A general bonfire is so great a necessity that unless we can make of it an orderly and good tempered affair in which no serious injustice is done to anyone, it will, when it comes at last, grow into a conflagration that may destroy much else as well."
John Maynard Keynes, The Economic Consequences of the Peace, 1919. (Shiller 2008, p.4)
Global financial crisis is a worldwide financial FIASCO which was remarkable with so many different characteristics, where America was at the epicenter of all the actions taking place. This credit crunch of 2008 is the worst economic crisis since the great depression of 1930.
The term financial crisis is applied broadly to a variety of situations like banking panics, stock market crashes, bursting of financial bubbles, currency crisis and sovereign defaults (Dr.Trivedi p.4). The main cause for the global financial crisis is securitization. This was a result of three others factors which can be listed as the change of labor market from manufacturing sector to the service sector, the changing pension system and the OEM model. Let us look into these factors.
Firstly the changing labour market, on the macroeconomic level, economies shifted from manufacturing to service sector this led to the transformation of long term employment(seen during the period of Fordism) to short term employment relations. This period is known as Post Fordism when America shifted from manufacturing to service sector. During this period the employee relation with the organization was shortened. America presently has less than 10% of its population working in the manufacturing and agricultural sector. Walmart alone employs more people than the entire manufacturing and agricultural sector.
The change of labor gave rise to the portable employment which in turn gave rise to portable pensions. Pension financing system changed from 'defined-benefit' to 'defined-contribution' system. In 'defined-benefit' it was the employer's responsibility to create a sufficient pool of investment to pay its employees when they retire. With the 'defined-contribution' system it transferred the risk from employers to the workers, who were now responsible to make sensible investment choices. The Growth of 'defined- contribution' system fuelled the growth of mutual fund industry. In 1980 they were 564 mutual fund companies, in 1990 there were 3079 and in 2000 there were 8155. Assets under mutual companies increased from $135 dollars in 1980 to $12 trillion in 2007. Households increased from 6% in 1980 to 45% in 2008. (Davis 2009, p.5-6)
When corporate executives look out at their investors today, they don't see the dispersed widows and orphans of times past-they see a relative handful of financial institutions. The relative rise of concentrated institutional ownership has corresponded with an increased focus on share price as the most relevant measure of corporate performance. The outcome of three decades of increased individual participation in financial markets, through mutual funds, has been a reconcentration of ownership in the hands of a few financial intermediaries. By the end of the decade, any lingering doubt about the purpose of the corporation, or its commitment to various stakeholders, had been resolved. The corporation existed to create shareholder value; other commitments were means to that end. This even more widened the gap between the employer and employee. (Davis 2009, p.7)
All the above causes lead to securitization; this happened on the microeconomic level, the credit crisis was caused due to the main reasons like large leverage investments, asset liability mismatch, regulatory failures and self fulfilling prophecy (Dr.Trivedi, p.11). In credit crisis the most common used terms are subprime mortgages, collateralized debt obligations (CDO), frozen credit markets, credit default swap (CDS), mortgage backed system (MBS) and etc. The whole build up to the credit crisis was started somewhere during 1995 during the rule of Bill Clinton he wanted his nation to live the 'American Dream' , where every person has his/her own house and he made it easy for the borrowers to borrow money from the lenders. A group of financial players, including banks and mortgage brokers, saw it as an opportunity to make some money. The Federal Reserve Bank also played a big role in this as it cut the interest rate to 1% which encouraged banks to borrow more money which in turn made them go berserk with large leverage investments. The investors also became interested in this and bridged the gap between the borrowers and investors through mortgages. The financial crisis was triggered in the first quarter of 2006 when the housing market turned. A number of the mortgages designed for a subset of the market, namely subprime mortgages, were designed with a balloon interest payment, implying that the mortgage would be refinanced within a short period to avoid the jump in the mortgage rate. The mortgage refinancing presupposed that home prices would continue to appreciate thus the collapse in the housing market necessarily meant a wave of future default in the subprime area. (Rihardson, M., Acharya, V.V., 2009 p.2). This decreased the value of the CDO's and in turn increased the value of credit default system(CDS) , the CDS of US in 1998 was nill , the CDS increased at such a fast rate that the value of it in 2008 was $62 trillion which is 5 times the value of US's GDP.
The solution for this global financial crisis, not much can be done on the macroeconomic level; to solve this, the microeconomic level can be altered. The long-Run solutions for global economic can be to have a New information infrastructure which means comprehensive financial advice, new financial watchdog, default-option financial planning, improved financial disclosure improved financial databases, new system of economic units of measurement. We can also even look into the expanding financial markets to cover more risks that really matter like the real estate markets and long-term claims on incomes. (Shiller 2008, p. 27-28)
Recommendations to rating agencies -To avoid confusion, the agencies need to be explicit and attach actual numbers to their forecasts. For any particular type of instrument that is being rated, there is the need for a clear statement about the methodology used to derive a given rating and the underlying assumptions. These have to be generally available, so that in principle the rating could be reproduced by an independent party. The ability to independently validate a rating would go a long way to reduce the effects of conflicts of interest. Independent validation requires that data be available. For asset backed securities, the government should sponsor an agency that collects information on a timely basis about the collateral pools and make it available to market participants. This will facilitate an independent party's ability to reproduce the credit ratings. Clarity is required about the data sources used to reach a rating. (Turnbull, M.S., et al., pp 30-31)
Recommendations to valuation- There is a need for the simplification and standardization of instruments. Many instruments have become too complicated, making reliable pricing or risk management problematic. For many different asset classes, the industry needs to develop markets for indices written on standardized assets. This will help in price discovery and for pricing related assets. (Turnbull, M.S., et al., pp 32)
Recommendations transparency-For banks there is the need for transparency as to the magnitude of explicit and implicit commitments arising from lines of credit, reputation concerns, backstop supports, and funding for levered buyouts. Examples are the implicit commitments to off balance sheet vehicles and enhanced money market funds. A bank should state in its annual report the consequences of bring back onto its balance sheet its off-balance vehicles. This would help reduce the information asymmetry. There is the need for greater transparency with respect to the nature of assets held by financial institutions, especially assets that are difficult to value (level three assets). (Turnbull, M.S., et al., pp 34)
Recommendations to risk management issues- Firms should adopt a comprehensive firm-wide risk management and share quantitative and qualitative information in risk management committees that meet frequently and include senior management as well as heads of business lines, legal and compliance officers, all as equal partners. Rigorous internal processes should be put in place to value complex and illiquid securities and internal credit quality assessment should complement external ratings. Traditional Value-at-Risk measures should be complemented by forward-looking stress testing to capture the impact of severe market shocks. The incentive and compensation system should be reviewed to better align the interests of all the participants in the securitization chain with the interests of the investors and shareholders of the firm. (Turnbull, M.S., et al., pp 41)
In conclusion the global financial crisis was caused in a 4 stage life cycle the first stage being the changing of labor market next being the changing pension plans then the OEM model and the last and final stage the securitization. This is truly a global problem and it needs a global solution. Solutions need to be implemented on a microeconomic level first and then on a common basis to the whole world. But the most important asset of today is of confidence and trust, the confidence about the future is needed for a confident today.
