Global Financial Crisis Which Hit Many Leading Banks Finance Essay - Free Essay Example

Sample details Pages: 7 Words: 2060 Downloads: 9 Date added: 2017/06/26 Category Finance Essay Type Analytical essay Did you like this example? Sub-prime loans are one of the types of loans that have higher interest rate and risk than prime rate which is the origins of sub-prime crisis. Sub-prime crisis aroused as a result of growth of housing loan lending to customers with poor credit histories and weak documentation of income sources and subsequently become unable to pay off their loans. Traditionally, banks would only offer mortgage lending after commissioning credit checks, assessing customers creditworthiness, income of the customer and the ability to meet the payment on loans. Don’t waste time! Our writers will create an original "Global Financial Crisis Which Hit Many Leading Banks Finance Essay" essay for you Create order Also, they would only finance their lending from customers deposits or not more than 90% of the value of the property which leads to limitation to losses bank would incur due to default payment from customers. Nevertheless, this method limited the growth of bank to go globalize, hence, mortgage-back bone has been introduced to the bond market where they sell mortgage to outside investors for the sake of financing more lending nowadays. (Principle of Banking and Finance, 2013) Due the greed of Wall Street and government desire to increase home ownership, sub-prime mortgage has gone viral whereby investment banks bundles up these pool of sub-prime loan as Collateral Debts Obligations (CDOs) or Mortgage Back Bonds and get credit rating agencies to rate an AAA rating so as to appear to be more attractive to investors. Sub-prime mortgage offers higher profit than the standard mortgage, thus, demand for securitization is high and to which this has led to an increment in house price until d efault payment started to occur; and the CDOs which include in the default of sub-prime mortgage, become worthless investment, thus investors lost a fortune. Also, houses that are unable to be paid off by borrower are forced to foreclosure which affects financial institutions by dragging down the financial system, thus the whole economy is affected due to the bankruptcy of banks. There are several causes that have led the economy into sub-prime crisis. The first major cause is excessively easy market admittance. In order to be more globalized bank with lucrative profit, banks started to aim to offer sub-prime mortgage loans to those customers who did not meet these criteria and who could not be able to meet the loan payment due to their poor creditworthiness, poor credit histories and weak documentation of income sources by reducing the admittance conditions of sub-prime home equity loans. In order to earn higher yield profit and attract more customers, some financial institutions even pushed the loan forms, such as permitting customers to obtain housing loan without down payment and capital and proofs to prove their repayment abilities. (Mark P. Taylor, August 2009). With lacking of risk consciousness and non-transparency of the product, investors blindly purchased houses as they reckoned that the house price will always go up without fully understand the pr oduct which in turn inducing loss of money. The second major cause of sub-prime crisis is imprudent ratings of rating agencies. Credit rating agencies, such as, Fitch, Moodys and etc are agencies who assign credit ratings for issuer of debt obligation. The credit rating agencies takes into consideration the issuers creditworthiness to see if they have the ability to meet the loan payment which takes on effect in interest rate. For instance, a higher risky investment generally generates higher interest rate so as to attracting more investors; conversely, a lower risky investment generates lower interest rate. Hence, the variations of interest rate are very much depending on the risk of investment. During the sub-prime crisis, banks split these sub-prime mortgages into three tranches which are higher tranches, mezzanine tranches and senior tranches and pooled these tranches together and repackaged them into Collateral Debts Obligations (CDOs). Subsequently, investment banks bought bond insurance for the higher tranches so as to get AAA ratings from credit rating agencies. According to the statistics, 75% of CDOs were rated as AAA ratings. (Mark P. Taylor, August 2009). The investment banks then sold these CDOs to those sophisticated institutional clients, such as insurance companies, banks, small towns in Norway, school boards who were seeking for a high-quality safe investment. Many investors had never come across with the possibility of the market liquidity and the drop of house price but reckoned that the rating could fully reflect the credit risk which result in loss of money. Due to the imprudent of credit rating agencies has been given to sub-prime mortgage during the rating process, the sub-prime mortgage became worse and worse, thus, sub-prime crisis inevitably happened. The third major cause of sub-prime crisis is large limitation existing in the risk prevention mechanism of financial institutions. There are three aspects that are chiefly embodied in. First, most financial institutions ignore the examination of credit risk as they will transfer the loans into securities such as, CDOs, asset-backed bonds (ABB) and mortgage-back bond by securitization. Financial institutions always reckon that the house price will continue rising, hence, even when the borrowers do not possess loan repayment capability, they can always compensate the loss by selling out the house property which has higher market value than it was. Therefore, when it comes to lending loans, financial institutions primary thought will generally come to the profit and commission rather than commissioning credit checks on borrowers loan repayment capability. This has shown imprudent management in the financial institution which leads to sub-prime crisis. Second, financial institutions has established the structured investment vehicles (SIV) to invest a set of mortgage, such as, CDOs, mortgage back bonds so as to earn the more income. However, when the market decline happens, bank urgently require capital to support, otherwise, SIV will go bankrupt. By this way, the risk of asset securitization will return to the financial institution again. Third, the sub-prime mortgage loan has built a complex uncertainty which might generate an unknown risk to the economy cycle. When something bad happen in the economy, the banks would try to offer liquidity when loans are not be able to turn into securities after deep consideration. Hence, the markets among banks are broken because of the inability for banks to trade in the market under such an uncertainty economy. (Mark P. Taylor, August 2009) The fourth major cause of sub-prime mortgage is too easy-money policy. The easy-money policy has induced a continually increased in risk burden. Also, a cheaper price of international credit can be obtained liberally when the housing price rises. During the year of 2001 to 2006, banks had been practicing the policy of low interest rate which apparently indicate that there is no inflation pressure. However, the easy-money policy has depreciated the exchange rate of US comparing with the emerging market countries, and on the other hand, it appreciates the currency of those emerging economies whereby it has been shown that the currency stimulation would lead to the growth of credit in global range which helps banks to earn more lucrative profit by selling mortgage into the mortgage bond market. Thus, the easier availability of fund and the relaxed lending condition are further promoted. Due to that, this has induced bubble burst as more and more customers who are unable to meet the loan repayment engage housing loan which has caused an intense impact or sub-prime crisis to the whole world. All these factors that cause the US economy into sub-prime crisis are to be blame on banks or lenders who are the biggest culprit for the sub-prime crisis. The parties who hold the highest responsibility for causing such sub-prime crisis are those lenders who ultimately lend funds to people who are poor in repayment loan, poor in creditworthiness, poor credit histories and weak documentation of income sources. This is when the central bank increased money supply in the market with capital liquidity, thus, it lowered the rate of interest whereby a lot of investors found this to be way too little return and seek to switch to higher risky investment that has higher return. Simultaneously, lenders found to have plenty of capital to lend as this business is extremely profitable for the banks and investors were likely to undertake higher risk to obtain higher return on investment. Nonetheless, the lenders tried to defense themselves by saying that there was an increased demand for mortgage and the price of houses would always rise due to the slippery slope of interest rate. In overall, lenders or banks hold the most responsibility as they made funds to be easier available for borrowers who were even had bad credit score and at higher default risk. The second culprit of causing such sub-prime crisis is the home buyers. Many homebuyers who have lower income and could barely afford buying the house, still insisted to purchase even it was very high risky and putting all their hopes in appreciation of housing price that had led generation of consumers to regard home equity loan as fundamental of finance program. When they reckoned that the housing price would undoubtedly continue to rise, they kept acquiring home equity loan so that they could refinance at a lower interest rate and sold out the house by earning profit out of this. However, the housing bubble burst and housing price dropped drastically which in turn resetting the mortgage at higher interest rate, and this had led many homebuyers to be unable to refinance their mortgage at lower rate of interest and houses could not be sold out, thus banks foreclose the house when homebuyers were default in payment. Due to the aggressive purchase they had made on housing loan, this h ad result in sub-prime crisis to be taken place. Thirdly, investment banks worsen the situation. In order to earn more lucrative profit, bank sell these mortgage loan to investment banks instead of holding these mortgages whereby they know that these sub-prime mortgage were all crappy mortgages. By doing so, banks would have more capital to finance lending. Due to the greed of investment banks, they bundled up these sub-prime mortgages into Collateral Debts Obligations (CDOs) or mortgage-back bond by securitization and sold these to the investors who seek for higher return on investment or to who seek for high-quality safe investment. The fourth party to be blame on is the credit rating agencies who were being criticized of simply giving an AAA rating to those CDOs which mislead the investors to fund into these securities as investors rely their belief on the rating. Credit rating agencies has the responsibility to sub-prime crisis as they were not carefully looking at the CDOs when they were rating the CDOs and some were only seek ing for self-interest whereby they rated CDO as higher rate just to earn more commission and bonuses. Credit rating agencies were enticed to give a better rating for the sake of receiving more service fee and commission. Investors are also to be blame as they were ignorant to the risk behind the CDOs and they would just follow the majority purchasing securities without fully understand to the product they bought. They are the one who are willing to purchase CDOs at outrageously low premiums with the norm of continually rise in housing price. So when the sudden drop of housing price, homebuyers were at default payment, investors faced huge loss at their own accord. Lastly, government also plays a vital and integral role in the sub-prime crisis where they have the power to voice in the variation of interest rate. Nevertheless, instead of discouraging lending, the government wanted bank to make loan to customers even if it was risky. They had even pressurized the bank to make loan to risky borrowers who were poor in creditworthiness and poor in income sources. This has in turn flooding the house price, and eventually the bubble burst. The government should discourage bank from lending too much to sub-pr ime borrowers by strengthening the rule and regulation. Also, Fannie Mae and Freddie Mac should not lower the lending criteria and the capital requirement. Overall, sub-prime crisis were all originated by the greed of people who always have never-ending satisfaction on money. Majority of people were doing these out of their self-interest, hence, this has caused bubble burst and sub-prime crisis happened. Investors should never buy anything that they do not understand clearly. The loss they had incurred were all to be blame on themselves who were not carefully managing their finance well but blindly following the crowd and thinking of a quick way to earn more money and profit.