The origins of the Global Credit Crisis

(2007-2009(

Mr. Karim ShehataTeaching Assistant of Accounting and Finance departments, Quality assurance

assistant, Faculty of Financial & Administrative Sciences, Pharos University, Masters Student at Alexandria University, Former Financial administrator at TE Data Company,

Alexandria, Egypt

Abstract

In 2007, The United States of America faced a financial crisis that become a controversial issue among the prominent people due to its severity in being like an infectious disease inflicting many countries out of U.S borders. The aim of this working paper is to illustrate the loopholes of the financial regulations which made the financial institutions & their investors vulnerable to such crisis. One of the main reasons was the Subprime mortgage which resulted from the deregulation in the credit terms of the U.S financial Institutions.

Introduction

The financial crisis is considered as a debatable issue among the economists & Finance researchers due to its harsh impact on the countries’ economic performance across the globe & as we or some of us believe that the history may repeats itself; therefore, we should take our precautions & learn from what was happened in the past from mistakes that driven many of countries to face the financial crisis. The financial crisis always looks like an infectious disease mostly when it starts in the developed countries than in the developing one because most of the people who live in the developing countries especially the richest one are typically invest most of their wealth in the developed countries’ financial institutions & markets & thus the contagion spreads over the world when

the crisis become real. You would also need to be aware that the financial innovation not always leads to the profitability, sometimes leads to financial crisis such as the great recession (Global financial crisis) when it started in 2007 till 2009 in the United States when one of its financial institutions created the subprime mortgage-backed security based on its believe that the price of the house will continue rising, ignoring other critical factors that led to the crisis. Two important things you have to take into consideration when you analyze financial crisis, the adverse selection and moral hazard problems, as long as they increase, the probability of occurrence of financial crisis will increase.

Causes of the financial crisis problem

In 11 September 2001, when the terrorist attack has occurred in the United States, the government found itself on the edge of the recession so it decided to reduce its Treasury bills interest rate from 3% to 1% to encourage banks for borrowing funds to stabilize the economy, as a result most countries around the world were enticed for taking loans from U.S. due to its low cost of funding. The investors found that this risk-free debt instrument is no more affordable to be purchased as an investment because it has low return so they had decided to look for another investments that could help them gain high returns with low risk (Jarvis, 2011). The investment banks always looking for something new that enabling them get high returns (financial innovation) for that reason one of these banks have created the securitization. The securitization is the process of converting illiquid asset to liquid asset that can be speculated in the financial markets such as the prime mortgage-backed security. The investment bank had invented this asset-backed security to transfer the risk of default to the investors. The bank always makes mortgage loans when calls mortgage brokers for looking for people who are seeking for purchasing houses. The bank gives a house to the house seeker when he paid a down payment and shown his capability of paying the principle and interest rate & if the mortgage holder failed in repaying his loan the bank will foreclose on the house & offer it to another one but after the securitization appearance, the bank sold the mortgages to the investment bank who purchased it by money financed from the Fed. The investment bank had securitized mortgages by taking mortgages with same features

from the mortgage portfolio & repackage them into a new financial product called collateralized debt obligation (CDO) that has the ability of slicing the mortgages into tranches in order to its degree of riskiness then asset-backed securities transferred to the Credit rating agency to rating & pricing them & it end up with selling them to the investors based on their risk-acceptance degree. (Little-risk mortgage-backed securities were sold to risk-averse investors & the normal were sold to other banks & the high risky securities were sold to the hedge funds). The investment bank called the finance banks for purchasing more mortgages to securitize and sell them to the investors to gain millions of dollars but the finance bank said no more house seekers are available, the investment bank got an idea which is to issue a sub-prime mortgage to the people who have less responsibility (Bad financial performance) believing that the price of the house will increase so if the sub-prime mortgage holders failed in repaying the required amount, the bank will foreclose it and offer it to someone else & make millions of net profits. But what happened in the reality is that most of the subprime mortgage holders have failed in repaying & this led to a horrible event, the houses which have been foreclosed & offered for sale to other people made the number of the supplied houses sharply exceeds the number of the demanded houses (Housing bubble) so the prices suddenly have been plummeted & this made the normal people who have a prime mortgages to forsake their houses because they found that the interests they pay on their houses are not fair after the decline in the prices of houses & from this point most of the banks failed in repaying their loans & announced their bankruptcy (Jarvis, 2011) (Marshall, 2009).

The following figure shows The U.S. Subprime Lending Expansion (2004-2006):

(U.S. Census Bureau Access 17/8/2015)

What you have to take into your consideration that the sub-prime mortgage loans is not the only factor that led to the global financial crisis. There were many other factors such as (Credit booms, highly leverage, Derivatives (Credit default swaps), inadequate monetary policies; lax lending standards). (Claessens, Kose, Laeven, Valencia, 2010) (Carmassi, Gros & Micossi, 2009).

References:

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http://ir.lawnet.fordham.edu/cgi/viewcontent.cgi?article=2929&context=flr

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http://www.youtube.com/watch?v=bx_LWm6_6tA

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