Assessment of Principal Causes of the Financial Crisis

The key factors that can be attributed to the global financial crisis that occurred during 2007/2008 are the incentive and information crisis. These two factors played key roles in ruining the financial market, not only over this period but also during the crisis experienced at late 90s. This paper will try to highlight and deduce the economical scandals of the period in question. To perform an informative analysis is of importance in investigating the banking crises, more so in under developed economies.

Some of the recurring causes that had caused the late 90s crises were evident in the global crisis that occurred during 2007/2008 period. The motivations of providing misguiding information and creating a scenario of compromising interest (Barbera 2009). Apart from the misleading information and the conflicting interest, other obvious factors in this problem were fraudulent conducts and motivation for high risk taking. The other cause may be regarded as a poor modeling of economics parameters: misunderstanding securitization of economy, poor market risk models and lack of proper information on probable events.

The incentive crisis started with  executive compensation plans,  with support of banking crisis, led to generation of misguiding financial information-over bidding and letting the liabilities hang on the balance sheet. CEOs that earned their salaries from stocks raised the value of the capital market. Owning to economic principles, these motivations were only possible theoretically. As a result, the executives increase the reported income but not the actual income. Using the misguiding information, the executives created an avenue to provide reasons to earn exorbitantly from stock. This option of stock leads to poor accounting, leading to greater problem in the financial computation. It is in such a model, where the CEOs participate in sharing the gain, but do not take part in losses and other forms of risks. The corresponding bonus systems in the markets give high incentives for greater risk taking. In this set-up, more profit may be made over a short time, resulting to increased compensation for the executives, while stakeholders incurred the loss. It is the stakeholders who took high risks but at their own peril (Barbera 2009).

The other greater contributor to the crisis was the incentives, associated to the accounting and auditing firms. It should be noted that most of these auditing firms were hired by the executives; and that more often than not their incomes are attached to the consulting services they offer. With this in consideration, it is most likely that they were motivated to reward their bosses. They do this by advancing accounts that exaggerate the actual profits, leading to exaggerated shares value, hence, exorbitant gain by the CEOs. In the case of Sarbanes Oxley, this ploy was executed by limiting the services of the hired audit firm to the provision of non accounting service (Griffith 2010). This services were also deployed by the corporate board who are the beneficially of the whole scheme. At no point, the shareholders (risk takers) were involved.  From this position, the audit and other accounting services were provided under the supervision of the CEOs. The audit companies were bound to impress the executives since they had the power to hire and fire. This can be considered as one of the reason that the accounting firms could not carry out their duties of exposing the potential economics risks.

Securitization is another possible cause of the economic crisis. Over the last decade, there has been over dependence on the market and securitization, this has corresponded with a decrease in financial firms such as banks for credit provision. The focus has been directed into the capacity of a market, so as to distribute risk over a greater scope. Market has gained this reputation since it gathers more information as compared to banks, making it more efficient, information wise (Griffith 2010). However, prior to the crisis, this move was compromised, and a new one was adopted - securitization. Securitization formulates other information irregularities, where banks are motivated into making sure their mortgage customers will repay or there are high probabilities of the repayment. In securitization, the bank just needs to provide papers that it can fob off to others. This system was planned in a way that, once the problems in the mortgage arise, it was impossible to renegotiate the deal. It was hard to foresee all eventualities and to evaluate the way out in each mortgage contract.

Securitization made it difficult to renegotiate, which is otherwise, a better option with a lower cost than mortgage (Griffith 2010). This is so because of a bigger pool of creditors with varying interest and differing beliefs. Some creditors believe that a bargain will give them much on average, even when there is the likelihood that some part of the mortgage will be defaulted. This is possible, when the creditors have no trust in those who handle the mortgage, thus, enforcing restriction to renegotiation. Banks had more information and capacity to figure out the nature of the likely problems to tell whether a loan defaulter anticipated defaulting, and if by restructuring the mortgage, would ease it to enable the customer repay (Barbera 2009). This was the case in America, renegotiation was impossible, since the creditors have the incentive to appeal in a court of law anyone who is trying to renegotiate.

Securitization of medium mortgages created new information irregularity problems, where mortgages were acquired by banks, modified the package, part of which were sold to the pension fund and other investment firms and banks, while retaining some on the balance sheet. This posed a risk that was not even seen by those who designed the package. The risk was intertwined in the complexity of the designed products, making it hard to evaluate the process at every stage of reprocessing the packages (Read 2009).

Other incentives that were berated for the global economic crisis that occurred in 2007/2008 period are that of rating agency. The agencies had underestimated the potential risk to Asia; eventually, they grew so large to be ignored, their reaction was to suddenly downgrade the assets. This forced the pension funds to sell these assets, hence, worsening the problem. This contributed significantly to the economic crises in Asia. These, under performance of rating agencies, can be viewed as a significant part of the crisis. Another aspect that these agencies can be viewed as a failure is that they were getting their income from those, who they were rating. This might have made them compromise in their rating, giving the pleasing but untrue grades (Read 2009).

It is impossible to discuss the 2007/2008 global economic crisis, and not to mention Steagall repeal. Conflicting interests were introduced, when the walls between commercial and investing banks were removed. This enlarged the scope of the crisis of interest, allowing the commercial department to lend to investors who the investment department had issued IPO.  This was meant to make the IPOs appeal the public. Though, Steagall repeal was not at the core of crisis, it played a rather clear role in its mitigation. The drive of investment banks clashed the conservatism culture of commercial bank, eventually the speculative culture of investment banks dominated.

Bail-out provide an incentive that is distorted economically, in an event that a bank take a risky loan and wins, it is the shareholders who wins, and if the bank fails in this gambling, the government has to get in the name of bailing the bank out. This  model is a needed  government supervision on banks, just as an insurance firm, providing fire cover, has to make sure the insured facilities have fire combat equipments, reduce the chances of risk occurring. The government has to cub the banks that are not in unnecessary gambling. Bernanke has made bail-outs coverage much extended to investment banks. This has worsened the economic crisis. Though the outcomes of some unavoidable bail-outs are clear and positive, it sometimes benefits the unintended beneficiaries. The economists have to answer the question on bail-out. The best answer depends on the terms of bail-out. If there was no bail-out, it is obvious to all involved mortgage originators, repackaging investment banks to rating agencies and to other regulators, that something would have gone wrong. Some mortgages had neither the documents nor were there down payment for some others. With this scenario, conflict of interest was expected. The fraud was already designed, where loans 10 times higher than the value of facilities was issued.

The next contributing factor was in the modeling. Most of the misconducts in the market can be attributed to unplanned incentives. The mistakes in modeling before crisis were not evident but maybe the crisis that was brought about by some other factors led to adoption of poor models. The models that were there prior to this problem could not predict the outcome of the structures that were guiding incentives. Models, that at the time of crisis were not in effect, did not reduce the risk they only worsened the situation, by misleading firms that were persuading borrowers. This financial uncertainty mitigated the chances of corruption. The finance brokers had a pool of cash at their disposal over an unusually short time, which came in the form of bail out. For the mortgage that had not provided full financing, but the payment due was less than the interest would have been, they ended up, obtaining amount greater that what they owned.

The market gave little considerations to the risk that was emerging systematically. Participants had thought that securities with large mortgages were unlikely to make a loss greater than 10% of the market value. What they did not realize is the extent of diversification, which is limited to certain market value. This crisis was not a new one; there were  others of the same nature previously. The common fact about all of these crises is that they have resulted from underestimation of unlikely occurrences and induced risks. This problem seems to recur after every decade (Mcdonough 2010).

With open minded economists, little attention to the economic progress, prior to the down fall, would have realized that all was not well, and the situation was not sustainable. Two things were happening behind the curtains: a lot laxity in transparency and up surge of pyramid schemes. In a scenario, where the price of mortgage would have kept on the rise, all would have been well. The borrowers, who had been conned by market and borrowed more than their capacity to pay, would have been on the save side, making considerable gain. The investors, who lent carelessly, would have been saver. The borrowed fund having negative pay-off, the debtors had more to pay by the end of the agreed period than when they began the deal. The concerned customers were assured that they would still refinance the mortgages and to save from the capital gain, through equity withdrawals. This was a vague believe for it was not possible for the price to go through the market ceiling that was already in effect, having in mind that there was no increase in the interest rates. In America, individual income was in decline, and the mortgages prices were on a rise. With this set up in the market, it was obvious that there existed a limit to the value of a mortgage could have commanded. This was clear to anybody who was careful in monitoring the housing prices. This was a clear pyramid scheme (Mcdonough 2010).

The economic systems failed to perform a rather obvious and important function. It is difficult to tell what they were doing. It is clear that the financial models that were in place at the time were irrational, and hence, they could not have predicted the crisis from these rational behaviors of a market. Without blaming the whole saga to the rationality or irrationality of the market, this crisis has shed light on the role, played by perfect information. In each, the late 90s and 2007/2008 crisis, one thing comes out clearly that the financial systems were to blame, since they failed to execute their duties, of managing risk and distributing resources efficiently. In 90s, non-proportional resources were allocated for investment in fiber optics; other case is where there was a massive investment in housing at the beginning of this century.  This triggered creation of packages that were supposed to manage risk, instead of doing so, these products worsened the situation. Transparency was missing in these systems to the extent that, once the crisis surfaced, not a single bank could identify its own balance sheet. The risk management systems did not consider the social risks that were to be managed. The systems were not designed to meet the need of those who were at risk. To worsen the situation, once these systems were designed they were to be sold. This created a market for those who were creating the systems (Mcdonough 2010).

In some instances, medium mortgages were sliced and recombined; the outcome was mixed with some other artificially created products such that it was difficult to predict the risk of the mortgage. The social need for risk management was not met. The new products raised the risk in the housing market, in terms of increased interest rate to be borne by homeowners. The effect was much felt on; the mortgages had balloon payments, which were bought with the assumption that originator could refinance them (Grossman 2010). There were other mortgages that highlighted the risk in the market. These could have made it easier for buyers to manage the market risk. The key problem in the market was to fund high risk-medium mortgage; this was to be done in line with the market regulations that were in place, restricting the financing of such mortgages. These restrictions were put in place by the financing firms, such as banks and pension funds, with a good faith.

In conclusion, 2007/2008 economic crisis raised a concern on the high risk of the world economy, collapsing due to poor financial systems that underestimate the importance of rational indicators of such crisis. The current systems propagated to a point that it was becoming difficult to articulate the market value of economic instruments. This lack of proper calculations of institutions value created difficulties in measuring the value of the market that held them. The preliminary crisis occurred during the collapse of American subprime housing scheme (Grossman 2010). The institutions that financed these schemes realized that the value of the mortgage was declining, provoking a concern on the firms that they had financed. At the same time, hedge funds established greater risk, rendering investors to financial shock. Institutions were caught up in the crisis that forced them to look for alternative equity capital, to fulfill requirements from the regulatory agencies and uphold retain their customers. This additional equity caused the liquidity to reduce from these financial institutions (Stiglitz 2010).

The recession in the developed countries was inevitable. This was much the case in USA; there were expectations that Europeans economies that were much connected to US would follow suite into recession (Grossman 2010). This caused the central banks reduce their interest rates, increasing their financial liquidity. New York initiated tax refund program in an attempt to reduce the personal taxes. Though, this was meant to relieve the global economy, it resulted to higher crisis. This crisis can also be attributed to the worsening lending that had started early in 2004. Households that could not meet the payment to secure a mortgage were motivated to buy homes through loans that are charged high interest rates; at some point, most of these people were not able to repay their mortgages (Stiglitz 2010). This called for their financiers to sink deeper into the already looming crisis. In an attempt to secure the situation, the central banks had to bail-out most financial institutions.