2007-2009 Economic Crisis: Introspection

Some of the major investment banks in the US and UK collapsed and resulted in the closure of the many more creating ripples of uncertainty across global markets. The few prominent names to be mentioned are Lehman Brothers, Bear sterns and Northern Rock eroding over $ 3 Trillion of wealth and millions of job losses which was poignant.

The economic crisis that started in 2007 can be attributed to two different division of factors namely the macroeconomic and the microeconomic factors.

Macro Economic factors

" Global financial economic imbalances: This refers to ''the large and the persistent current accounts deficits and the surplus that comes from the capital flows across the emerging market countries and the (Asia and the oil rich Gulf) to the capital rich industrial economies (Particularly US).''There has been an imbalance between the saving in the developed countries and the developing countries. The reasons for these imbalances can be attributed to the fact that the investors in the emerging market wish to hold their assets and the in the more stable currencies as well as the changes brought about by the new trade flows (Vaidez & Molyneux,2009) affecting level of inflation.

" Long period of the low interest and overleveraged business model:

As per the article published on the ' financial crisis' by Acharya, Philippon Richardson and Roubini ( 2009) there was a serious mistake on the part of the Federal reserve ( and some other central banks ) to keep the Fed fund rates too low ( 1 per cent) who tried to behave magnanimous until 2004 resulting in the credit and housing bubble. In other words there was a cheap funding available and the government failed to control the deleterious underwriting standards in the mortgages markets. The profess practices like the no down payments ,no verification of income ,assets and the jobs., interest only mortgage negative amortisation ,teaser rates were widespread among the subprime near prime ( Alt - A ) and even the prime mortagages.Also the Fed and the other regulators supported the financial derivative complex innovations resulting in a highly leveraged business model.

The lowering of the interest rates fuelled a credit boom in many industrialised countries with an increase in the annual growth rate of the between 5% and the 10% in the UK and the USA between 2003 up to mid 2007.Most of this attributed from parsimonious mortgage lending which helped to fuel up the prices.

" The low rates increases the present discount value of the revenue streams from the earning assets and this appreciated the asset prices (relationship between the bond prices and the interest rates) .As per the BIS reports the actual prices in the US and the UK witnessed an apprehensive increase of more than 30 per cent and the global market equity grew more than 90 per cent over this period.

" One of the implications of the low interest rate is that it encourages the banks and the other institutions to take more risks with temerity so they can meet relatively higher nominal returns committed in the various long term contracts. The portfolio managers have obligation of high returns and if they stick to their usual product portfolio their targeted returns on the investment would be difficult to attain. Therefore the low interest rates encouraged higher risk taking.

These macro economic factors fuelled the housing market, consumer spending and in the desire to achieve the higher returns on the investment (S. Vaidez and Molyneux, 2009).

Microeconomic factors:
From the onset of the credit crisis in the mid - 2007 myriad the micro economic factors resulting in the financial crisis became appenrent.Households were unaware of the mechanisms pertaining to operations of the bank's extensive risks and how their solvency was threatened. The rating agencies rated the high risk firms as the low risk firms in order to grab the larger market share of the rating business revenue. The insurance firms were insuring the credit risk of the variety of the financial instruments which they assumed to be the low probability of the loss. The following can be summarized by the BIS as follows.

" Consumes failed to watch for themselves: The consumers assumed that their investments were in the safe prerogative hands and so did the regulators who did not carry out enough auditing process.

" Manager's compensation scheme further encouraged the risk taking: They in the major financial firms lured for the maximum short rate of return as it was a part of their compensation to the incentive package .They did not consider the long run implications ,impact and took the maximum risks deliberately knowing that these assets were bubble .

" Skewed Incentives of the rating agencies: There was a rapid growth in the new securitised financial instrument (derivatives) that created a massive demand for the credit rating agencies services. A traditional low risk bond (AAA) paid low returns and there was a strong desire from the investors for the higher returns rather than low risk investments. There was an opaque and complex situation in the markets that forced these rating agencies to manipulate the results. The rating agencies were happy because they earned the higher returns as a part of their incentive.

" Limitation of a proper risk management methodology, Derivative financial Instruments and the regulation: As already mentioned' 'the whole range of the market participant were incentivised to take on the more risks to obtain a greater returns and a main route through which this was done is securitisation business. The banks extended the loans to the households including the risky households. - subprime lending.).and covered them with the increasingly complex forms of the derivative ,created a new legal structures off balance sheet. To attain the motive they had them rated ,issued and other instruments ( like short term commercial papers) so that the activities could be funded .They rated the securities and then sold it to the bank with a portion of it with themselves. This complex web of interactions needed a proper risk management system with new technology. There were apparent problems as many of the securitised products were new and they were backed by assets like subprime mortgages that had experience a short booming life span. The risk management models engineered by talented and skilled experts were mainly modelled on the basis of the good times leading to the exaggeration of the low risks associated with the securitised assets. The risk managers whose duty was primarily to gauge the implications of the risks could not gauge the risk metrics and parameters. With the changes in the interest rates it destabilized the entire system.