Rizwan Ali Momin
Question 01: Explain the role that Governments have taken in solving the financial crisis. Which specific measures have the US and UK governments done to solve the immediate liquidity crisis and solvency problems of banks, and to get the economy growing again and out of recession?
Financial crisis on 2008-2009 was cause by many factors, the most important one from among all those were was ability to create a new line of credit which stop the money flow or slow down the econmonice growth and buying and selling assets. These really hurt individual, businesses and financial firms, and many corporations who holded mortgage backed assets. The current financial crisis started from US and covered up entire world. The 2007 crisis were triggered by shortfall in liquidity in US banking system.
The system of money lend out and credit check by banks was not been carriedout properly. Cheap loans and subprime loans created a housing bubble and later on because of shortfall in liquidity or defaults collapsed whole US housing and banking sector.
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Bad governance, bad money advises and lack of involvment in the process of lending money especially in the housing sector created financial crisis. In result jobs lost in private, government and financial sector. And crisis leads to bankrupcies, liquidity and solvency problems specially faced by banks. If banking sector doesnt work properly then economic growth is bit difficult and generation of new projects stop. It would be government resposibility to monitor banking sector and incase of any solvency regulators should mointor why bank getting fail.
Bail out plans was announced in order to prevent banks to get bankrupt.Chinese and japanes investor forced US to nationlise their two big mortgage institutions.
Bail out is no only the solution, governement have to stablize the financial system and economy and have to arrange long term planning and financing to improve financial system and country economy.
Recapitalization of financial sector by using taxpayer wealth is another option for government which they has used to buy assets at above market prices. Close weak financial institutions under a new bankrupt's law or Court could replacement a new management selected by commitee of business leaders and financial industry.
Large number of nationalizations may require, its all depend on how all these done by our political regimes's survival. Setting up the job and education programs, work with states to prepare necessary legal and finanical apparatus, implement a big monetary stimulus as japan done after the 1989 crash (means zero interest rate or keep it below the level of inflation)
Some steps which governements have to take are:
Central banks of every country should have to cut down their interest rates which can stimulate growth.
Goverrnments have to purchase stocks of banks to shown off their confidence in banking sector for public.
Central bank have to assured public that their deposits are safe and are guarantee to return deposits and interest incase the banks fail.
Short selling should stop for temporary period specially developed countries.
Cause of the problem subprime lending should come under regulation; carelessness from banks which led to financial problem should mointor.
The market of $62 trillion CDS should be regulated.
Question 02: Several derivative instruments have been implicated in causing great instability in the financial markets in the run up to the financial crisis. Describe two of these instruments including their basic structure, how they are used, what concern investors have with them regarding level of risk and what alternatives investors could invest in instead?
Financial crisis of 2008 were the worst ever financial crisis so far, which put world in the great depression.
In reply to in question, I will explain the series of events which lead the ongoing financial crisis. Financial instruments like MBS (Mortgage backed securities), CDO (Collateral debt obligations) and CDS (Credit default swaps) resulted in stock market crash in US and affect the international market too.
After the dot com boom bubble burst in back 2000 and 11st September event, US economy went to recession. Because of the downturn in economy, US government reduce the interest rate to stimulate the demand. Credit was available for people and low interest rate increased the demand for buying houses because taking loan at low interest rate were available easily.
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Because of this measurement the demand housing increased but the supply didn't increase, therefore increase in demand increase the prices or in inflation. To overcome this problem US government increase the short term fund rates. During this period loans were given by banks easily to people whose credit history were not really good or have low income. As a result of the lending, large number of borrowers started failing to pay their loans on time and lender started to foreclose or started to take possession of the properties. Most of the possessed houses were worth less than the loans and therefore institutions had to short sell them.
To understand more about financial instruments and its effect on financial crisis, we will shortly take an example of MBS but before that what is MBS?
A mortgage-backed security (MBS) is an asset-backed security whose cash flows are backed by the principal and interest payments of a set of mortgage loans.
Let suppose we are three parties A, B and C in this example. B purchases a house from a loan of 100,000 dollar. Party A loan out the money to B through the help of C, here A receives commission on gave business to the party C. Under this scenario party ‘A' itself doesn't loan out from its account, instead it securitizes the loan and sells it to hedge funds or commercial banks. And commercial bank or investor get dividends on MBS in the form of monthly instalment which borrowers give to banks, in this case borrower is party B. Pool of mortgage related loans only called MBS. CDO is also a pool of mortgage and other non-mortgage including credit card loans and subprime loan and etc.
Financial institution not lended out the money, it's a bank who lended out money actually to us. Corporation acts like agent. They sell loan to us by charging extra interest rate than bank charge to them and how they make profit. And they also get commission to sell securitized product to Wall Street. All was running fine until people started making defaults on paying back and net worth of MBS started reducing down in value and they had to affort the losses from defaults taking place on loans. All these effect to financial market and corporation, and banks and they had to beared big losses.
When the MBS was introducted, lenders haven't realized the risk of loan default to subprime. In order to fulfill the demand of money banks heavily borrowed money for cash flow. One in every 416 household of US filed for foreclosure. When subprime stopped payment on loans and MBS reduced it net worth and then CDO also lost roughly half of its value.
All these problems later affect the house builders, because there were no buyers to buy houses after forclosures and reduced prices of houses. There were supply demand mismatch because of increase in supply and decrease in demand.
Next financial instrument which made global crisis worst was credit default swaps (CDS). It defined as credit derivative or contract between two counterparties, where one party makes payment to other and gets promise of payoff if a thrid party fail. Lets try to understand this my an example. Let suppose there is a profitable group (A), bank (B), and company(C). ‘C' has issued bonds to public and these bonds rated AAA by moody's and no chances for default. ‘A' holds ‘C' bonds and has insider information that ‘C' is going bankrupt and bond holder would be defaulted. What ‘A' does is that it goes to ‘B' and insured its bond that it holds. For doing this ‘B' asks for annual interest at particular rate, could be 4 or 5, on the amount of bond. So ‘A'will has to pay every year, for say 5 years. In these condition now bond is insured by ‘B'. Incase of any default on interest or on principal from ‘C' then ‘A' will receive from ‘B'.
Today's economy is in ruins because of these derivative instruments. US biggest insurance company AIG had bailed out by US government after it defaulted on worth of 14 billion dollar CDS.
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These derviative instruments credit default swaps, mortgage backed securities and CDO were 3 major instruments which put world in financial crisis especially to US economy. Its an government job to tackle these kind of problem before it arised. It's a fact that most of the CDS have been done over the voice messages
If you already invested in the stock market through mutual funds then its better not to redeem your investment and panic sell. In fact buy some more shares of which you think fundamentally sound good. Warren Buffet says” be fearful from other when they are greedy and be greedy when others are fearful”. In last 10 years, world face over 300 crises; however nations always recovered from it and start growing again.
Question 03: Leveraging. Explain how the effect of leveraging can enhance or detract from investment returns. Provide an example of the effect of leveraging and the problems it creates in terms of credit creation and volatility in markets. How can governments or regulators control leverage? And is this wise in light of the financial crisis and its effects?
One of the best ways to increase the company profit is through financial leverage (FL). Financial leverage uses debt instruments so that level of return on the company equity increases. The level of FL can find by getting the total debt and equity and ratio of debt.
Leverage is explained to use borrowed money to do investment and return on investment. It is very risky for an organisation to have a high ration of FL.
Most of the company take the effect of FL to improve the company's position and earning.
Leverage can create through options, margin, futures and some other financial instruments
Households or firms normally borrow money to do investments. To buy or sell a new house obtaining a mortgage are very common examples. We define this process of borrowing to finance part of an investment as leverage.
Leverage played an important role in the financial crisis of last year, so therefore it is important to understand that how leverage relates to risk and how it makes the financial system weak. The answer will explain the core principle both for households and individual financial institutions and for overall financial system.
Leverage and Risk: sometime it is really necessary to borrow money. If families not able to get mortgage then it not most likely that he buy a house. If new business couldn't borrow then it couldn't buy the equipment. Modern economies heavily depend on borrowing to make such investment.
It could lead to bankruptcy if more the leverage then the greater the risk. Suppose two families just bought a house for the similar price. One borrows 100% of the value, while other borrows 50% of the value of house. Both borrow on same condition and terms. First family are paying double mortgage then second family. If both families temporary loss the income, then first family will face more difficultly then second one to pay for their mortgages therefore the first one is more highly leveraged. What would happen if the price of houses itself falls. Because second family borrowed 50% of the value therefore its net value would be asset minus liabilities. So that they have a cushion to absorb the losses that come when houses prices fall. The first family who borrowed 100% of the value has not cushion. This example applies to financial institutions and even to governments. More they borrow to finance investments, greater the chance that negative impact will make them default or bankrupt.
Financial institution have more highly leveraged than households. Many financial institutions have more than thirty times leverage than their net value.
Very high leverage means that very small change in value of assets would be vulnerable. Suppose when borrowers have more than thirty times leverage than a small decline of 3% net value could lead to make his net asset value zero.
When highly leverage financial firms making losses, they normally try to reduce their leverage by deleverage (by selling assets and issuing securities that raise their net value). These sorts of actions reflect an increased awareness of risk or reflect to reduce willingness to take risk.
Government rules compelled financial institutions on deleverage that require them to hold larger cushion to insure against possible losses from assets.
When there is sufficient demand outside the financial system for the asset that banks are selling to try, it's not possible to institutions to deleverage at same time. When many institution try to sell assets a once is called paradox of leverage their efforts will surely prove counterproductive: fall in value mean losses, rise in leverage, and making asset they hold to be seem risk.
Falling price and reduce in net worth make it riskier for financial firms to hold the inventories of securities needed to make markets, so liquidity of market reduces. If price fall dramatically, the value of net asset of financial institutions can cause investor to demand a risk premium for giving them money so their chance for liquidity declines. Fall of prices and widespread deleveraging cause the financial crisis of 2009. Highly leveraged financial firm just aware of their exposure to risk sough to sell assets quickly and raise their net asset.
No doubt leverage increases the profit from an investment but it also increase the risk of default. When financial crisis hit household leverage, financial firm and even governments were forced to learn more core principle that compensation required for risk. Reduction of risk through deleveraging sometime proved infeasible and some firms failed and other were looking for merger partners or public help to survive.
Abir Qudrat, Financial derivatives and the global finanical crisis, student of north south university, 2009.
Abhishek gupte, Financial instruments responsible for Global Financial Crisis, 2009.
Fabius Maximus, A solution to our financial crisi, September 2008.