Effects Of The Financial Crisis That Hit The Western World

The Causes and Effects of The Financial Crisis That Hit the Western World After September 2008
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Introduction
On September 15th, 2008, Investment bank Lehman brothers bank filed for Chapter 7 bankruptcy as the United States grappled with the worst financial crisis and economic recession since The Great Recession of the 1930s. The financial crisis prompted the government to bail out large financial institutions with $700 billion else according to Ben Bernanke (the then Fed Chairman) the United, States ‘would not have an economy by Monday’ CITATION Anr08 \l 1033 (Sorkin, et al., 2008). As the issue spiraled, the stock markets crashed, many financial institutions under duress were either acquired or filed for chapter 7 bankruptcy. The financial crisis had a ripple effect on the economy as it led to increases in unemployment as the US lost 2.6 million jobs in 2008 aloneCITATION Lou09 \l 1033 (Uchitelle, 2009), many people lost their investments and savings. The issue also went global causing the European debt crisis and slowed economies of many countries. The financial crisis was many years in the making primarily caused by deregulation and compounded by financial innovations in the unregulated financial industry and complex relationship between investment banks and rating agencies. Financial innovation birthed subprime loans, predatory lending, the creation of CDOs and the cumulative impact of these products in an unregulated space led to the crisis. All these issues could be traced, to decades-long deregulation of the industry which allowed the financial institutions to create new, highly profitable financial products, which bore catastrophic effects on the economy.
Causes
Deregulation
After the Great Depression, the government tightened its grip of the financial sector to ensure stability. The regulations prevented another financial crisis and were epitomized in 1999 by the Gramm-Leach-Bliley Act (Citigroup Relief Act) which repealed the Glass-Steagall Act of 1933. However, starting in the 1970s (after 40 years of no financial crisis, even during and after World War II), the bank lobbyists in Washington lobbied for deregulation, especially which barred banks from speculating with depositor’s savings. They cited that American banks could not be competitive internationally and they promised low-risk securities to protect customers. The deregulation enabled some financial institutions in America to consolidate and become ‘too large to fail’ because their failure threatened the whole financial ecosystem. For example, in 1972, Morgan Stanley Bank had 110 total personnel, one office and controlled a capital of 12 million dollars and by the time of the financial crisis, it had over 50,000 workers and several tens of billions in capital CITATION Cha10 \l 1033 (Inside Job , 2010) despite losing about 2.3 billion dollars first few months of the crisis CITATION Dav08 \l 1033 (Ellis, 2008). Citicorp and travelers group merged to form Citigroup, which became the largest financial services company in the world and although at the time of the merger it violated the Glass-Steagall Act of 1933, its repeal followed shortly after. Most of the other banks and investment financial institutions had become large and amassed lobbying power to deregulate the industry to their advantage further.
Additionally, financial institutions created new complicated financial products which were not regulated following the deregulation. Commodity Futures Modernization Act was passed to exempt Credit Default Swaps (CDS) and other derivatives from regulations. This federal legislation overruled state laws which had prohibited banks from speculating on derivatives. Derivatives are natural products of speculations and banks financial institutions were now exempted from regulation from products that catastrophically threatened shareholders, investors and depositor’s money. Concisely, financial institutions were allowed to speculate in an unregulated market using monies from shareholders, depositors, and investors. This deregulation attracted very high-profit margins, which hooked financial institutions to lucrative but temporary and catastrophic operations which cumulatively led to the crisis.
The relationship between Investment banks and rating agencies
As banks became hooked to the profits of trading derivatives and speculating on them, they were largely helped by rating agencies. Financial innovation largely backed by deregulation of the derivatives allowed financial institutions to gamble on everything and they shook the financial sector CITATION Cha10 \l 1033 (Inside Job , 2010). Since the financial institutions were dealing with investors’ monies, there was a rudimentary framework which necessitates banks to invest in certain specific products. Banks were only allowed to invest in low-risk products rated ‘AAA” with depositors’ monies. Triple ‘A’ rating is the highest possible rating level for any derivatives, which concisely means low risk. The investment banks then collaborated with rating agencies to rate some products which the banks and rating agencies knew were an inherently high risk to be given ‘AAA’ rating CITATION Cou15 \l 1033 (Council on Foreign Relations, 2015). This complex rating process which is largely based on the ‘opinion’ of the rating agencies spread the impact of the investment banks to other sectors especially hedge funds. Financial institutions created new products known as CDOs (Collateralized Debt Obligation) which is simply a pooled financial product aimed to be sold to investors and consists of mortgages, car loans credit loans, etc. These CDO’s were rated highly, and thus investors (who were mainly hedge funds) bought them as they offered good ROI. The rating agencies had no liability on their ‘opinions’ on the quality of the derivatives which were commonly referred to as CDOs. Thus, investment banks did not care about their loanees as they sold the liability to investors packaged as CDOs and thus they had a very little downturn. Rating agencies had no liabilities for their opinion, and they were paid to give the CDOs very high rates (AAA), so the investment banks could fetch very good profits from the investors.
Subprime lending and Securitization
When Fannie Mae and Freddie Mac assured banks that they would securitize subprime loans to reinvigorate the mortgage industry, banks started offering riskier mortgages. Subprime lending is giving loans to high-risk loanees, and banks had ‘insured’ these loans. Since the banks suffered little or no cost for loaning to high-risk individuals, their appetite grew and offered more loans to high-risk individuals. Between 2000 and 2003, the number of mortgage loans made each year nearly tripled CITATION Cha10 \l 1033 (Inside Job , 2010). Investment banks gravitated more towards giving subprime loans as they offered higher returns. This led to predatory lending, and it was largely powered by securitization, which was in the industry CITATION Kim181 \l 1033 (Amadeo, 2018). Securitization involved ensuring the loans such that the investment banks suffered little or no loss if the loanees were unable to pay. The securitization chain involved investment bankers who gave subprime loans and placed many borrowers under the subprime category to earn more interest on loans selling repackaged loans as CDOs to investors after paying rating agencies to rate the loans highly. The subprime lending caused the 2005 housing bubble which further fueled the subprime lending. Since almost everyone could afford a mortgage, according to the investment banks, demand for homes skyrocketed because of high demand. Some speculators bought the houses and held them to sell them at a later date bagging millions of dollars in profits. The public sought more loans as they had very low-interest rates owing to adjustable-rate mortgages by the Fed. Since the interest on the mortgages was adjustable, the Fed started raising them in 2004. From a low of 1.24% in November 2002 to 5.25% by 2006 CITATION Gra06 \l 1033 (Wong, 2006). Many people who could afford the loans were now unable to repay them due to the high-interest rates caused by rai...