Financial Crisis is a Disruption to Financial Finance Essay

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A financial crisis is a disruption to financial markets in which adverse selection and moral hazard problems become much worse, so that financial markets are unable to efficiently channel funds to those who have the most productive investment opportunities (Mishkin, 1992,p. 115). The term "financial crisis" describes the several situations where financial institutions lose their values. Financial crisis are related to defaulting, subprime, currency crisis, stock market crashes, banking crisis, recession, securitization, wrong rating, common chocks and many others.

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Many empiric models have tried to explain the financial crisis. Principally, the first, second and third generation and the non-conventional models should be taken into account. The models’ examination started since 1979, by way of the first generation models that describe the unstable financial crisis, as an anticipatable but unavoidable event, resulting from the changeability of monetary policy with the exchange and fiscal rate. The second generation models existed in the mid-80, where anticipations examine the act of the auto crisis, where a financial crisis may or may not happen. The third generation models appeared after the East Asia financial crisis and join the economic crisis and the delicacy of the financial sector and infection from other countries (Ramírez et al., 2008). Kaminsky & Reinhart (1998), state that the second generation models cannot be used to explain other financial crises where the trade balance is not an indicator of monetary crisis, as well as the first generation models. In addition to all that, regarding the non-conventional models of financial crisis, the events of the 90A´s financial crisis have encouraged the improvement of models in order to convey an empiric action which helps understand and simplify these events; and try to reduce the adverse impacts on the economy (Ramírez et al., 2008).

The latest credit crisis started in 2007 in the subprime mortgage market in the United States. The term "Subprime" describes the classification of the mortgagees who are not qualified for prime mortgage rates. The reason is their poor and impaired credit history or low income. Their low credit put forward for consideration that they are risky costumers because they are more likely to default on paying back the dept. Subprime lending carry more credit risk (or default risk) and a very high interest rates. Some mortgagees are considered as subprime borrowers even with their good credit history since they did not provide enough verification of the assets or income while applying for a loan. Taking for example, an employee who has a good salary and a good credit history (with no existing liabilities, charge offs, payment delinquencies or a low credit scores) applied for a loan but has elected to not provide the needed verification of her income. This costumer will be considered a subprime and charged a higher interest rate on the loan because she is considered a risky borrower who has a chance of defaulting (Subprime Lending, 2001).

Many previous studies considered the factors and the aspects of the subpime mortgage crisis. Velde, in 2008, implies that the financial crisis is producing a slowdown in most developed countries and segments, and governments predict that "the worst is not yet over". All regions have suffered declines in growth. According to World Bank estimates, the global economy contracted by 1.7 per cent in 2009, the first decline on record in world output (World Bank, 2009). Moreover, the UNCTAD, in 2009, explained that the risk of falling into deflation cannot be treated as unworthy of serious consideration for many chief economies and that the basis causes for the crisis should be identified.

1.1_Purpose of the study

Financial crisis take place at the economic and the banking level. Since both a country’s economy and its banking system have a major effect, directly or indirectly, on the citizens’ budget, and thus, on their entire life, it is important to understand the different aspects of a financial crisis. The latest crisis was nothing like any other that happened before. Therefore, this study will shed light on it and comprehensively discuss the different factors that have contributed in the subprime mortgage credit crisis, its consequences and the policy responses.

Chapter Two: Literature Review

2.1_Economy and the Banking Systems

There is no "strong" country with a weak economy. The development of the financial position of public and private sectors in a country in addition to the average development of the financial position of each individual, which represent the Gross Domestic Product (GDP), determine the economic growth. The comparison between the economic growth of a country and that of its competitors identifies the local growths that are made or kept up. If there is no growth, or the economy is growing really slowly, then this is going to significantly have an impact on business strength. An economic growth can offer improvements in all the country’s segments. Even a small rise in annual economy can have great impacts thereafter. In addition to that, an economic growth lead to a human development, there is a strong relationship between economic growth and human development which shows the importance of a strong economic system (Ranis et a.l, 2000).

The economy cannot operate unless being accompanied with the banks. The health of the economy is strictly associated to the soundness of its banking system. The banking system has made the personal transactions and the improvement of agriculture, industry and trade easier. Simultaneously, it made to economic development easier as well. The banking system plays an important role in the mobilization of savings; resources are organized by banks and as the banks’ deposit is liquid so people are able to get money even in crisis. The banking system have also a role in capital formation; it is essential for improving the economic state of a country which leads to a better employment rates and a better degree of material comfort available to a person or community. Regarding the promotion of employment; banks support the economy by reducing the level of unemployment since they give loans self-employers, manufacturer and businessmen to start or expand their businesses which create more job opportunities. Therefore, a good banking system and economic growth support and encourage entrepreneurship. Furthermore, banks play a role in the safety of wealth; banks keep peoples’ money safe which lead to more savings. Lastly, banks help transfer money and make transactions in distant countries without difficulty which enlarged trade and market. C:UsersdayanaDocumentsMUBSseniornew articlesimportance Role of Banking System in the Economy

2.1.1_Financial Crisis and the Economic and Banking Systems

The latest subprime mortgage crisis which started in 2007 caused the global economic system to tremble. It began in the financial sector and had a major effect on the economy. More essentially, the crisis spread widely and unexpectedly. Researchers, internationally, tried to find out how to stop the crisis of happening (European Commission, 2009) or how to reduce its possible impacts. The financial sector was well known to be very exceptional. Banks have several roles in the economy and are critical to the financial system and the real economy too. Above all, they perform an important role in corporate governance. Banks increase a big portion of their capitals by demandable deposits and investments in long-term assets. The maturity does not match between their assets and liabilities and their joinable through the interbank markets and the payments system, however, reveal financial institutions to the risk of insecurity and systemic crisis. Additionally, the good dependence on leverage and property information that banks hold on their borrowers and mortgagers may convince them to take too much risk (OECD, 2009).

2.2_The Subprime Mortgages Crisis

In the summer of 2007, "subprime mortgage crisis" was a widely used term to refer to the "U.S. mortgage market, and losses from mortgage backed securities (MBSs) and collateralized debt obligations (CDOs) backed by subprime mortgages" (kirk, 2007, p. 1).

Mortgage-backed securities were the basis of the problem that caused the latest financial crisis. Mortgage-backed securities are a type of bonds issued by governments and firms who repay its holders a stable and constant interest rate for a distinct period (Chadda, 2008).

2.2.1_Types of Subprime Mortgages

There are different types of subprime mortgages. They can be categorized in three types. The first type is the "Interest-only mortgages" that let borrowers pay just interest for a defined period (usually 5-10 years). The second type is the "Pick a payment loans" that let borrowers choose their monthly payment which can be full payment, interest-only, or a minimum payment (may be lower than the payment required to decrease the balance of the loan). The third and last type of subprime mortgages is the "Initial fixed rate mortgages", it can be changed to variable rates (Chadda, 2008).

2.2.2_The Securitization of Subprime Mortgages

Securitization is the financial practice of pooling together different types of assets and offer them as interest-bearing collateral for third-party investment. It first began in the 1970s in the US (Jobst, 2008).

"Lenders/originators often securitize mortgages into MBS bonds sold to investors. Payment of interest and principal on MBSs derive from the borrowers’ payments on the mortgages backing the bonds" (Kirk, 2007, p.3). Securitized subprime mortgages (as MBSs) are distributed into portions of bonds so as the cash flow from the bonds may go well with certain investment necessities. Every portion is given a credit rating by rating agencies. By this credit improvement process, MBSs backed by subprime mortgages may get investment grade status in spite of the basic collateral is a poor quality. MBS bonds are paid in order of seniority, and more senior bond portions pay before lower portion. In case the cash flow received from the basic mortgages is not sufficient, then lower portions may not be paid. Taking into account, that the lower portions of the bonds have a high risk that they will not be paid, they obtain higher returns and profit. Higher risk means higher return. Furthermore, investment banks have securitized lower level portions of MBSs into collateralized debt obligations (CDOs). CDOs create portions for their bonds as well. Investment banks have been capable to get the highest credit rating for senior CDO portions despite the fact that they have MBS bonds ranked lower than the investment rating. In addition, MBSs and CDOs are hard to be rated because they are not sold or bought on dealing markets, this is why investors rate their MBS and CDO bonds according to how much they estimate these bonds are priced in the present-day market. Investors have to rerate their securities in case the defaulting level on paying back the interest and principal payment goes up and the liquidity goes down. This can result in cash or in collaterals via entities that borrowed money to the investors with the intention of investing in the MBSs or CDOs (Kirk, 2007).

2.2.3_Risks Associated with Subprime Mortgage Crisis

There are four types of risks related to subprime mortgages and can cause a subprime crisis. The first risk is the credit risk; it is borne by the lending financial institutions and it represents the potential that the issuer of a debt security (in this case MBS) will not be able to meet its obligation to make periodic interest payments or repay principal to investors. In order to reduce the lender’s credit risk, the lender may perform a credit check on the borrower or seek a third party guarantee. The second type of risk is the asset price risk; it is about the valuation of MBS, if it will be capable to overcome the credit risk or not. However, valuation of MBS is a personal perspective. It is resulted by computing the chances of subprime mortgage beside the presence of viable market into which these assets can be sold. Because the mortgage delinquency rates are rising, the MBS value began to decrease. Nevertheless, Banks and Institutional investors have recognized significant losses on adjustment of their securities downwards because of Mark to Market accounting. This is caused by asset price risk. Thirdly, there is the liquidity risk; it is on account of decliner of liquidity in market on account of the two risks previously mentioned. Many firms depend on access to short-term funding markets, such as commercial papers and repurchase market, in order to run their operations and make profits. Frequently, firms get short-term loans through issuing commercial paper by pledging MBS. Investors deliver cash in interchange for the commercial paper, receiving money-market interest rates. However, concerning the value of the MBS due to subprime crisis, the capability of many companies to issue such paper has been considerably impacted initiating liquidity risk. The last type of risks is the counterparty risk; it is on account of associated parties impacted by the brutal circle of subprime crisis. Investment banks support firms and governments increase money by issuing and selling securities in the capital markets, whether they are equity or debt, besides giving advices on transactions. Foremost Investment Banks and financial institutions have taken important positions in credit derivative (MBS) transactions. However, concerning the previously discussed risks, the financial health of investment banks has taken a southward position, possibly bringing a higher risk to their counterparties and creating additional uncertainty in the market (Chadda, 2008).

2.3_The Fluctuation of the Subprime Mortgage Market

2.3.1_Subprime Boom

In the early years of this decade the residential and property prices went up, and securitization supplied more capital for mortgages, criteria level was deteriorated by lenders in order to issue more mortgages. Simultaneously, investors asked for higher returns on their investments and asked more for MBSs and CDOs backed by subprime mortgages. Between 1995 and 2005, subprime mortgages upraised from 5 to 20 percent of the mortgage market. In 1994, $35 billion were made in subprime mortgages, and by 2006, that number had risen to more than $600 billion. Moreover, between 2003 and 2006 AMP initiations were triplicated for residential mortgages. The most important cause for this boom seems to be the rise in the securitization of mortgages. Securitization supplied financiers with supplementary capital in order to issue extra mortgages, as well as a greater amount of AMPs, and to move the default risk to investors (Kirk, 2007).

2.3.2_The Deterioration of the Subprime Market

It seems that the latest subprime mortgage crisis was due to a mixture of industry changing with both financial and economic aspects. In 2006, interest rates went up whereas the housing value fell. Some borrowers could not pay their obligations and were incapable to refinance or trade their houses in order to repay the mortgages. Additionally, in 2006 and 2007, borrowers faced "payment chock" because teaser rates went down and other higher inconstant rates came to be operative. Consequently, the rates of defaults on subprime and mortgages went up considerably in 2006 and 2007 as well as early payment defaults in 2006. Many lenders went bankrupt because they couldn’t afford the repurchase of mortgages. This increasing in defaults has led rating agencies to reduce the rating level of MBSs and CDOs backed by subprime mortgages. Thus investors were at a loss and since the financial markets were insecure and unstable regarding the value of these securities and losses, the liquidity was affected. Several reporters expect that the losses would go above $100 billion (Kirk, 2007).

2.4_Countries at Risk

The latest financial crisis had major effects on developing countries. Some types of countries are more expected to be at risk. The crisis has further effects on countries with important exports, whether direct exports or indirect, to other affected countries like the United States and European Union countries. Other countries are those exporting products that their prices are impacted or those with high income pliability; taking for example, "Zambia would eventually be hit by lower copper prices, and the tourism sector in Caribbean and African countries will be hit" (Velde, 2008, p.4). In addition to that, countries that depend on remittances are also affected. Countries depending greatly on FDI, portfolio and DFI finance to address their current account problems should be also mentioned besides the countries with sophisticated stock markets and banking segments with weakly regulated markets for securities. Besides, "countries with a high current account deficit with pressures on exchange rates and inflation rates" (Velde, 2008, p. 4) are also included; South Africa cannot meet the expense of decreasing interest rates so it has to draw investments to address its current account deficit. And finally, countries those have high government deficits and countries that rely on aid (Velde, 2008).

2.4.1_List of Affected Countries

According to the Publications Office of the European Union, in 2012, the countries affected by the subprime mortgage crisis are: Belgium, Bulgaria, The Czech Republic, Denmark, Germany, Estonia, Ireland, Greece, Spain, France, Italy, Cyprus, Latvia, Lithuania, Luxembourg, Hungary, Malta, The Netherlands, Austria, Poland, Portugal, Romania, Slovenia, Slovakia, Finland, Sweden, The United Kingdom, Croatia, The former Yugoslav Republic of Macedonia, Iceland, Montenegro, Serbia, Turkey, The United States of America, Japan, China, EFTA, and the Russian Federation

2.4.2_Social and Economic Effects

Even though the effects change from country to country, but there are common economic and social effects that can be generalized and applied for all affected countries. The economic Effects include a decrease in the returns from exports, more stresses on current accounts and payments’ balance, the rates of investments and GDP go down. While the social effects include an increase in poverty rates due to the decrease of the GDP, a larger number of committed crimes, a fragile health system and fewer opportunities to fulfill the Millennium Development Goals (Velde, 2008).

2.5_The Size and Length of the Contraction

The variety of previous crises means that averaging them to get an approximation of the possible effects of the crisis could be ambiguous. But as a substitute of considering these variations a negative aspect, it should be considered as an opportunity. This could happen by using the variance through time in order to comprehend the elements of the length and cost of the contraction following crises by conditional models. The goal is to have a better comprehension of the length and relentlessness of the existing contraction. (Cecchetti, et al, 2009).

2.6_Lebanon Facing the Financial Crisis

The MENA region was affected by the subprime mortgage crisis just like other developed countries. These effects took place on many networks and they included "terms of trade, capital inflows, tight credit, economic slowdown, higher unemployment, lower hydro carbon prices, and the bursting of real estate and stock market bubble" (Byblos

Bank Group, 2011, p.1). The latest financial crisis created a major external risk of remittance inflows to Lebanon lately. These inflows were affected briefly and limited at the beginning of the crisis.in the MENA region, Lebanon was the solitary country which was affected positively by the crisis, the GDP showed a raise of 1.3%. In addition to that, despite the insecure state of the country, Lebanon could manage to positively relate the remittance inflows and the risks that the country faced because of the political issues. Throughout the crisis, GCC economic risks went up, and the remittances inflows went up as well. Late 2009, comparative to the GDP, Lebanon was biggest receiver of money transferred by foreign Lebanese workers. It was the center of remittances inflows (Byblos Bank Group, 2011)./////////////////////////////////////

"Lebanon’s economy has shown remarkable resilience to severe shocks, thanks to a credible monetary policy, a stable currency, prudent banking practices, including the separation between retail and investment banks, and sound public debt management" declared the Central Bank Governor Riad Salameh ("Salameh: Lebanon endured," 2012, p.2).//////////////////////////

2.7_Gaps in Literature

After reviewing several studies, articles and reports regarding the subprime mortgage crisis and related subject as well, many information gaps were present and need to be filled. The main gap is the data gap; there are no enough researches that give accurate numbers and results. Better researches should be done on the credit default exchange markets. In addition, the data on financial institution’s activities were weak. The number of countries that reports their data was not fully complete; data on some countries (related to the topic) were missing or weak (IMF Staff and the FSB Secretariat , 2009).

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