banks were set to improve their income by selling these securities. Banks obtain commissions to sell the new security of the debt. Banks may benefit from taking the default risk associated with the securitized debt off their balance sheets to allow for more leveraging of their capital. Banks can more effectively use their resources by reducing their debt load and risk. After some time since lenders were using big banks for the securitization, there was no risk of losing finances even if the homeowners defaulted. This led to the fall of lending standards, and this meant that many incompetent or under-qualified borrowers also referred to as subprime borrowers were able to secure hazardous loans. Due to the increased mortgage-backed security loans, the banks to make more income gave loans to subprime borrowers. In this scenario, the banks eyed the higher rates charged on this risky group of borrowers and the payments they could make to stand in for Default insurance. The banks needed Subprime borrowers’ insurance to help in mortgage-backed securities risks (Schwarcz, 2015).

 As the real estate market was booming, there was high profitability. Some states like Arizona and Florida, the home prices were ever-increasing during those periods when securitization caught roots in the United States. The market was increasingly flooded with money. There was no risk as long as the market conditions were favourable until by the year 2005 the subprime mortgages were almost a third of the mortgage market. (Kim & Ryu, 2015). By the year 2007, the housing market was on a fall and the respective banks which held the mortgage securities were in trouble. As many banks tried to free themselves of them as the value was getting plummeted, the financial crisis was already on their necks. The securitization of Collateralized debt obligations (CDOs), Mortgage-backed securities, Mortgage debts, and subprime mortgages stood out as the major causes of the estate bubble in the United States 1990s until the year 2000s. This bubble popped up into the financial crisis, which followed in the subsequent years. This case is depicted in the Wall Street banks in the U.S., which gave out their mortgage securities and was left with significant losses (Fligstein, Stuart Brundage, and Schultz, 2017).

The shadow banking system and its contribution to the crisis.

 The crisis’s main culprit was financial regulation and supervision, which before the crisis made grave mistakes in allowing some developments within the sector, which proved detrimental when they came to fruitage—the shadow banking system’s allowance. According to Ban and Gabor (2016), The shadow banking system is a term used to refer to the number of financial intermediaries from non-banks that offer services similar to conventional commercial banks but outside the usual banking regulations. Finance firms, asset-backed commercial paper conduits, securities lenders, limited-purpose finance companies and government-sponsored companies are examples of shadow banks. More examples include liquid investment vehicles, credit hedge funds, money market mutual funds (Perotti, 2015).

 Compared to a traditional commercial bank, the fundamental distinction between Shadow banks was that they were subject to far less extension of legislation and liabilities. However, the former did not have access to deposit insurance and the rediscount rate. How do the shadow banks work? Based on tax havens, they invest in long-term loans and credit across different financial systems by matching both the borrowers and the investors at individual levels. In some cases, they form part of the chain link, which involves mainstream banks and other financial entities. In the 1980s the financial sector came up with shadow banking, which during its early stages allow for easy borrowing from investors (Lysandrou, & Nesvetailova, 2015)

This ability to borrow was rendered even to those companies that could not match the blue-chip credit ratings for borrowing. This operation was very fragile, and as a result of their underregulated operations interconnected with the banking system, they have posed a threat to financial stability. Due to this apparent cause of financial and economic havoc, some warning signs were to alarm the policymakers.

The case on the Long-Term Capital Management (LTCM) failure made it necessary for a private bailout that was composed by the Federal Reserve Bank to avoid destabilization of the financial system. The shadow banking system continued underregulated even after these warning signs were shown till the crisis broke out. Continuing with their lending and borrowing systems, the shadow banks originated subprime mortgages, and they distributed them throughout the financial system packing them into mortgage-backed securities. In the case of the American International Group insurance company is an exact scenario that depicts the effect of the shadow banking systems and their mortgage-backed securities. After skyrocketing from $300 billion to $1 trillion within seven years from 2000-07 (Luchtenberg, & Vu, 2015).

 AIG venture in offering financial products more so was the London subsidiary actively involved in the writing of the Credit default swaps (CDS)- this product was an over-the-counter derivative providing purchasers protection against security’s default. This the insurance group did on the subprime mortgage-backed securities that emerge from the unregulated shadow banking operations. This risk was more complicated than the traditional insurance covers. These CDS enabled most of these MBS holders to hedge their risks by purchasing protection from the company. While the housing market was healthy upon its feet, the AIG made earnings, until the deterioration of the housing market came upon its knees that the company faced the trouble of falling. The company was required to pay out on its CDS as the housing market worsened. The company had to go further in posting additional collateral and margin to help the CSA positions’ declining value. This unfortunate occurrence strained the companies finances and eventually a lot of withdrawals of potential customers who were creating a bank-like run on the company let to its utter fall during the crisis in the year 2008 (Diallo, & Al-Mansour, 2017).

The case of Lehman Brothers’ bankruptcy

The collapse of Lehman Brothers, a sprawling global bank, in September 2008 almost brought down the world’s financial system. When this occurred, there was a panic financially in the U.S. Many banks tightened their inter-banking lending. Its fall to a given extend triggered the global financial crush which constituted to the 2009 financial crisis. Lehman brothers designed its activities within the gaps within effective regulatory regimes. It was engaging in leveraged maturity and liquidity transformation, making the banking system fragile. It funded long-time and illiquid positions in the Subprime mortgage-backed securities and commercial real estate investments. (Adu-Gyamfi, 2016).

 These investments had high runnable short-term debts. Before its collapse, for Lehman to fund its balance sheet, it relied on approximately $200 billion in overnight repurchase agreements and short-term collateralized loans. A third of the company’s overall funding was represented in this repo transaction which left the firm in an extremely critical financial posture. By 2007 up to $97 assets of the company were funded by debts. The collapse of the housing market equally rendered the loss of value to Lehman’s assets, and the creditors pulled off from the firm by their refusal to roll over their short-term funding transactions. After these, the company was forced to sell off its illiquid assets at low prices to generate the cash needed to meet creditors’ demand. Plus, the pressure from the derivatives counterparties who demanded an increase in their margin and collateral. The liquidity strain from the creditors and the collapse of the value of its housing-related assets drove the firm to bankruptcy. (Adu-Gyamfi, 2016).

Conclusion

In conclusion, as thought earlier, the financial crisis of 2007-09 was caused by external factors more than the (internal) endogenous factors cannot hold water. From the above case studies and various scenarios considered in this paper, the leading causes were from within and not as held before. The government responsibility in the cause of this crisis was when there was withdrawal of regulations of the operations of the financial institutions from operations and investments like the hedge fund case in the United States. The financial system in their quest for exponential growth and the growth of the economy ventured into the developments which proved to be the enemy of the growth they eyed. By easing lending regulations and the deregulations in the banking system, all the financial woes hit the American financial sector and other European nations. The allowance of the Shadow banking system with its resultant derivatives and mortgage securities proved to as that the events that were leading to the crisis can be dated back in the 1970s and 80s and when the fruitage was reached at last the aftermath of what earlier seemed an excellent development project proved devastating. The collapse of the Lehman’s company and the American International Group shows how the unexpected general financial collapse was gradual under the apparent growth that was experienced at the infancy of the developments

References

Adu-Gyamfi, M. (2016). The bankruptcy of lehman brothers: causes, effects and lessons learnt. Journal of insurance and financial Management, 1(4).

Ban, C. and Gabor, D., 2016. The political economy of shadow banking. Review of International Political Economy, 23(6), pp.901-914.

Carpenter, D. H., Murphy, E. V., & Murphy, M. M. (2016). The Glass-Steagall Act: A Legal and Policy Analysis.

da Silva, M. F., Pereira, É. J. D. A. L., da Silva Filho, A. M., de Castro, A. P. N., Miranda, J. G. V., & Zebende, G. F. (2016). Quantifying the contagion effect of the 2008 financial crisis between the G7 countries (by GDP nominal). Physica A: Statistical Mechanics and its Applications, 453, 1-8.

Diallo, B., & Al-Mansour, A. (2017). Shadow banking, insurance and financial sector stability. Research in International Business and Finance, 42, 224-232.

Dell’Ariccia, G., Laeven, L., & Suarez, G. A. (2017). Bank leverage and monetary policy’s risk‐taking channel: evidence from the United States. the Journal of Finance, 72(2), 613-654.

di Patti, E. B., & Sette, E. (2016). Did the securitization market freeze affect bank lending during the financial crisis? Evidence from a credit register. Journal of Financial Intermediation, 25, 54-76.

Fligstein, N., Stuart Brundage, J. and Schultz, M., 2017. Seeing like the Fed: Culture, cognition, and framing in the failure to anticipate the financial crisis of 2008. American Sociological Review, 82(5), pp.879-909.

Francis, N. R., Jackson, L. E., & Owyang, M. T. (2020). How has empirical monetary policy analysis in the U.S. changed after the financial crisis?. Economic Modelling, 84, 309-321.

Kim, J. S., & Ryu, D. (2015). Effect of the subprime mortgage crisis on a leading emerging market. Investment Analysts Journal, 44(1), 20-42.

Lysandrou, P., & Nesvetailova, A. (2015). The role of shadow banking entities in the financial crisis: a disaggregated view. Review of International Political Economy, 22(2), 257-279.

Luchtenberg, K. F., & Vu, Q. V. (2015). The 2008 financial crisis: Stock market contagion and its determinants. Research in International Business and Finance, 33, 178-203.

Orhangazi, Ö. (2015). Financial deregulation and the 2007–08 U.S. financial crisis. In The Demise of Finance-dominated Capitalism. Edward Elgar Publishing.

Perotti, E., 2015. The Roots of Shadow Banking.

Shelby, C. M. (2017). Closing the Hedge Fund Loophole: The SEC as the Primary Regulator of Systemic Risk. BCL Rev., 58, 639.

Schwarcz, S. L. (2015). Securitization and post-crisis financial regulation. Cornell L. Rev. Online, 101, 115.

Thakor, A. V. (2015). The financial crisis of 2007–2009: why did it happen and what did we learn?. The Review of Corporate Finance Studies, 4(2), 155-205.