Causes Of The Actual Global Financial Crisis. While many argue that this is the main cause of the global savings glut, the opposite is the

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1 YourLastName 1 YourFirstName YourLastName Instructor's Name Course Title 1 August 2015 Causes Of The Actual Global Financial Crisis Introduction The US is one of the countries that have demonstrated their propensity to consume. While many argue that this is the main cause of the global savings glut, the opposite is the truth because most of the emerging economies tend to anticipate another global financial crisis, and thus have a propensity to save too much. The United States has over the past five years experienced an influx of foreign capital and this has lead to the global imbalance. The global financial crisis started in late 2006, and could have been detected if the financial, regulators examined the financial trends. For example, the subprime lending in the US could have helped predict and prevent the possible economic crisis. With income adjustment, a rise in the level of desired savings at any given level of income, interest rate and exchange rate (such as is supposed to have occurred in the emerging market economies ), will reduce aggregate demand in the domestic economy, which will lower income not only in the domestic economy, but globally. In short, a global savings glut will produce a global recession, where there is no necessary reason for any change in the long term interest rate, and also no reason why current surpluses and deficits relative to GDP should move in the manner suggested by the glut theorists.

2 YourLastName 2 Democratizing finance- means solving gratuitous economic inequality problem using finance. For example, inequality that cannot be justified on rational grounds in terms of differences in effort or talent. The Triffin dilemma theory : The US currency was used as the global reserve currency so it supplied the world with an extra supply of its currency to fulfill world demand for these foreign exchange reserves, thus leading to a trade deficit. Financial engineering theory refers to the application of technical methods, mathematical, and computational finance, in the practice of finance to exploit financial opportunities while solving financial problems How the crisis occurred Banks crated a lot of money faster than others players leading to an influx or flooding of foreign currencies leading to the currency glut. The prices of houses increased faster leading to a housing bubble. Many investors took loans (housing mortgages) due to the housing bubble thereby creating too much paper money. The circulating cash was only 10% of the global money as the paper money (loans) was too much The investment bankers and regulators relaxed the rules and marketed financial instruments to the unsuspecting investors The banks invested their earnings in the housing (mortgage market) especially in the residential property. The housing bubble arose as a result of the demand for residential

3 YourLastName 3 property and availability of cheaper and unbaked securities. The commercial real estate was also another attractive investment for both individuals and corporations. The investment in the financial sectors was lost during the financial crisis. The credit cards and personal loans were written off due to the financial crisis eliding to a further fall (Savings + Fiat Money Creation) > Investment = Current Account Surplus When a country s savings when combined with the paper money created by its central bank exceeds the amount of its investment, then that country will have a current account surplus that will force other countries Insider trading the main financial industry players The financial industry was stable when the regulation was strict. However, due to the deregulation, there was a savings and loans crisis that was costly on the tax papers. This lead to the consolidation of the financial sector into only few firms such as: Investment bankers: Goldman Sachs, Morgan Stanley, Lehman Brothers, Merrill Lynch, and Bear Stearns, Financial conglomerates: Citigroup, JPMorgan Chase Deputized insurance companies: AIG, MBIA, AMBAC Rating agencies: Moody s, Standard & Poors, Fitch Investment banks bundled mortgages with other loans and debts into collateralized (CDOs), which they sold to investors. Rating agencies gave many CDOs AAA ratings. Subprime loans led to predatory lending. Many home owners were given loans they could never repay.

4 YourLastName 4 In 2000, there was an internet bubble that busted. The bubble was caused by the investment market promoting the internet companies that had invested in (insider trading) leading a loss of over $5trilion Early 2000 derivative trading lead to further financial instability as the Commodity Futures Modernization Act of 2000 rejected the proposal to regulate the derivative trading. In 2007 the credit default swap (CDS) was high as the bans owned a lot of assets than the investment banks. The financial bubble saw an unprecedented increase in the number of debts as speculates bought CDS to bet against the CDO The banks backed their CDO with the subprime mortgages Goldman Sachs managed to sell over $3bilions worth of CDOs by 2006 and bet against the cheap CDO by marketing them as high quality CDO. The number of AAA rated instrument increased by over 100% within three years by 2007 The actual crisis and Subprime lending over $10bilin. CDO market collapsed and the investment banks remained with loans amounting to borrowers Mortgage companies started lending at very low rate due to lack of credit worthy

5 YourLastName 5 Many mortgage firms made loans to people who they knew would have difficulty maintaining the payment schedule. Most of the borrows had very low FICO scores (as low as 600). The subprime borrows were given loans at high interest rates, and did not have adequate collateral. The terms of landings were not favorable because the banks wanted to compensate for the credit risk. Most ochre subprime loans were in the form of mortgage backed securities which the customer defaulted leading to the 2007/2008 financial crisis Mortgage and underwriting standards were relaxed in favor of competition Most of the less credit worthy borrowers got mortgages Securitized could not keep up what the malpractices so they divested in mortgage business, originators had power to manipulate the market Private securitizes disregarded the market standards and the government sponsored enterprises (GSE) regulations and issued risky loans between 2005 and 2007 The securitized competed for the market share for the GSE leading to subprime lending The credit conditions were relaxed making it easy for companies such as Lehman Brothers and Goldman Sachs to o offer The role of Goldman sacks in the financial crisis

6 YourLastName 6 Goldman Sachs contributed to the foreclosure of millions of homes and fall of many business empires, as well as loss of jobs Goldman sacs were self interested promoters of risky and complex financial schemes that help in triggering the finical crisis Golan Sachs actively developed and bundled toxic mortgages into complex financial instruments Credit rating agencies labeled them AAA securities and sold them to investors thus magnified and spread the risk throughout the financial system Goldman Sachs bet against its instrument they sold and made profits especial by betting against the mortgage market. The main financial instruments that were key in the financial crisis include residential mortgage backed securities and collateralized debt obligation (CDO) In addition to easy credit conditions, there is evidence that competitive pressures contributed to an increase in the amount of subprime lending during the years preceding the crisis. Major U.S. investment banks and GSEs like Fannie Mae played an important role in the expansion of lending, with GSEs eventually relaxing their standards to try to catch up with the private banks. A contrarian view is that Fannie Mae and Freddie Mac led the way to relaxed underwriting standards, starting in 1995, by advocating the use of easy-to-qualify automated underwriting and

7 YourLastName 7 U.S. subprime lending expanded dramatically Subprime lending 1.2 Growth of the housing bubble 1.3 Easy credit conditions 1.4 Weak and fraudulent underwriting practices 1.5 Predatory lending 1.6 Deregulation 1.7 Increased debt burden or overleveraging 1.8 Financial innovation and complexity 1.9 Incorrect pricing of risk 1.10 Boom and collapse of the shadow banking system 1.11 Commodities boom 1.12 Systemic crisis 1.13 Role of economic forecasting References Koller, Cynthia A. (2012). White Collar Crime in Housing: Mortgage Fraud in the United States. El Paso, TX: LFB Scholarly Patterson, Laura A., & Koller, Cynthia A. Koller (2011). "Diffusion of Fraud Through Subprime Lending: The Perfect Storm." In Mathieu Deflem (ed.) Economic Crisis and Crime (Sociology of Crime Law and Deviance, Volume 16), Emerald Group Publishing, pp Bernanke, B. (2011) Global Imbalances: Links to Economic and Financial Stability, Speech,q Banque de France, Paris, February 2011.

8 YourLastName 8 Zhou, X. (2009) Reform of the International Monetary System, Speeches, People s Bankq of China, 23 March. Rajan, R.R. (2010) Fault Lines: How Hidden Fractures Still Threaten the World Economy,q Princeton and Oxford, Princeton University Press, pp Kirshner, J. (2014) American Power after the Financial Crisis, Ithaca, Cornell University Press,q Chapter 5. Ferguson, C.H. (2010) Inside Job (watch the documentary)q Wolf, M. (2014) The Shifts and the Shocks, New York, Penguin Press.q