Review On The Genesis Of The Crisis Finance Essay - Free Essay Example

The term global economic crisis (GEC) or global financial crisis (GFC) is used to describe the general slowdown of the world economy. This means that there are fewer and fewer people buying and selling to each other. As such, trade goes down whereby less money circulates in the market. A crisis is then developed, because once this cycle of less gets started, it is very difficult to break. Bludell-Wingnall and Atkinson (2008) simply defined the GFC as a situation where a dam is overfilled with flooding water but water is forcefully and continuously directed to it. Pressure increases and the dam finally breaks and the damage gets enormous. This is what particularly happened with the 2007-2010 GFC which has its roots in the United States, the worlds largest industrial military complex. The high risks that banks and financial institutions kept on taking for a greater inflow of money suddenly exploded and spread to the world as a scourge with developed and developing countries feeling the heat first and the least developing ones at a much later stage. 2.1 The Genesis of the Crisis While examining the origins of the financial crisis, we are much likely to start with the real estate market, that is the place where the crisis really began and focusing on the subprime mortgages and unscrupulous lenders and casting the blame on the unsustainable real bubble which began to collapse in 2006. This is what happened in the real estate bubble which is also one of the main factors of the GFC. Problems began when borrowing and lending between banks in different countries started to become a little unbalanced. Banks in the United States and Britain began borrowing large sums of money from banks in Asia and Russia. The UK and the US used this money to approve home loans that they would usually not consider. Basically, before a home loan is approved, the bank checks that the applicant has got a steady income and a clean credit history. That is, the person who wishes to take a loan has to prove that he is employed, reliable and good at paying his bills. However within the last decade, banks began to approve loans to applicants who did not necessarily satisfy these criteria. And to cover the risk of approving these less than perfect candidates, the banks, charged higher interest rates in order to make more money. This kind of home loan is called a sub-prime mortgage. And as Khatiwada and McGirr (2008) stated many of these sub-prime mortgages never made it to the balance sheet of the lending institutions that originates them. Moreover in many instances, applicants of the sub-prime mortgages defaulted their loans or were simply unable to repay the banks. The tool of last resort was finally put to use. The banks sold the mortgages to the investment banks. The latter in turn pooled together hundreds and thousands of mortgages as mortgage-based securities (MBS) and sold them. Securitization, the wonderful financial vehicle made it possible because as securities, mortgages could be resold. Thus securitization creates diversification and liquidity and also eases the risk of default or going bankrupt. In addition to this, credit rating agencies like Moody, Standard and Poor, and Fitch did not take into consideration the possible systematic risk and blessed the apparently low risk securities with AAA ratings. This attracted pension funds, banks, mutual funds, some money market funds and investors from all over the world which purchased the securities assuming that they were safe. Additionally, because investors considered such securities as low risk ones, they leveraged them. In short they invested more than they had actually capitalled for. In this process, none cared to assure the credit worthiness of the home buyers and their likelihood to keep up with their monthly mortgage payments. This was so because the MBS moved from investors to investors and the income they earned was from the origination fees rather from the eventual monthly payments. Investment banks have a similar incentives in their role as they buy mortgag es from the originators and sell them to the final investors and make most their money from processing fees also known as broker fees. To sum up, the securitization of mortgages was a process that was filled with perverse incentives to ignore the credit risks of the borrowers, and to make as much money as possible on volume and processing fees. However, the problem with securitization is that it does not provide protection against systematic risk. And unfortunately such systematic risk was not priced into the subprime mortgage pools; not until things went wrong and subprime borrowers started defaulting on their mortgages. 2.2 The Shock Soon subprime lending increased home ownership rate in the US significantly and about 5 million people went from tenants to homeowners. As a result rents went down and house prices increased till they reached unsustainable heights relative to rents. But in contrast to the stock market, in the real estate market when the asset prices rise, more assets are created through construction. Between 2001 and 2007, the construction of new housing units exceeded significantly, the new household formations and naturally this housing bubble could not grow infinitely. As Robert Collier (1885-1950) said supply comes on the heels of demands. So naturally, the housing bubble had to come to a stop as there was excess supply in the market. The rise in housing asset prices stopped in 2006 and the decline accelerated in 2007 and 2008. This implied that many of the subprime owners could no longer refinance when their mortgage rates were reset, which caused delinquencies and defaults of mortgages to increase sharply, especially among subprime borrowers. Moreover, insurers like AIG who insured these bad mortgages also got in trouble. From the first quarter of 2006 to the third quarter of 2008, the percentage of mortgages in foreclosure tripled, from 1 percent to 3 percent, and the percentage of mortgages in foreclosure or at least thirty days delinquent more than doubled, from 4.5 percent to 10 percent. These foreclosure and delinquency rates are the highest since the Great Depression. The previous peak for the delinquency rate was 6.8 percent in 1984 and 2002. The American dream of owning your own home was turning into an American nightmare for millions of families. Meanwhile, banks started losing their money which made overseas lenders nervous. The lenders demanded that the banks return what they borrowed, and made pressure worse by imposing a tight time frame which led banks into a financially unviable situation. Hyun-Soo (2008) however argues that it is the Trust Crisi s which caused this global predicament. It is, indeed, to some extent true, because people started to lose confidence in the banking system and everyone wanted to withdraw their money at the same time. On such incidence happened to the Northern Rock Bank which seeked an emergency loan to stay afloat, prompting a run on the bank as worried customers withdraw  £ 2 billion (BBC 2009). Furthermore confidence in many financial institutions was shaken and stock market witnessed systemic weakness across financial sectors. The share prices for large, small, and investment banks all significantly dropped and between July 2007 and March 2008, lost about a third of their value. This caused banks to stop trusting other banks and interbank lending was disrupted. This problem become so large that even banks with large capital reserves ran out. The government had to step in and inject money into the banks which took the form of taxpayer money. For Chan Lau (2008), the financial quake made the ailing US economy tremble and run the risk of a major bankruptcy. European economies which were well aligned with their American counterparts in the form of overseas subsidiaries and affiliates were eventually threatened by the crisis and it was foreseen that emerging economies in the developing world would suffer. 2.3 Causes of the Crisis Moving down the chain, after feeling the shock of the crisis which is likely to affect different countries differently depending on their economic structure; the next move that needs to be taken is about the precautionary or preventive measures. Though the GFC is not over yet, it quite an important step if one does not want history to repeat itself in the near future. This aim cannot be achieved without having a look at the plausible causes of the GFC. Many factors directly and indirectly caused the ongoing financial crisis of 2007-2010, with experts placing different weights upon particular causes. 2.3.1 Imprudent Mortgage Lending Low interest rates, increasing housing prices and above all flexible lending standards allowed anyone to own houses which were once unaffordable by them. However one cannot fully blame the bank as like everyone else, they also wish to maximize their profits in a materialist cultural environment where maximization of income and wealth is the highest measure of human achievement. 2.3.2 Lack of Transparency and Accountability in Mortgage Finance The current financial crisis in the US shows that the price to be paid for lacking transparency and accountability in the securitization process of mortgage loans has proven to be very costly in terms of loss of credibility, reputation, market share and value. Moreover without transparent responsibility, business leaders will not be able to regain trust and confidence which regrettably have been lost in this crisis. 2.3.3 ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦ 2.4 Impact of the Crisis on the Economy US Economy The crisis started to show its effects in the middle of 2007. The economic recession The economic recession worldwide has redefined many a modern economy, including the bigwigs like the United States of America and Russia. The down-trend exhibited by the US economy is hemorrhaging at a rate that is alien to the previous five decades. With nearly four million jobs on the line, revival seems a distant dream, but not impossible. The US economic crisis has hit the common man the most, reducing the quantum and quality of lifestyle greatly. Homes and investments have plunged, tagging along labor market statistical pressure. The main features of the current US economic crisis include: Steep payroll decline Loss of more than 4.4 million jobs Sharp contraction within the labor market Increase in involuntary part-time job slots and underemployment Drop in average hourly earnings Reduced consumer spending (Borade year unknown ) Impact on the various sectors of US The IMFs estimate of the US bank loses are as huge as $1.6 trillion. US banks have raised an additional $400 billion in capital so far, which means they need another $1.20trillion to get back to normal health. For banks to recover this amount through profits would take years. Until then, banks would not be in a position to provide adequate credit. The Bureau of Labour Statistics of the US released a monthly report stating that the US economy, in January 2009, lost almost 600,000 jobs. The official unemployment rate rose from 7.2% to 7.6%, the highest in 16 years. Inside that 600,000 figure are 207,000 manufacturing jobs, which is the largest decline in a single month. The US commerce department released its report stating that the new orders received by US factories fell by 3.9% in December, following a 6.5% slump in November (Prasad 2009a). Since January 1, 2009, as many as 20 million people have lost their jobs. Almost 5.4 million people go each week to collect their dwindling unemployment benefits; a year ago the number was 2.6 million. This is the highest figure since 1967 (Prasad 2009b). Reaction of US People During the mortgage crisis of 2007 and 2008, the average US consumer spent less because of a feeling that there may be a time in the future where his income will not be the same. He saved the money he earned instead of spending it on a new TV set or a new washing machine. At these times, even those who possess postgraduate degrees are not insulated from job loss. This past couples of years are those times when the average American would rather save most of his salary and spend less on luxury and non-essential goods. The problem gets exacerbated even further because corporate entities refused to expand their operations because of the amplified economic risk. As more people spent less, more people earned even less, hence an economic slowdown. (Miller 2010) This attitude of developing less created another problem. US had to cut down on imports and one of the luxury goods that have been affected is garment, or better said the textile industry. People are more and more focusing on th eir basic necessities. The Global Textile Industry The fact that the US is an important country for textile global market fundamentals, its ups or downturns is likely to have an impact the other textile markets. Generally, US import more garments and clothing from other developing nations in high volumes than any other country. Hence the financial crisis in the USA economy will have an impact on textiles import also which have dropped the market sentiments in overseas market since the last few months. Moreover it was sure that the financial turmoil will have an adverse impact on the global textile sector. But the real impact would be felt if the economic slowdown in the US and European economies persist over a long duration (more than 2 years), which would have an impact on the basic fundamentals of demand supply of various economies. This would result not only in the reduction in demand for the Textile Sector but also result in pricing pressures at time to time in markets. A we have seen earlier, the economic crisis has redu ced EU and US demand for at least some categories of imports from the South as economic uncertainty about job security, income and savings has lead many Northern consumers to cut back on purchasing brand products. This in turn has an impact on retailers who have to cut back on production due to shrinking consumer markets. Many consumers are now going for the sharply discounted apparel and lower end products, which will favour some brands and retailers over others, but in any event prices paid to suppliers will be affected. One such country that has been to some extent been affected is Mauritius. Textile Industry is one of the major pillars of the Mauritian economy. Further details of the impact of the GFC on this sector will be discussed in the next chapter. CHAPTER 3: Mauritian Textile Industry and the Global Financial Crisis 3.0 Definition of the Apparel Industry Instead of using the word textile, the most appropriate word to use would be apparel. Apparel industries are companies which design, manufacture, and/or license brands for mens, womens, and/or childrens clothing, footwear, and accessories. The apparel industry encloses or may be even called using the following names: footwear industry, textile and clothing industry, shoe industry, textile industry, clothing stores, fashion industry, clothing industry, apparel manufacturing industry, clothing apparel industry, garment industry, or even fashion and clothing industry (Bitpipe.com, 2000) 3.1 History of Textile In Mauritius   Ãƒâ€šÃ‚     Ãƒâ€š