International Investment and the Risks Example for Free

In its 2007, August 13 issue Business Week magazine called it the “Bonfire of the Builders”. Signalling what was already becoming the cause of a major financial crisis in the global markets. After the dot com bubble burst in the 2001 the U.S.

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was seen by many analysts as going through one of its worst periods since the stock market crash in 1987. However the U.S housing market started a period of unprecedented growth, brought in part due to the lowering of interest rates by the Federal Reserve which brought the rates down 11 times i.e. from 6.5% to 1.75% (Open Market operations, 2010). However, the boom started showing signs of warning towards the end of the year 2005. Rates remained flat much of the next year and towards the beginning of the year 2007 a downturn in the housing started. What should have been only a downturn in the housing market turned into a major global credit crunch and resulted in a run on a British bank (Northern Rock).This is not to say that the American financial institutions were any better off. Citi Group reported a 57% fall in its third quarter earnings that year primarily because of the sub-prime mortgage losses (USA Today, 2007). So what was the reason that this housing slump transformed itself into a global credit crunch? The Financial Times (2007) in its special report on the global credit squeeze blames the poor quality of lending by financial institutions in the U.S. primarily banks and mortgage providers gave loans to people with dubious credit history’s and sold these mortgages as bonds to Wall Street institutions which in turn bought these mortgage backed by securities. This encouraged pension funds, hedge funds and other institutional investors to buy them. Things looked good until some of the mortgage borrowers found it increasingly difficult to meet their obligations and rates of default increased. Many of those who defaulted on their loans were sub-prime borrowers, people who had shaky credit histories. As the value of these asset’s began to come down hedge funds began to sell assets of all types not only those linked with mortgages as they found it increasing difficult to get finance from Wall Street banks who were themselves caught in the mortgage mess. Once banks stopped lending to other institutions a liquidity crisis occurred. This crisis was became known as the “Global Credit Crunch”, the heat of which was felt across the globe and markets across the world from Beijing to Bombay and Sao Paulo to Singapore.

Causes for the crisis

Housing bubble and subprime lending: Between 1997 and 2006 the real estate prices appreciated and coupled with low interest rates borrowers were able to obtain housing loans easily. Banks in the anticipation of prices to rise further began to give easy credit to borrowers not realising the positional debt accumulation. As the prices of properties began to decline in second half of 2008 the borrower’s ability to repay reduced. The graph below shows the significant increase in foreclosure activity signifying the rising inability of borrowers to pay during the various period of the crisis. Financial Innovations: This refers to the development of financial products designed particularly to achieve the client objectives i.e. to obtain easy financial assistance. These include the Mortgage based securities (MBS) and a form of credit insurance called credit default swaps (CDS). The usage of such instruments was increasing drastically during the years leading towards the crisis. As Warren Buffet put it these “weapons of mass destruction” were an agreement between two parties and government did not have any control over them. As a result there was no mechanism of reporting. These CDS were the reason why one of the biggest insurance companies, AIG, required a bail out from US taxpayers after it defaulted on $14 billion of credit default swaps it had made to investment banks, insurance companies and many other entities (Financial instruments responsible for Global Financial Crisis, 2009). Ineffective risk measures: In a speech in June 2009, U.S. President Barrack Obama said that “culture of irresponsibility” was a major cause of the crisis. A key reason for the crisis was also the insufficient capacity of financial institutions to fulfil their commitments. It is important for the sellers of risk to have capital enough to meet their bets. This applied to both consumers and financial institutions, as consumers were unable to repay their loans while the institutions were incapable of feeding their credit needs. Incorrect assessment of risk cost dented the financial system. Shadow Banking System: These were non institutional banks which aided the institutional banks to invest their money into more profitable ventures .To name a few, Lehman and Bear Stearns were such institutions. Though this system was assumed to do a better job by reducing risk and spreading investments, the after math of the mortgage crisis didn’t quite aid the objective (Krugman, 2009, p158). Panic and fear amongst the people resulted in refraining them to participate in the auctions and increased the default rate in mortgage loans which lead to the global financial crisis. These shadow bankers were not under the governmental control and traded short term funds for long term riskier funds. However during the crisis they had to let go of the long term assets as depressing rates due to their vulnerability. Paul Krugman, laureate of the Nobel Prize in Economics, described the run on the shadow banking system as the “core of what happened” to cause the crisis. He referred to this lack of controls as “malign neglect” and argued that regulation should have been imposed on all banking-like activity. Rise in prices: The increase in commodity prices also was one reason of the recession as it diverted the expenditure of consumers in an importing country. For instance if the prices of fuel went up in US, the economy of the fuel importing country, in this case US would decline which in turn would enhance the economy of the oil exporting country (Light Crude Oil, 2010). There was a significant increase in the prices of metals and minerals which also contributed to the credit crunch (Taylor, 2009). Poor Corporate Governance: The financial crisis can also be attributed to the poor corporate governance incompatible executive remuneration structures. The lack of transparency in procedures of trading, handling financial instruments, recording and presenting financial reports also caused the market failure. Lax in regulations and legislations for the product innovations also caused a detrimental effect on the economy (Zandi, 2009). Ineffective economic forecasting: Business week’s cover story on April 16, 2009 accused the economists of being incapable of predicting the crisis. This is another school of thought which seems to be quite applicable. With assets bubbles being created, prices rising, liquidity drying up the market, why were the mainstream economists and analysts unable to foresee the crisis. Warren Buffet also said that the expectation of real estate prices to decline was something no one was willing to predict or believe. Such ineffective forecasting also set the economy on a back foot when it came to meeting the demands of the crisis and be proactive in order to bring up measures to curtail it (Zandi, 2009). Financial ill-literacy: People were able to understand that they can buy expensive homes with a subprime adjustable rate mortgage (ARM) loan, assuming that they could sell it off quickly to make profits, however barely did they know what could be the repercussions of entering into such trade. Most the borrowers did not understand completely the mortgage terms and relied on their brokers to fetch interest rates they could afford and be rest assured that the agents would take care of their financial assets. The general financial ill-literacy contributed to the credit crunch and the borrowers did not make wise decisions on borrowing, saving and investing (Zandi, 2009). This could not have been the case 20 -30 years old as there were not so many investing options which could confuse an investor. But the complex mortgage options that were available during the subprime loans were mind boggling for the borrowers to comprehend at times to make decisions which not result in such perils. Inadequate and untimely analysis: Lack of timely and accurate information also disturbed the policy makers’ ability to response to the crisis. Most of the data on mortgage crimes and defaults come from private sources and data banks which makes it difficult for the regulators to monitor and foresee trends. The government does not track the number of foreclosures being made or umber of defaults in payments that are happening (Zandi, 2009). The Home Mortgage Disclosure Act (HMDA) provides for the reporting of some information pertaining to loan application and approvals. However they do not provide for reporting of foreclosures or delinquencies that happen in mortgage loan cases. This contributes to the inability of the regulators to understand the forthcoming perils which may lead to unexpected situations.

Effects of the Crisis:

U.S.-based credit watchdog S&P said that total losses to be booked by the global financial sector from subprime asset-backed securities could reach $285 billion, but opined that the end of write downs was now in sight for large financial institutions (Edwards, 2008). However, the loan default activity of U.S. banks suggested that the floor in the real estate market is not yet in sight. Let’s consider some of the macro effects of the subprime crisis:

Impact on Financial Institutions and Banking Industry:

Subprime crisis created a vacuum in the bank business model, eliminating volume and income while limiting resulting in net effect of large reduction in credit availability. In the long run, loan origination would now imply retention of the asset as default option. Banks had limited funding, revenue options. The entire sector was under pressure to reduce leverage. When the market is good the bankers try and increase their leverage by building up their assets of both loans and securities. However in bad conditions they take a back foot to try and reduce their debt burden. With the fall in property prices, the banks had to write down their book values of such mortgages and by spring of 2008, the globe’s biggest banks had collectively written down their assets by almost $275 billion (Zandi, 2009). These losses were a direct hit to their capital. What further aggravated their wound was the lack liquidity in the market at a time when they were in desperate need to reduce their leverage. The International Monetary Fund estimated that large U.S. and European banks lost more than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009. One of the first victims was Northern Rock, a medium-sized British bank. The highly leveraged nature of its business led the bank to request security from the Bank of England. This in turn led to investor panic and a bank run in mid-September 2007.

Reduced risk appetite:

The subprime crisis has changed investor and lender preferences dramatically. Structured assets of all ratings grades were shunned in favour of simpler cash securities. Dealers are walking away from low-risk markets such due to concerns about capital availability and “fair value” risk (Whalen, 2008). As the Bear Stearns collapse illustrates, there had been a huge reduction in market liquidity overall, and a sharp decrease in leverage used by all market participants. Lack of credit in markets : Economist Paul Krugman and U.S. Treasury Secretary Timothy Geithner explain the credit crisis via the implosion of the shadow banking system, which had grown to nearly equal the importance of the traditional commercial banking sector as described above. Without the ability to obtain investor funds in exchange for most types of mortgage-backed securities or asset-backed commercial paper, investment banks and other entities in the shadow banking system could not provide funds to mortgage firms and other corporations. This meant that nearly one-third of the U.S. lending mechanism was frozen and continued to be frozen into June 2009. According to the Brookings Institution, the traditional banking system did not have the capital to close the gap as of June 2009. It would take a number of years of strong profits to generate sufficient capital to support that additional lending volume. While traditional banks have raised their lending standards, it was the collapse of the shadow banking system that is the primary cause of the reduction in funds available for borrowing. Insolvency causing retrenchments: The global financial crisis, brewing for a while, really started to show its effects in the middle of 2007 and into 2008. Around the world, stock markets had fallen, large financial institutions had collapsed or been bought out, and governments in even the wealthiest nations had to come up with rescue packages to bail out their financial systems. On one hand many people were thinking that those responsible for the financial problems were the ones being bailed out, while on the other hand, a global financial meltdown was affecting the livelihoods of almost everyone in an increasingly inter-connected world. The downturn in economic activity took effect earlier in the United States, where the unemployment was 4.9% and reached 10.1% by October 2009 (Goodman, 2009).

Effect on the global economy:

There’s no doubt that conditions in the major economies took a sharp turn for the worse in the period following the Lehman collapse in September 2008. Business and consumer confidence deteriorated drastically, as did the financial sentiment. In the general climate of uncertainty, households around the world responded by cutting their discretionary spending. This seems to have had a particularly pronounced effect on demand for manufactured goods. The result was a sharp fall in global industrial production, and significant contractions in GDP in most of the major economies. The Chinese and Indian economies continued to expand, but at much reduced rates. Indications are that world economic conditions have remained very weak in the early part of 2009. Decline in exports for developing economies: Recession in the United States and other G7 countries will in general reduce the demand for their imports, as these markets are important destinations of developing-country exports. A significant proportion of US imports are from developing countries. Many of these imports are also imports of services, not just goods. Thus, the India’s software sector, which exports IT services to the United State, for instance, and other advanced economies have registered slower growth.

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Source: IMF (Between 2007 and 2008, as estimates of December 2008) Description: 1 Countries in official recession (two consecutive quarters) 2 Countries with economic slowdown of more than 1.0% 3 Countries with economic slowdown of more than 0.1% 4 Countries with economic acceleration The above chart displays the spread and impact of the global crisis across the globe, with clear indications that though the developed countries were facing severe downturn the developing economies were also being affected gradually. Impact on Balance of payments: For many countries, primarily commodity-importing countries, the reduction in export earnings will come at a time when their balance of payments is already under pressure due to rising food and fuel prices in 2007 and 2008. Such countries may be in particular need of balance-of-payments assistance from the IMF and other sources. Developing countries require financial inflows from the rest of the world to facilitate and accelerate economic growth, trade and development. These flows include official development assistance (ODA), investment flows (portfolio and foreign direct investment (FDI), trade credits and flows of remittances. All of these are set to be affected negatively during the current crisis which will have adverse impact on the current account of BOP.

Portfolio risk management lessons learnt

The financial crisis has forced investors to take a more nuanced approach to portfolio risk management. Dan Farley, global head of Multi-Asset Class Solutions at State Street Global Advisors, said the crisis exposed the need to “understand the limitations of traditional practices”, such as Modern Portfolio Theory, and “heightened the need for new approaches” to strategic and tactical asset allocation. Many investors have gained a more nuanced reminder of portfolio risks centring on market volatility, portfolio construction and trading liquidity. It has been observed that investors have moved increasingly away from risk models centred on average market behaviour and normal return distributions, instead adopting strategies that focus market turbulence, risk, liquidity and diversification. Based on the understanding of the crisis situation the following important portfolio risk management lessons have been identified. Intelligent Diversification Matters: Traditional approach of diversification will always hold good. Owning certain asset classes like treasuries, certain commodities, and cash did help in 2008. Benefits of diversification provide beneficial shock absorbers for most investment portfolios. Economist Burton Gordon Malkiel sums it up succinctly, “Diversity reduces adversity.” While consumer financial services were down 54% in 2007, healthcare outperformed the S&P 500 by 10% – only a few years ago, the situation got reversed (Siegel, 2007). Lehman had placed too many of its financial eggs in one basket: mortgages. When the mortgage securities market went bad, it had nowhere to hide. When you concentrate your investments in any single company, industry, sector, or country, you run the risk of being hurt by a calamity like the collapse of the mortgage securities market (Young, 2009). Rather than investing in a single stock or single sector of the economy, one should invest in mutual funds that distribute the investment across many businesses. Another option, index funds, which are less subject to seismic shifts in the market because they are based on a set of rules of ownership that remain constant, regardless of market conditions. Diversification does not mean in spreading investments over 10 stocks, overseas investments should also be considered. Diversification by itself cannot guarantee a profit or protect against loss, but it can give you more chances for success and reduce the effects of volatility on your portfolio. Managing Risk Appetite: People when they are over confident enough to believe that the investing laws don’t apply to them tend to make decisions which dint work for them. One such law is that leverage, the act of borrowing other people’s money to invest, it can work both ways-for you and against you. Lehman had financed around $600 billion worth of assets at a time when it only had$30 billion of equity (Young, 2009). This is a clear example excessive risk. It is important that investor invests keeping in mind his risk appetite is comfortable making adjustments over time. Any panic caused out of unexpected risk will result in decisions which will be extreme and eventually affect the portfolio adversely. Investor should create portfolios which are not excessively complex for them to understand. It is necessary to have full transparency of investment performance, attribution and investment strategy along with the premise behind the strategies. Investor should try to have as much information about all aspects of the investment process so that there is a lower likelihood of significant problems. Maintain Substantial Liquidity: As the crisis unfolded we realised that one of the major damages was caused by the lack of liquidity in the markets, which resulted in cases of default in payments. It is important for the investors to remember to maintain enough liquidity in order to protect themselves from the market volatilities. Not having liquidity forces the investors to sell off assets in case of highly illiquid markets. Northern Rock suffered from funding liquidity risk in September 2007 following the subprime crisis. The firm suffered from liquidity issues despite being solvent at the time, because maturing loans and deposits could not be renewed in the short-term money markets (Tobias & Shin, 2007). For long term investors it can mean that they have to compromise on their long term objectives in order to meet their short term liquidity demands. Conclusion: Flawless execution of risk management does not guarantee that losses won’t occur as losses depend on upon business decisions and luck. The risk models established during the crisis failed due to the unexpected fall in mortgage prices. Thus systematic risks are bound to exist and financial crisis happen as a result of cases which have not been experienced in the past. Significant monetary, political and risk management changes are underway in order to cope up with the crisis; however the formal risk management models cannot substitute for judgement and experience. By analyzing the root causes of the financial crisis, it is possible to estimate the costs of resolving the crisis utilizing current policies of bailing out investors who made poor investment decisions. In any event, it would seem imperative that the financial managers of the future be better educated in the art of credit analysis and investement management.

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