November 18, 2008
How Did The Global Financial Crisis Start?
In my search to answer this question, I conclude the question can be answered by answering the question “Where did the financial crisis started?” Knowing where the global financial problem started then we can know how it started.
It is just like identifying the earthquake epicenter. Knowing where the epicenter is than geologist can identify how the earth quake originated.
Now coming back to “Where did the global financial crisis started?”. From what I read online, the current crisis is something not been seen before. The crisis is very serious and can result in a global financial melt down. Know if you were like me, where in the world can a localized financial crisis happened and spread globally? The answer is no other places than the US (The United States)
In a speech by Angel GurrÃa, OECD Secretary-General, to Victoria University and the New Zealand Institute of International Affairs. He touched on this when he said in his speech:
Where did the global financial crisis start?
There are no doubt many causes – and many consequences: high levels of market liquidity, low global interest rates, low cost of capital, and very low yields on safe investments.
Faced with strong investor demand for higher yielding assets, banks saw an opportunity to expand mortgage lending and then to repackage and sell the underlying credit risk as securities with different levels of risk and return – what is referred to as “securitisation” – the packaging of loans into securities.
In fact, we have seen a remarkable expansion of credit, especially in the United States, in parallel with a dramatic rise in securitised mortgages, especially after 2004.
Take note of the last sentence “In fact, we have seen a remarkable expansion of credit, especially in the United States, in parallel with a dramatic rise in securitised mortgages, especially after 2004” .
The word securitised mortages which finally resulted in the problem of subprime mortgages. This is what happened.
But the rapid growth in securitised mortgages created some perverse effects. One result of securitisation was that in many cases loaning institutions no longer felt the consequences if the loans were not repaid. This allowed relaxation of the criteria for making loans.
This gave access to credit – and to home ownership – to a new group of borrowers, but opened opportunities for fraud. Many of the new borrowers did not understand their loans or have enough income to make the payments, especially those with adjustable rate mortgages, and regulators did not sufficient capacity to follow these developments.
On the investing side, securities products were extremely complex. Investors did almost no due diligence of their own, but relied on credit ratings. Unfortunately these ratings often gave a misleading picture of the quality of the underlying loans and the securities. Another important shortcoming was that the banks had set up structures to acquire and hold loans which depended entirely on continued access to short-term funding.
Thus this eventually leads to the unraveling of the subprime crisis
The crisis itself was triggered last summer, when the market saw higher-than-expected defaults on US subprime residential mortgages. Investors suddenly realised they were in a much riskier world than they had thought. Markets froze. The short-term funding for securities dried up and their prices plunged. And because no one knew which banks held the damaged assets, even lending between banks stopped. There was no more liquidity to help markets function. While the subprime mortgage problem is largely limited to the United States, the repackaging practices I mentioned a moment ago were international, so banks outside the US, especially in Europe, were also drawn in.
Eventually this leads to the current global financial crisis when trust between banks is gone, the lending stops and the credit and liquidity crunch happened. On this part I would like to add how Friedman ( author of “The World is Flat” ) sees how the crisis eventually enfolded :
So with easy credit seemingly endlessly available, American consumers saved virtually nothing and bid up housing prices to record levels. Retailers expanded stores and China expanded factories to accommodate all the shopping. It was quite a party. We had banks in America giving mortgages to people whose only qualification “was that they could fog up a knife,” one mortgage broker told me.
But when something seems too good to be true, it usually is. When these reckless mortgages eventually blew up, it led to a credit crisis. Banks stopped lending. That soon morphed into an equity crisis, as worried investors liquidated stock portfolios.
He also stated that on the “how” part of the global financial crisis. The way he sees it, it is the interaction of 4 factors which he calls “chemicals”. These chemical are :
Those chemicals are: 1) massive leverage — by everyone from consumers who bought houses for nothing down to hedge funds that were betting $30 for every $1 they had in cash; 2) a world economy that is so much more intertwined than people realized, which is exemplified by British police departments that are financially strapped today because they put their savings in online Icelandic banks — to get a little better yield — that have gone bust; 3) globally intertwined financial instruments that are so complex that most of the CEOs dealing with them did not and do not understand how they work — especially on the downside; 4) a financial crisis that started in America with our toxic mortgages. When a crisis starts in Mexico or Thailand, we can protect ourselves; when it starts in America, no one can.
Again note the fourth chemical. Thus we have two experts who concluded that the current financial crisis started in the US and by the subprime mortgages crisis. And this leads to the collapse of many financial institution and one of the most famous one is the Lehman Brothers.
Quoted Sources : -
http://www.sltrib.com/opinion/ci_11006345
http://www.oecd.org/document/