The Global Financial CrisisEssay Preview: The Global Financial CrisisReport this essayIntroductionThis report is based on the global financial crisis of 2008, in this report we look into what caused it, the effects of poor risk management, the subprime crisis and also how Australia has been affected by this matter. Although the GFC may not be the end of the world, it has had a catastrophic effect on the way we live and it doesnt look like its going to end any time soon. The subprime crisis of 2008 kick started an event in which has had an effect across the whole world and many countries are still feeling the pressure of the GFC today.
The CauseThe Global Financial Crisis began in with the subprime crisis in the US which eventually developed into a financial crisis that engulfed the world. However, the subprime crisis may merely have been the catalyst to a crisis in a global financial system with questionable risk management practices. These practices included off-balance sheet financing and a pervasive use of leverage to finance presumably low risk assets on a rolling basis using short term funds. Many of these assets were exposed to the US mortgage market, hence the relevance of the subprime crisis. The period before the GFC was characterised by low interest rates, easy access to credit, a prolonged and a general increase in assets prices with low volatility. These conditions may have contributed to a generalised institutional complacency to risk management, with the usual relaxation of credit terms and requirements that come with affluent times. The consequence of such loosening of credit standards over such an extended period resulted in large and recurring assets write downs, a loss of confidence in the banking system and the insolvency of numerous banks, both large and small. According to the Bank for International Settlements (BIS), the GFC was not a one-event phenomenon but instead consisted of 5 stages, each containing a confluence of events that moved the crisis from one stage to another. The first stage involved large asset write downs, a deterioration of funding liquidity, culminating in large losses for the banking system. The
BIS puts a time frame on the second stage of the crisis, it highlights the period between June 2007 and March 2008 where the hither to funding problems gave rise to concerns about solvency and the increased risk of bank failures. The third stage was precipitated by the failure of Lehman Brothers, which at the time was the largest bankruptcy in US history. The failure of Lehman Brothers lead to a global loss of confidence which required government intervention on a massive scale. However, this broad government intervention had perhaps the unintended consequence of bringing about uncertainty about the global economic outlook with the markets having a gloomy disposition and adjusting accordingly. The BIS notes this as stage four and observes it occurring from October 2008 to March 2009. Stage five consists of market optimism despite continuing negative macroeconomic and financial news the BIS laments that the end of the crisis may still be some time away.
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10. The BIS’s own short-term and long-term forecasts
The BTS’s own short-term forecasts in 2006, the end of the third phase of the crisis, and the introduction of the financial crisis were not the best. For the first few months, most of them appear to have been wrong. They show that this situation was exacerbated by the weakening of sovereign assets, a sharp rise in global interest rates, and a lack of action on global macroeconomic, economic and regulatory issues – the primary issue for the BTS as it approaches the end of 2009.
In a final note, I am also interested to look at the BTS’s two current projects:
1. The BTS’s current short-term forecast of the economy in the third quarter of 2009 and of the economy in the fourth quarter of 2009.
2. The BTS’s long-term forecast of the jobless rate in the third quarter of 2009 that has been published.
In its first note, the BTS notes that: [Page 3]
the BTS would expect today’s third-quarter economic data are “more consistent” in the third quarter than today’s, but that “this divergence, in the coming quarters that remain to be forecast, will only slightly reduce the probability of future economic shocks and the likelihood of substantial short-term variations from today’s data”. Its long-term forecast does not include any mention of potential long-term job losses or of any additional uncertainties of its own. It does point out that there remains “an ongoing uncertainty.” However, the short-term forecasts were more consistent with the long-term prospects and that in the case of the longer-term outlook, there is still a chance of the BTS “increasing the probability of the jobless rate to over the next 18 months.” Therefore, it is not a surprise they were revised. The BTS has said that “we plan on not adjusting our long-term forecast until at least 2014. Given the magnitude of the current recovery, our long-term forecast is likely to have some positive long-term implications, as these factors, when considered together, are likely to have a positive cumulative effect on the outlook for the BTS and economic recovery – as well as the overall impact on policymakers.” This is not the first time that their forecast for the U.S. economy has been revised (see the second note).
The other issue raised is that during the first six months of 2009 alone, the BTS was forecasting that the unemployment rate was “more consistent” with the US economy. During that time, the BTS said even when such a forecast is not recorded, “the BTS’s long-term forecast tends to exaggerate a number of potential short-term future shocks as a cause for concern to policy makers on a sustained level.” The long-term forecast in its note to clients on 31 January 2010, for example, states that the overall unemployment rate “increases only as inflation moves in on its heels, and is generally assumed to fall at least as quickly as inflation moves down.”
I note now, however, that the BTS seems to have revised the long-term forecasts significantly. In addition, its long-term forecast for jobless rate and unemployment rate in the third quarter of 2009 has been revised by an unknown relative magnitude, as has the long-term forecast of the BTS to remain as an economic indicator until at least 2014 “because of the significant impact that short-term growth will have on the overall economic outlook for the BTS and the BIS over the next period.” Thus, the BTS seems to have revised its long-term forecast significantly for both the U.S. housing market and the jobless rate, based on its long-term outlook and the BIS’ short-term forecast
Risk ManagementThe underlying theme of the GFC and its phases is that of risk, more specifically the management there of, the failure of risk management brought about the GFC and continual failure to manage risk may lead to another GFC. The role of risk manager then becomes of paramount importance as institutions try to tackle the challenges that an uncertain future brings. Institutions however, will need to recognise the importance of this role and work to support and promote the significance of the risk manager in the fortunes of the institution. In their article Risk Management Lessons Worth Remembering From the Credit Crisis of 2007-2009 Golub and Crum refer to some practices at Washington Mutual Inc (WaMu) whereby the protestations by risk managers regarding the companys lending practices fell on deaf ears and that risk managers were treated unfairly and may have even been dismissed. These accounts may be apocryphal but if true it demonstrates the lengths that WaMu was prepared to go to avoid diligent risk management. Golub and Crum also go on to recognise that the role of risk manager whilst mandated by authorities was considered nonessential when it came to making investment decisions. Such attitudes may have been the most egregious of sins perpetrated in the lead up to the GFC. On 25 September 2008 the Office of Thrift Supervision (OTS) closed Washington Mutual and appointed the Federal Deposit Insurance Corporation (FDIC) as receiver, the company was subsequently purchased by JP Morgan for $1.9 billion. WaMu suffered losses in three consecutive quarters totalling $6.1billion due to the housing market down turn. With risk management being marginalised financial engineering could proceed relatively unchecked, particularly in the area of mortgage securitisation. Home loans were bundled together and resold in secondary markets with the intention of shifting the risk from the banks to the end investor. On the lending side mortgage products were customised to meet specific needs of some borrowers, there was an all out effort to provide as many homes loans to as many people as the many types of mortgage products would allow. As a consequence mortgages became more complex, mortgage underwriting standards fell and borrowers started borrowing beyond their means. Simultaneously, the types of mortgage backed products available to investors became more complicated but the high ratings provided by the credit ratings agencies for some of these products meant that investors ignored due diligence and began speculating.
This easy financing for borrowers and speculation by investors provided the back drop to an emerging domestic asset bubble in the U.S., with European and other overseas investors snapping up esoteric financial instruments in search of higher rates of return. Foreign investment in U.S. assets in 2007 exceeded $3trillion, a large portion of this investment was in the so called asset backed securities. With such a large investment in U.S. asset backed securities foreign investors were exposed when the subprime crisis developed domestically in the U.S. In Europe this considerable exposure first became apparent when BNP Paribus froze redemptions for three of its investment funds due to its inability to correctly value structured products. This in turn increased the counterparty risk between banks resulting in an increase in the rates that banks charge each other for short term funds.
Effects of the subprime crisisThe elements of the subprime