Elements Comprising The Global Financial Crisis Essay Example Pdf - Free Essay Example

Let us recap the previous chapters, we had cheap global debt searching for high returns and this search was channeled into a deregulated market by the innovation of complex financial instruments based on the elements of uncertainty, compounding interest and speculation. Subprime mortgage crisis was the result of a market that was too prone to transact in debt based transactions rather than equity based transactions. Ultimately this activity automatically spread through the process of globalisation all over the globe. Debt and compounding interest in its nature is open invitation to crisis but this situation was worsen by the securitisation of transaction which were not accurately reviewed for the risk they were carrying. Use of faulty finance models and equally faulty credit ratings increased the devastating effects of the Subprime mortgage crisis. When all these elements combined together: here we were in the middle of a perfect storm. The Subprime mortgage cris is exposed vulnerability of various regulatory frameworks working in the financial markets. Without vigorous financial and economic conditions in the world markets contagious risks are very common, and market expansions in such circumstances are a definite threat to the economic system.  [1]  Islamic economists frequently referred the Subprime crisis as a result of compounding interest rates (Riba). Imbalance between the equity and debt based transactions, excessive expansions of the firms through debt borrowings, payment deficits, and inadequate regulations by the financial market; all is linked to the Subprime mortgage crisis.  [2]  In 2008, injection of $250 billion of taxpayer money as capital into major banking organizations by US Treasury was an attempt to reinstate the consumer confidence in the banking system. More than three trillion dollar bail out and liquidity injections to crisis did not come out of blue there are number of causes. Robert Priester, Head of Depar tment Banking Supervision and financial Markets observed; ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦ Crisis was due to the combination of three levels: First level: Sub prime loans in US were regulated by institutions which were not regulated by the Fed and lending conditions were based on the unrealistic projection on real estate prices evaluation and completely over looked the borrowers repayment capacity. Second level: CDOs were not easily understoodÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦and Third level: Imprudent behavior of the banksÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦ On one hand banks were selling Money when there was no actual money in existence and Assets before their existence. While on the other hand they allowed the debt to grow unchecked. This unchecked Excessive and imprudent lending worsen by excessive derivative and speculative transactions on the capital market and resulted in unavoidable default causing the capital market to crash, further destabilizing banking marke t which brought another episode of financial crisis harming real economic sector. Edward Estlin once said Im living so far beyond my income that we may almost be said to be living apart. and this was what exactly happening in our real economy. While observing too much interest of conventional financial system (CFS) towards Debt bases financing in comparison with Equity based financing Wolfgang Munchau in Financial Times states that ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦ The US market was overprized with 40 to 50%. People took loan after loan and you have reports that people in US having 25 credit cards, taking mortgages that are 20 times more than their incomes, 130% of the Value of the houseÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦ Under the pressures of reviving economy government supported the Too Big to Fail, and one after another of the major banks and other financial institutions has received government assistance. This chance of receiving regulatory forbearance is making big organisat ions to go beyond the boundaries of prudent financial transactions and pushes them to the limits of recklessness. With big position comes a big responsibility but these organisations have used this position to black mail governments for their voracious and self-interested drives, as if governments let them fail they fear that there failures would cause havoc to the real economy.  [3]  Islamic financial system strikes a balance between flexibility and oversight. Such situations of credit crunch could not happen under Islamic financial system because this system is based on partnership between the client and the banks or a social commitment within the Islamic banking and financial market. The financial crisis has proven very clearly that the apparent strength of modern financial markets was illusionary. The happy-go-lucky mood vanished instantly, with the write down of losses accompanied by the sackings of executives and followed by more rigorous lending for the real victims of th e credit crunch. Moreover, this financial crisis also gave rise to inflation as the unbalanced situation caused the demand for oil and food pushed prices up globally. This crisis has stunned the economies through out the globe. The modern financial economy differs from Islamic economics in many critical respects.  [4]  But one thing is very apparent that the elements that caused the global crisis are the elements completely prohibited under Islamic financial system. We do recognise that although Islamic financial system is new and obviously requires time to develop against it rival but indeed provides perfect set of basic principals on which new alternate financial instruments can be developed to avoid further crisis. Current Subprime crisis  [5]  can be evident as a crisis of failed morality giving rise to a relationship created by voracity of investment originators and ended up on exploitation of investors who where unaware of the risk they were investing in. As a conse quence we have witnessed a sharp decline in equity markets through out the globe, collapse of numerous financial institutions and rescues by central banks and governments by investing trillions of tax payers money on bailouts, liquidity injections, and by reducing interest rates in order to Increase liquidity and avoid recession to revive the financial market and to restore assurance in the monetary system. But in reality a prudent and rational solution for further avoidance of financial crisis is not possible without following the basic guidelines advocated by Islamic financial system Economic and monetary crises are not strange to financial history, from the Mexican currency crisis (1994) to Asian currency crisis (1997), Russian sovereign default (1998) and LTCM bailout (1998) till devastating dot-com (2000), and very recent housing (2006) and commodity bubble burst (2008) they always have showed indicating signs of the bigger problems ahead influencing the world economy at large.  [6]  The panic that began in US mortgage sector rapidly spread through out the globe. Since the experience of Great Depression 1930 the Current crisis has exposed the world economy to a worse and very long period of economic slowdown. This default and failure of financial market has brought down a notable spill in financial world.  [7] In principle impacts and causes of the present catastrophe were not different from other significant crisis in financial history. Mainly this time, the credit risk assumed by lenders in US on Subprime clients was overlooked. The transactions were not balanced between debt and equity based transactions stressing on debt based transactions ultimately ended up in entering into a recession spreading the economic slowdown and panic through out the globe. People acquired debt which they were unable to pay back. Debt was not the problem; the crunch was caused by the compounding interest which people were unable to pay. There is nothing wrong in borrowing money the problem comes when there is too much money borrowed by the borrowers on interest rate (which is not fixed). As early stated after the Great Depression in 1930s the current financial crisis is the greatest one that hit the world economy making the speculative explosion a reality. Charlie McCreevy Commissioner for the Internal Market and Services, European Commission in his speech states that the only way to prudently lend money is on the basis of a realistic assessment of the capacity of the borrower to repay- not from crystal ball gazing about the prospects of finding some one to refinance but from the borrowers sustainable cash flows. In the US much of the market moved towards the assumption that one could indefinitely rely on mortgage refinancing with increase debt on the back of rising asset values and an environment of permanently low interest ratesÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦ fragility of this system became clear once falls in US house prices w ere followed by inevitable high default levels among over leveraged borrowers. Exposure to these losses was transmitted partly via the securitization markets to financial intuitions around the world, trading of these underlying financial instruments on over the counter markets made these loses hard to locateÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦ . As market confidence fell, problem started to appear in other credit markets and default spread to higher quality segments of the US market, to credit card debt and to car loans. In the monetary world maximisation of income and wealth is the highest measure of human achievement and banks also wish to maximize their profits by extending more credit resulting in high profits. It is high leverage which enables excessive lending. Excessive lending, however, leads to an unsustainable boom in asset prices Followed by an artificial rise in consumption and speculative investment. The higher the leverage the more difficult it is to unwind it in a downturn. Unwinding gives rise to a vicious cycle of selling that feeds on itself and leads to a steep decline in asset prices followed by a serious financial crisis, particularly if it is also accompanied by overindulgence in short sales.  [8] Almost all crises like Stock market crash of 1987, the Long-Term Capital Management (LTCM) collapse in 1998, and the Dot.com bubble burst in 2000 etc are the result of excessive and imprudent lending by banks  [9]  that can not only damage their own long-run interest structure but can blow-off the balance of whole economic system. Mr. Bernanke, Chairman of the Board of Governors of the Federal Reserve System, stated in one of his speeches that far too much of the lending in recent years was neither responsible nor prudent. in addition, abusive, unfair or deceptive lending practices led some borrowers into mortgages that they would not have chosen knowingly (Bernanke, 2008, p.1).  [10] The interest on lending operations is t he major source of profit in the conventional financial system by banks, but the bad episode of loss starts when banks are unable to recover these loans with interest. Hence it is very prudent to think that banks would carefully analyse their lending operations to avoid loss. But two scenarios prevail in real world where they assume their immunity from losses. The Indispensable and Unavoidable Collaterals stand in front for managing the risk of default. Collateral when exposed to a valuation risk can be impaired by the same factors that diminish the borrowers ability to repay. And then comes the Too Big To Fail concept that provides protection and ensures their survival  [11]  and proved to be encouraging negligence to undertake a careful evaluation of loan applications ultimately resulting in unhealthy expansion in the overall volume of credit, to excessive leverage, and above all unsustainable speculative investment that gives rise to financial fragility and debt cris es and builds instability into the fiscal structure.  [12]  False sense of immunity and assurance against losses provided bankers with such a safety net which is like incentive to take greater risk than what they otherwise would in normal circumstances. Because as soon the big banks and borrowers are threatened by the default they are immoderately bailed out by IMF or central banks or the governments. This kind of free subsidy proved to be very harmful for the financial system this is Rewarding Greed and Stupidity not the Ingenuity of the Market.  [13] For example in the present scenario the excessive and imprudent mortgage lending by financial institutions like Washington Mutual to many high-risk home purchasers boomed the defaults of Subprime mortgages in the United States in 2007. Let us analyze the crisis step by step. The lenders paid certain amount of service fees to Washington Mutual in return of the sale. Mutual securitized this lending and sold to mortgage guara ntee institutions (Fannie Mae and Freddie Mac) to earn more funds. The guarantors pooled and packaged the mortgages into instrument called Mortgage backed Securities (MBS). MBSs were sold to the Wall Street. After that, the Wall Street re-packaged the MBS into another derivative instrument called as Collateralized Debt Obligations (CDOs) and sold them to some investment banks, e.g. Lehman Brothers. The investment banks mixed prime and subprime debt to pass the entire risk of default of even Subprime debt from mortgage originators and sold the instruments to the ultimate purchasers who due to this disguise packaging could not see the inherent risk of the financial instrument they bought against their default. The high ratings and higher yields on CDOs, made it easier for mortgage originators to pass the risk of default to the ultimate purchasers. Unscrupulous lenders also used deceptive tactics to sell adjustable rate mortgages (ARMs) to promote the sale of debt to unsoph isticated borrowers. Loan volume accordingly gained greater priority over loan quality and the amount of lending to Subprime borrowers and speculators increased steeply. This bundle of doughy debt became structured investment vehicle (SIV). In the end they structured no risk but crisis. This camouflage created uncertainty in creditors and they sought for protection against default by buying derivatives like Credit Default Swaps (CDSs). They paid premium to hedge funds for the compensation they will receive in case the debtor defaults. An additional dilemma was that the hedge funds did not only sell the CDSs to creditors, they also sold the derivatives to a large number of others who were willing to bet on the default of the debtor, and those speculators further resold those instruments to others. Consequently, the default of hedge funds and investment banks to pay such promised incentives to the instrument buyers brought them to unavoidable bankruptcy and those buyers to extremely h igh investment losses.  [14] Generally the securitization enables the banks to transfer the risk of default to the other purchasers by selling the debt and use the proceeds for further loans and increase their profit. Under the above scenario a rational purchaser would be willing to buy the prime debt but reluctant to buy the Subprime debt. So a camouflage of collateralized debt obligations (CDOs) was created to hide the issue. Prime and Subprime debts were mixed and securitized by trenching them into different groups with varying degrees of risk and maturity. Since complex models were difficult to understand, this made their purchasers rely on rating agencies, which issued ratings on the basis of information that was provided to them without verifying its exactness. Credit rating companies were paid by the companies they were rating plus they had business interest in encouraging companies to multiply off balance sheet vehicles which they have to rate. They emerged as first vil lains of the crisis as they had actively contributed to the real estate bubble by over-rating senior trenches in special purpose vehicles. Moreover, it also appeared that they faced serious conflict-of-interest problems as discussed above because they not only rated the products, but also gave advice on how to structure them . Ratings agencies are special entities, however, and there were only few that counted in the crisis. The two largest ones, SP and Moodys, are said to control 80% of the global market. Their ratings played a quasi-formal role in markets. A downgrade by a rating agency has immediate and dramatic consequences for a firm, or even a country. Lehmans fate for example was sealed when its credit rating was cut to junk status on Friday, September 12th.  [15] The lack of transparency and information asymmetry led to adverse selection, of transactions resulted from inadequate information, which ultimately led to unreasonable compression of credit spreads in the finan cial market. Assessments that were based on complex modeling did not provide a clear picture of tail risks or liquidity risk and this put creditors to have a heavy reliance on rating agencies. The set-up was so unclear that After august 2007 when London market went down a well know city firm Lake Street Global Market issued a statement saying: Market participant dont know whether to buy on rumor or sell on news, do the opposite do both or do neither depending on which way the wind is blowing. This brings us to a conclusion that the current financial crisis is self created by the market system under the huge influence of greed. Advocates and the opponents of both who believe in government intervention and free market economies have failed to deliver a practical long-term solution to the crisis. The break down of old relationships of depositors and borrowers for sources of funds moved to capital markets through Securitization process. This ultimately created a web of Innovation dri ven new risks by creation of complex and opaque financial instruments of Hedging and Speculation for transfer of risk that were not well understood by the investors resulting in crisis of financial markets. This phenomenon on one hand caused the financial institutions to suddenly lose significant proportion of their value and on other unexpectedly affected the Investors to lose substantial amount of their investments causing constraint to the flow of credit to families and businesses bringing adverse effects on the real economy. CFS promoted derivatives to transfer one kind of risk, but created newer risks through complex securities which being novel in their nature were difficult to assess. Investors were unable to know the exact nature and inherent risks of assets underlying these securities. All this defacing of financial system was originated by excessive profit-motives driving the creation of complex instruments and operations and deregulation of system which invited the nightm ares of default in the reality of Financial Crisis.  [16] On one side these complex tools of Derivatives increased the systemic risk during the current crisis which brought not a different result from 1930s depression portraying a very mortal picture of the relationship between derivatives and liquidity. While on the other side, many members of financial institutions boards have proved to be too ignorant and incompetent to serve as directors, as they were unable to understand leverage or the implicit risks behind derivatives. A well known Swiss bank which prompted the Governments aid had only one member of the board with experience in derivatives, and the Lehman Brothers board included the head of US Red Cross and a well known Broadway play writerÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦ experience in derivatives and risk was sacrificed at the expense of diversity.  [17] One of the most important lessons to be learnt from the present crisis is that the financial sector became too r emoved from the real world economy. Many financiers were very detached from the originating transactions due to activities such as securitization, repackaging of assets, utilization of CDS and over-reliance on credit rating agencies, such that the management of risks was inadequate. Islamic financial System (IFS) can make a valuable contribution I n repairing the present crisis.  [18]  IFS techniques if applied and executed properly create a much closer nexus between the asset, the customer and the financier. IFS prohibits the creation of debt through direct lending and borrowing, hence prohibiting excessive leverage, which is a root cause of the crisis. The creation of debt, through the sale or lease of real assets (via the Murabahah, Ijarah, and Salam or Istasnah modes of financing) is permitted subject to the conditions. The crisis has proven that IFS is a credible alternative system that is free of the major weaknesses found in the conventional system briefly a major reason of CFS default was its too much involvement in Debt Based Financing instead of Equity Based Financing which is opposite in IFS as IFS encourages the Equity Based Financing and discourages the Debt Based Financing against it. The current crisis shows up the soundness of a trade and investment-based financial system as advocated by the IFS. The strengths of Islamic finance are derived from its adherence to ethical finance and socially responsible investment.  [19]