High Leverage from the Financial Product Innovation Finance Essay

From 2000 to 2003, the Federal Reserve made the interest rate target to 1%. This was done to soften the effects of the collapse of the dot-com bubble and of the 911 terrorist attacks. On the other hand, Globalization and trade imbalances made up the large inflows of money into the U.S. from high savings countries, such as China. These two factors lend a cheap credit for the lenders who can take a much higher leverage than before.

The default of sub-prime lending

Between 1997 and 2006, the American house pricing increased by 124%. Easy credit, and a belief that house prices would continue to appreciate, had let many subprime borrowers to take mortgages. The term subprime refers to the credit level of particular borrowers, who have poor credit histories and with a large risk of loan default than other borrowers. Subprime borrowers who found themselves unable to repay the high monthly payments will begin to default.

High leverage from the financial product innovation

The term financial innovation refers to develop the financial products, which designed to achieve their clients' objectives, such as offsetting the risk. Examples related to this crisis included: the adjustable-rate mortgage; the bundling of subprime mortgages into mortgage-backed securities (MBS) or collateralized debt obligations (CDO) for sale, which also can seemed as securitization; and a kind of credit insurance called credit default swaps(CDS). The usage of these products was widely over the world in the years which the crisis happened. These products are very complexity and they easily be bought or sell between the financial institutions. The CDO was a kind of financial instruments which was created for investors fund subprime mortgages and some other lending. It improved the debts liquidity and which also was the one of the main reasons that results to the housing bubble. Firstly, the different kinds of mortgages were pool together. Then a cash payment was allocated specific securities in a priority sequence.

Those securities obtaining cash first received investment-grade ratings from rating agencies. Lower priority securities received cash thereafter, with lower credit ratings but theoretically a higher rate of return on the amount invested.

Miss grade of credit rating

The rating agencies usually were asked to give a higher rating to the MBSs comparing to other instruments. The higher ratings of the MBSs get the easier to sale. Sometimes, more liquidity means more expensive and valuable. The high ratings also misleading the investors because in their opinion, they thought the MBSs were rated higher, and they were safer. So the investors pull more money in these MBSs which was booming the MBSs' value. But actually, the values of underlying assets of these MBSs were decreasing. This also means the probabilities of default were increasing. And the rating agencies could not reflect this on time.

These four factors created a great situation for the GFC and the crisis was so heavily to collapse the financial system all over the world.

Australian banking system is far more stable than our overseas counterparts. This isn't just rhetoric; it comes down to a number of factors.

Australian regulatory framework has proven to be one of the most effective in the world. Australian banking system is far more conservative in our approach to risk than many of our US counterparts. Lenders, in Australia, also tie the re-payment of mortgages to the borrowers, not just the house, which meant Australia didn't see the 'jingle mail' that happened in the US where home-owners simply mailed their house keys to the bank when they couldn't keep up with the mortgage, or burnt their houses down rather than hand them over to the banks. And Australian banking system didn't undertake the kind of subprime housing lending that was one of the initial landslides in the earthquake that became the GFC. The conversion of mortgage securities from huge, illiquid assets owned by local banks into liquid financial instruments that could be sold across the world combined sophisticated U.S. financial services dangerously with relatively unsophisticated financial services elsewhere. The subprime lending and the 'jingle mail' phenomenon, combined with an excess supply of housing, were a toxic combination that set the credit crunch in motion. And Australia doesn't have these three factors.

But it's obvious that the Australian banking industry has been impacted by the GFC. A quick scan will show that consolidation in the industry has reduced the number of regional banks, and almost all the regional banks are about to be bought out or taken over. And governments are now charging banks more for their wholesale funding guarantee. Earlier 2009, David Morgan, the former Westpac CEO, spoke about the future of Australian banking. In his speech he indicated that any standalone financial institution with a credit rating much below AA will, at best, struggle to obtain funding on a cost competitive basis with the Australian majors. Federal government intervenes to stop the unemployment rate increasing and stop consumption rate failing, and try to slow down the failing stock market. The government started shoring up the economy in a variety of ways. There was a $700 billion guarantee of bank deposits to last for 3 years, and establishment of a $20 billion Building Australia Fund to speed up infrastructure development as one of several new "nation building funds" amounting to $42 billion in all. The "economic stimulus plan" included payment of a "tax bonus" to tens of thousands of Australian taxpayers, enhanced grants to first-home buyers, and a variety of rescue arrangements for industries in serious difficulty such as child-care centers and the automobile industry. These interventions were both timely and necessary and potentially avoided a major financial crisis here in Australia. However the initiatives also had the effect of distorting our competitive banking system, particularly in the area of wholesale funding. The head of the ACCC, Graham Samuel, has spoken out of his concern about the growing concentration of power of the big four banks.

Currently, there was another crisis around the world, especial in the European area, which called European debt crisis.

Compare with the global financial crisis of 2008, it seems that both crises were result from the lacking of confidence. But actually, the current European debt crisis is quite different from the global financial crisis.

In 2008, lots of questions were asked that whether the banking sectors ability to absorb major crisis shocks. The banks were unwilling to lending the money since the confidence in the market fall. This also results to the illiquidity of the market and it also made the crisis worse. This period was before the Lehman event, so it was called 'post-Lehman' period.

Nevertheless there is one slight difference - subprime mortgages have now been "replaced" by US debts that do not have the same toxicity, so in at least in this respect the current crisis is on better footing than the crisis of 2008. In addition, tensions observed in the Interbank lending market - in which banks lend to each other - are much lower than in 2008. Especially since the European Central Bank (ECB) launched an unlimited loan program in order to make a total economic gridlock almost impossible. But, just as in 2008, the markets are calling into question the capitalization of banks. Do these institutions have enough capital to cope with significant losses? Although a vast movement of recapitalization was already launched across Europe, the markets do not seem to be responding in any significant way to this effort.

Now, just as then, debt is the main problem. But the debt in the 2008 financial meltdown was largely private sector debt (households and businesses), which the government simply took in order to jump-start the economy. While this plan did help reinvigorate the economy it eventually led to an over-indebted public sector. At the end of 2010, public debt in developed countries accounted for 92% of their gross domestic product (GDP), as opposed to 78% before the Subprime Mortgage crisis. So in many ways, we never fully solved the problem of the 2008 crisis - we simply moved the problem from the private sector to the public sector. Whereas in 2008 we suffered from a massive Private Debt Crisis, in 2011 we are currently experiencing a massive Public Debt Crisis.

On October 8, 2008, after the shock of Lehman Brothers collapse, seven central banks, including the U.S. Federal Reserve and the European Central Bank, joined forces in order to respond to the crisis in a coherent and unified manner. In 2011, the political and economic rhetoric remain the same - everyone agrees that the US and Europe need to form a unified front to deal with the crisis - yet it seems that actions have fallen short of promises. In Europe, several nations launched the European Financial Stability Facility (EFSF) in 2010 with a glimmer of hope, but divisions between European national governments slowed down the implementation of its tools and prevented it from finding a lasting solution to reassure markets of the strength of the Euro Zone. In the United States, internal differences have triumphed national cohesion. The differences between Democratic and Republican economic thought has led to deep disagreements on national policy and in the end resulted in the adoption of severely watered down economic policies. Last but not least, on both sides of the Atlantic, political and economic leaders have exhausted their cartridges - interest rates are at their lowest and the coffers of the state are empty.

Thus, the major difference between the economic crises of 2008 and 2011 is that today there is no more room to maneuver.

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