The Financial crisis in USA and Canada – Reasons

Presentation2Financial crisis – causes

Map od financial crisis

There are many countries in our world. The USA is one of them, which is also one of the richest countries in our planet. But like everything else it can also collapse. Do you know that USA lost millions of dollars during the period of its financial crisis? Many banks collapsed and many big companies bankrupted. Many people lose their jobs, houses and cars. The reason for this event is not single and there are different opinions about the possible causes.

Firstly, the humans want more and more and sometimes do not think about the consequences. In this way people take credits in order to buy different things. This form one of the major factors for financial crisis in the USA – people take too big credits for houses. The research made by Obi, Choi, & Sil (2010) supports this statement trough showing and explaining different studies about financial crisis:

Virtually all the studies and commentaries on the financial crisis deal primarily with factors believed to have encouraged excessive household debt. In some cases, the arguments are quite declarative. For example, Taylor (2008) blames the abundance of credit as the chief cause of the crisis. He finds that the Federal Reserve’s unusually low interest rate policy in the late 1990s and 2000s was responsible for accelerating the housing boom and ultimately the collapse that followed (p.403).

The same research made by Obi, Choi, & Sil (2010)   also reports another supporting indicator for the problem with credits: “Two unusual market events occurred between 2000 and 2007, when home prices reached record highs. The first was that household debt grew twice as fast as personal disposable income.”(p.401). Furthermore, we can explain more deeply this citation through presenting a graph originally prepared by the specialists of Bureau of Economic Analysis:

Fig.1:  Total Household Debt Outstanding versus Disposable Income (billions $)

Sources: Bureau of Economic Analysis (income); Federal Reserve Flow of Funds (household debt)

In this graph we observe that the disposable income was bigger than the household debts from 1980 to 2000. After that the household debts started increasing rapidly and in 2007 they became with 6% bigger than disposable income. This in an obvious reason for coming crisis.

Moreover, the government policies are in some level bad and banks do not protect themselves well – they do not think to whom they should lend money and to whom not. However, a research made by Gandel (2009) gives examples for a bank that started to create such a policy:

One of the firms leading the charge to capital-light banking was Bank of America. Starting in 1993, a predecessor firm became one of the first banks to develop and embrace computer models that were supposed to improve a bank’s ability to determine the risk of a particular type of loan. After a merger in 1998 that formed the bank, BofA officials often argued to investors and regulators that these new advanced risk controls meant the bank needed to carry less capital per loan. And BofA officials frequently fought regulations that would boost capital requirements for them and other banks. In 1998, BofA argued that tying capital requirements to credit ratings, which would have required banks to hold more funds in the vault to account for the riskiness of subprime loans, was silly.(para. 8)

Secondly, many people think that everything has its good and bad consequences and maybe it is true. Another reason for the financial crisis could be the economic growth and the rapid free market globalization. The same research of by Obi, Choi, & Sil (2010) reports:

Rogers (2008) takes a more macroeconomic view and blames the rapid development of free market globalization for the eventual economic recession that followed the financial crisis. He argues that globalization produced two conflicting results. The first, a benefit, is a boost in economic growth. The second, a detriment, is a deepening wealth-poverty gap. To combat the latter, the U.S. government encouraged subprime credit, which, although it was well intentioned, resulted in the transnational banking and economic crisis that followed (p.404).

Thirdly, sometimes government does things in order to help society but finally its policies harm people. For example, Government intends to fix the exchange rates for the improvement of international trade, for the development of investments and to gain credibility in licking inflation but it results in crisis. Why this happen? The research made by Barisik and Tay (2010) reports the Second-Generation Crisis Model which is also valid in some degree for the USA financial crisis:

Second-Generation Crisis Models: Defined by Obsfeld (1994) as self-fulfilling speculative attack model. The model is built on double equilibrium of fixed exchange rate and preference of high interest and unemployment. Economic units act according to the expectations. Government intends to fix the exchange rates for the improvement of international trade, for the development of investments and to gain credibility in licking inflation. Cost of exchange rate fixation is experiencing higher interest and unemployment. Later, these costs lead to disbelief of investors in exchange rate fixation . Government resumes fixed exchange rate as long as the benefits are more than the cost. However when the cost is more than the benefits, fixed exchange rate system collapses. According to second-generation models, a currency crisis occurs due to: 1) coherent self-fulfilling expectations, 2) rational herd behavior, and 3) contagion .

 Coherent self-fulfilling expectations depend on multiple equilibrium in the equations of exchange rate and monetary policy (as well as other policies) and various triggers that can range from political scandals to negative official statistical reports on the economic activities. Speculative behavior on foreign exchange markets, involving approximately the same number of optimistic and pessimistic participants regarding the exchange rate movements, may lead to stabilization of the exchange rate movements. However, if the number of pessimistic participants expecting a devaluation of the national currency prevails for any reason, they will cause devaluation by their actions in the market.

Herding models are based on the costs of gathering complete information for small investors; the majority of the market (composed of small investors) follows big participants in their investments (who are considered to be well informed, i.e. having a good reputation from the past) or a general market trend.

The occurrence of contagion is based on the perceived spread of a currency crisis to other countries in the region where it originally appeared, due mainly to regional trade and financial linkages or a regional approach of big investors/ big banks usually forming a joint regional securities portfolio for the emerging markets. That can be easily understood for countries that are regionally related commercially and financially; a currency crisis and worsening trends in fundamentals in one country definitely have an adverse effect on fundamental macroeconomic variables in another country, thus increasing the possibility of stirring up a currency crisis in that second country (p.405).

Furthermore, to protect us from the future crisis, there were invented some models. Such model is presented in the graph of Buggey (2007, summer):

This scheme shows us an attractive model of converting various forms of loans into tradable securities resulted in the creation of speculative bubbles, which overvalued various assets, in the first place real estate.

Fourthly, we can think about the crisis from the point of view of M. Boskin` perspectives on the elimination of U.S. banks’ toxic assets in order restore the credit market in 2009 in the country. The author asserts that the initiative of the federal government to buy toxic assets with the 700 billion U.S. dollars Troubled Asset Relief Program (TARP) has resulted to capital infusions. He believes that these toxic assets were the reason behind the crisis in the credit market. Boskin reports:

The original idea for the U.S. government to buy up toxic assets with the $700 billion Troubled Asset Relief Program gave way to capital infusions (and auto bailouts). Treasury Secretary Timothy Geithner’s new publicprivate investment program to buy toxic assets has few takers, despite subsidized non-recourse financing. So the toxic assets remain on bank (and other) balance sheets. Can banks generate enough profits for long enough to buy time to write down smaller losses and raise private capital later in a stronger economy? Or are the losses so large—and in danger of mounting further as others (such as commercial real estate) are added—that a gradual workout is unlikely, if not impossible? Estimates of the losses on U.S. loans and securities range from under $1 trillion to almost $4 trillion. The International Monetary Fund puts them at $2.7 trillion, but the range of uncertainty is enormous. More than half is held by banks and broker-dealers. And analogous problems exist in Western Europe (for example, for loans to Eastern Europe) and Asia. Gradualism and profitability, and eventually U.S. Brady bonds, worked in the Latin American debt crisis in the 1980s. But a difficult economy will drive down the value of toxic assets and make more assets toxic. For example, falling home prices put more families in negative equity—mortgages worth more than the home. This creates an incentive to default, which increases foreclosures and lowers the value of the mortgagebacked securities on financial firms’ books. Policymakers need a Plan B in the event that one proves necessary, modeled on America’s rapid resolution of insolvent savings and loans in the early 1990s, together with sales

of toxic assets in large blocks (to prevent so-called adverse selection from unraveling any bidding process). History is instructive. Of the $500 billion that America required for the Resolution Trust Corporation (equivalent to $1.25 trillion today), $400 billion was returned from asset sales, for a net cost of $100 billion, one-tenth the worst-case private forecasts of $1 trillion. The final tab on the toxic mortgage bailout and

other assets is likely to be a larger percentage of a larger, but still far less than the face value of the loans, because the underlying assets will in many cases retain considerable value. In addition to bailouts and toxic asset plans, governments worldwide want central banks to monitor macroeconomic and overall financial-sector risk (as opposed to focusing on individual firms). Barack Obama’s administration would anoint

the Fed, whose history has been to recognize crises late. The Bank of England seeks similar powers. The EU wants to establish a European Systemic Risk Board composed of the national central bank governors, chaired by the European Central Bank. What will these central bankers do to advise on macroprudential risk? Demand adjustments in large current-account imbalances? Call for reductions in taxes, spending, and government debt, which are the primary systemic risks? To do that

could jeopardize monetary policy independence and heighten the threat of future inflation. Dealing with financial institutions deemed too big to fail

won’t be easy. The current system, which allows privatized gains from highly leveraged risk-taking but socializes losses in the event of failure, must be changed to avoid episodic financial meltdowns. To balance the benefits of scale and scope with the socialized losses to taxpayers, firms deemed too big to fail should be required to have more capital, and the amount should rise disproportionately with size. Converting some portion of debt to equity under predetermined solvency-threatening conditions

would provide an extra layer of protection. Add a higher bar for government bailouts, and these stronger incentives would induce private financial institutions and investors to take responsibility before disaster strikes.(p.44-45)

Fifthly, everything in life is connected with something else. Everybody knows that if the weather is cold and his noise is running maybe he will have problems with his throat later. In the same way the companies and the business as a whole are connected with each other, too. A research made by Sloan and Burke (2008) explains the financial crisis through observing the connection between different institutions:

The fear-a justifiable one-is that if one big financial firm fails, it will lead to cascading failures throughout the world. Big firms are so interlinked with one another and with other market players that the failure of one large counterparty, as they’re called, can drag down counterparties all over the globe. And if the counterparties fail, it could drag down the counterparties’ counterparties, and so on. Meltdown City. In 1998 the Fed orchestrated a bailout of the Long-Term Capital Management hedge fund because it had $1.25 trillion in transactions with other institutions. These days that’s almost small beer, because Wall Street has created a parallel banking system in which hedge funds, investment banks, and other essentially unregulated entities took over much of what regulated commercial banks used to do. (para. 11)

On the other hand, there are some people who are very religious and most of them have no knowledge in the sphere of economics. Thus these people do not believe and do not accept all the previous factors for the crisis in America. The only thing in which they believe is that The God punished them for something through the financial crisis or He just put them under obstacle which they must take over.

In conclusion, there are many theories and opinions about the reasons for the financial crisis in the USA. Some people insist that it is a result of bank crisis, other think that it is part of the economic recession, other people say that it is because of the bad policies and unreasonable wanting of short-term profit, rather than aiming the long-run one, and so on. Everybody can accept whatever he/she wants. But the financial failure is fact, the economic theories, too. Therefore, it will be good if we learn from the possible mistakes we did and do not do them in the future in order to protect us from future crisis. Do you think that our society have lived enough failures to have the enough knowledge to protect itself?

                                                 References

Barisik, S., & Tay, A. (2010). An Analysis of Financial Crisis by Early Warning Systems Approach: the Case of Transition Economies and Emerging Markets (1994-2006 Period Panel Logit Model). International Journal of Economic Perspectives, 4(2), 405. Abstract retrieved from http://proquest.umi.com.ezproxy.umuc.edu/pqdweb?did=2168331091&sid=1&Fmt=3&clientId=8724&RQT=309&VName=PQD

Boskin, M. (2009). Time for Plan B?. International Economy, 23(3), “44-45”. Retrieved from http://web.ebscohost.com.ezproxy.umuc.edu/ehost/detail?sid=04b573a6-5006-47b9-97e7-e34e5cc751ee%40sessionmgr114&vid=1&hid=111&bdata=JnNpdGU9ZWhvc3QtbGl2ZSZzY29wZT1zaXRl#db=bth&AN=44369871

Buggey, T. (2007, Summer). Storyboard for Ivan’s morning routine. Diagram. Journal of Positive Behavior Interventions, 9(3), 151. Retrieved from http://web.ebscohost.com.ezproxy.umuc.edu/ehost/imageQuickView?sid=d38bb837-4b78-41b4-aaeb-2ff685109252@sessionmgr104&vid=8&ui=12857906&id=54463024&parentui=54463024&tag=AN&db=bth

Gandel, S. (2009). America’s Broken Banks. Time International (South Pacific Edition), 173(5), para.8. Abstract retrieved from http://web.ebscohost.com.ezproxy.umuc.edu/ehost/detail?sid=d38bb837-4b78-41b4-aaeb-2ff685109252%40sessionmgr104&vid=1&hid=111&bdata=JnNpdGU9ZWhvc3QtbGl2ZSZzY29wZT1zaXRl#db=bth&AN=36532577

Obi, P., Choi, J., & Sil, S. (2010). A Look Back at the 2008 Financial Crisis: The  Disconnect between Credit and Market Risks*. Finance a Uver, 60(5), 401. Abstract retrieved from http://proquest.umi.com.ezproxy.umuc.edu/pqdweb?did=2301805461&sid=1&Fmt=3&clientId=8724&RQT=309&VName=PQD

Obi, P., Choi, J., & Sil, S. (2010). A Look Back at the 2008 Financial Crisis: The Disconnect between Credit and Market Risks*. Finance a Uver, 60(5), 403. Abstract retrieved from http://proquest.umi.com.ezproxy.umuc.edu/pqdweb?did=2301805461&sid=1&Fmt=3&clientId=8724&RQT=309&VName=PQD

Obi, P., Choi, J., & Sil, S. (2010). A Look Back at the 2008 Financial Crisis: The Disconnect between Credit and Market Risks*. Finance a Uver, 60(5), 404. Abstract retrieved from http://proquest.umi.com.ezproxy.umuc.edu/pqdweb?did=2301805461&sid=1&Fmt=3&clientId=8724&RQT=309&VName=PQD

Sloan, A., & Burke, D. (2008). On the Brink of DISASTER. (cover story). Fortune, 157(7), para.11. Abstract retrieved from http://web.ebscohost.com.ezproxy.umuc.edu/ehost/detail?sid=743411ed-47dc-481a-8c4a-7f3e0d8a9f07%40sessionmgr111&vid=1&hid=111&bdata=JnNpdGU9ZWhvc3QtbGl2ZSZzY29wZT1zaXRl#db=bth&AN=31694499

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