Examining The Causes And Effects Of Financial Crisis Finance Essay - Free Essay Example

A financial crisis is interruption to financial markets that disrupt the markets capacity to allocate capital financial intermediation and hence assets come to a cut short. Recently in 2008 the world has been affected with financial crisis. In this paper we are going to see the cause of financial crisis, how it started and effect the world. And also the thoughtful and critical analysis is made for the origin of the recent financial crisis. All the articles and various volumes in coming future will explain why the crisis was actually predictable and why it should have been foreseen and the world id taking note of these warnings. Origin of Recent Financial Crisis: As we know that if USA effects with the financial crisis automatically the whole world will get affected. As we heard that recently in 2008 the world is affected with the financial crisis, now its in better condition. This 2008 crisis has been started in USA then it widely spread throughout the world. Early in 2000 and 2001 there was terror attacks on the USA, at that time USA and most other advanced economies embarked on the period of constant expansion economy policies to ward off recession. For example, during that time, the Federal Reserve had lowered its discount rate more than 27 times. So by the reduced in the discount rate, other countries like china had purchase US treasury bonds, due to this there was a rapid growth in credit. Additional rise in the house prices which further fuelled credit growth, through lending mortgage. In USA, the banks will lend mortgage to households without the necessary means to pay back loans, which took on huge proportion. The average mortga ge lend by the bank is about US$1.3 trillion (Lin, 2008). In USA, Fanny Mae and Freddie Mac the mortgage lenders had secure these subprime loans, which were sold all through the financial system as assets. They were able to issue and securitize these bad loans due to a mixture of insufficient parameter and financial innovation. And which later made difficult for the other institutions to judge the risks of these securitized mortgages and led to increase subprime mortgages. C.O.D.s and S.I.V.s, R.M.B.S. and A.B.C.P were sold on false pretences. There were promoted for making safer investment. There has to make lot of money for their creators, but instead of that they didnt have to repay. It leads to bust and spread misunderstanding, luring investors into taking on more risk than they know. In the middle of 2007 by increasing defaults on mortgages and growing number of foreclosures in the USA which signaled that the subprime market was in crisis. By which the house prices and fi nancial stock price falling down. This reduced the household assets in USA by trillions. The financial institutions like Fanny Mae and Freddie Mac and well known other institution was threatened by these defaults and drops in house and stock prices. And in 15th September 2008, the firm of Lehman Brothers filed for bankruptcy with US$39 billion in assets, which was resulted in largest in history of USA. This resulted in financial panic, with large scale of selling stocks. Due to this reaction the central had reduced in availability of credit, mainly in interbank market, which leads to fall of many institutions. Later by this effect the banks in Europe were soon affected due to the exposure of the United States financial market. As we see above there are many reasons for occurring crisis in short; easy credit, weak regulation and supervision of complex financial instruments, bad loans, loss of trust on financial institutions, debt defaulting, selling of stocks and hoarding of ca sh by banks and individuals, financial panic. Critics: The loans from the bank are sold by the originator to a syndicate of banks and some financial institutions, including insurance companies, mutual funds, and pension funds and so on. The loans which are given to them have fallen down from $659 billion in 2007 to $175 billion in the august to October 2008. Ivashina and Scharfstein find out that the fall in this form of lending because of the amount of loans outstanding by the domestic offices of USA commercial banks has increased. And there have given three possibilities. Firstly all the data on syndicated loans consists of loans which was taken by financial institutions other than commercial banks, it may be possible that financial institutions are carrying less debt. Secondly it has to be seen that all firms are repaying their debts. The firms are not forced that the funds which there get are to make investments on plant and equipment. Thirdly the firms which had taken loans from banks with some commitments are now draw ing down on these commitments. By this banks are not giving loans to other firms which are profitable. All these firms are small firms which drawn down $13 billion of their loan assurance. Even there is a big increase in the use of loan commitment; its difficult to see why that increases in evidence of a massive failure. To see why, the explanation of such commitments which represent an insurance contract between banks and firms, which allow firms to be on these commitments when required. For example, the insurance company has to pay the insurer when he requires because it has to follows the commitments given to the insurer. It does not make any sense by saying that it is impossible to use economic theory and hard proof to make sure the market failure that necessitate such a huge government interference. But the thing is rather doing that we can set alarms a little earlier, and doing the hard work needed to make the case. Problems: It is always good to have a voluntary suspension of payments, because if creditors wont accept that there should be some mandatory like some agency should play the key role on the part of both debtors and creditors. Main the scope of any delay of payments may differ from case to case, and the extent and nature of the exchange controls or other limits on capital mobility will have to be bespoke to each case too. Any selective delay raises problems, e.g.: would there be a run on debts not covered? What about cross-default clauses? It may be difficult to enforce the capital controls required for a change (but their duration should not be too long, if the management of the workout is expeditious). Offering superiority to new credits may encounter obstacle in existing pari passu clause in loan contracts. It is claimed that no workout could be fully orderly, because trade credit would solidify but that has happened anyway in the Asian crisis countries. Market participants claim that any orderly workout necessities would pose a threat to the international interbank market. But the evidence for this threat is unclear. Principles: Normally, a systematic workout of international debt will require both rescheduling and restructuring: partly the expansion of maturities, partly translation of debt into equity. It may also require writing off significant amounts of debt this has been well understood since the 19th century, however much creditors may resist it. The workout should not be a bailout of the creditors: implementation should put a high priority on minimizing moral hazard and avoiding nationalization of private debt. We have made several recommendations for contractual and institutional innovations to promote cooperation among holders of securitized debt (Eichengreen and Portes, 1995), and it is hopeful to see that these have been taken up seriously in the report of Working Group. I would stress the importance of collective action clauses and other ex ante commitments in debt contracts. I am confident that these would be worthwhile even if, as market participants claim, they would entail larger sprea ds and indeed lower levels of capital flows although I believe this claim is much exaggerated. Still, if it were correct, that would suggest that the terms have been improperly and unsustainably favorable to borrowers. Conclusion: The epicenter of the financial crisis is in the US, and this is also where the most considerable economic slowdown will be experienced. Our analysis has raised questions about the claims made for the method whereby the financial crisis is affecting overall economy. We highlight that we do quarrel that the USA is undergoing a financial crisis and that the US economy may currently be in a recession or there may be an incident in the near future, perhaps even a very deep one. We do not dispute that spreads between safe securities and risky securities have increased. Our analysis is based on availability of publicly data. Policymakers have access to other sources of data as well. Policymakers could well believe that bold action is necessary based on data that are different from that considered here. If so, responsible policymaking requires that they share both the data and the analysis that underlies the need for bold policy with the public.