The relevance of the International Financial Crisis - Free Essay Example

The financial disasters of the late 2008 and the period since can be attributed to a false understanding of risk by the institutions because they forgot to apply it. Management of risk is one of the canons of their business but rather than apply it in their dealings, they allowed greed for more profit to becloud their judgement. Banks and other financial institutions are indeed in business to make profit and add to shareholders value. By so doing, they confront all manner of potential risks all firms must face in order to achieve the goal of profit maximization and shareholders added value. It is in the pursuit of these twin objectives, that banks and other financial institutions ignored risks inherent in the various transactions that took place during the financial crisis of 2008. There were so many risk factors the financial institutions failed to take into consideration in their quest for profit maximisation. Outlined below are some of the relevant risk issues associated with the financial crises which they failed to consider and apply. 1] Concentration risk 2] Portfolio risk 3] Default risk 4] Liquidity risk 5] Systematic risk Concentration risk Most of the banks and other financial institutions in that period failed to diversify their loan portfolio. They became heavily involved in mortgage lending because of its high yielding returns and because they were fully secured by the underlying tangible asset. It is well known that concentration in one product market is dangerous hence, the massive downward adjustment in global real estate market prices that led to massive losses. Had the institutions diversified their portfolio, the losses would have drastically reduced. Portfolio risk Asset Based Lending During the period, most of the financial institutions were encouraged to be involved in mortgage lending and other complex collateralised debt obligations forgetting that collateralised assets do not pay debts except cash flow and the ability of the debtor customers to pay their debt obligations when they fall due. Moreover, in a period of crisis and defaults, collateral values tend to decline and that calls for lenders to seek additional collateral with a view to correcting the collateral deficiency of the debt or demand to be repaid or seize and sell the collateral pledged. During the crisis, wave of foreclosures forced down prices of all manners of collaterals. The repercussion was that, the foreclosure of the properties drove down liquidity. According to Davis (2008 p.15) in his explanation in his DIIS working paper, unsecured lenders saw that money was being lost by secured lenders (when their properties were put on sale) and began to withdraw their often short-term funding too thereby creating liquidity problem. Another was the Collateralised Debt Obligations: Banks involvement with CDO raised so many questions as to if the CDOs were what caused the crisis, although it served as a good reason for the banks to keep on lending along with investors who also saw a positive way of increasing returns in events of a drop in interest rates (Marinescu, 2010 p.1). These CDOs were categorised under three segments which were; Junior, Mezzanine and Senior. The Junior level involved high risks and returns, along with mezzanine which stood in the middle, while the Senior level was regarded as the safest with low risks and returns. This however did not stop the investors from wanting to gain higher returns especially in the year, 2002 and 2003, which made banks create what Tett (2009 p. 110) referred to as a CDO of CDOs (meaning) instead of the company purchasing a bundle of loans, it would possess pieces of debt issued by other CDOs and then issue new CDO notes, all with the main purpose of making bigger profits. Liquidity Risk Liquidity was another major risk that the banks and other institutions faced which later became a critical issue in 2008. They took it for granted and were attracted by the fees available in a high-churn business of extending new loans, selling them on and lending again. They also presumed continually that rising asset values would protect them against any borrower difficulties. With what was known as the Structured Investment Vehicles (SIVs) not being able to sell their commercial notes, in addition to the leverage of the banks, default of payments on the part of the customers, investors being too afraid to invest anymore in what they were not sure of and a bank-run on the part of the customers, all if not more contributed to a decrease in liquidity in the process. Also the Collateralised mortgage obligations contributed to this because they were assets and generally not cash at hand which made them somewhat difficult to be sold on a quicker pace and led to the problem of liqui dity which pushed the unfortunate banks to insolvency. Default Risk This risk later became a reality when the customers defaulted in payment which may have come about because of a crash in house prices and not wanting to end up paying back the loans they took, or as a result of the unemployment and the increase in interest rates, the average rate on an adjustable mortgage rose from 3.5% in late 2005 to 5% by autumn of 2007 (Tett 2009, p. 226). Tett (2009) also mentions the unkempt nature in which some of the houses were left by the defaulters who moved out, making it difficult for the institutions to sell them for a good price- which was also impossible because of the fall in prices as mentioned above. Systematic Risk The Financial Institutions were interested in moving assets from their portfolios by spreading them out that they failed to look at what might happen in the future concerning those risks. They were focused solely on idiosyncratic risk and were blind to the record build up of systematic risk that had happened right in front of their eyes, partly with their permission (Kapoor, 2010 p.31) CONCLUDING REMARKS Operational risk played a major role in showing how some of the Financial Institutions took the coming of a crisis for granted. Majority of the banks were not prepared for the shock, which brings us to the question of asking if no careful attention was put in place to reduce these levels of risk. At first, the banks felt they were diversifying their risks by embarking on projects they considered safe which were indeed not, although some rating agencies declared them safe, it was later observed that there was no transparency on the part of these agencies which meant there was a high rate of information asymmetry which served as a disaster to Lehman Brothers who invested in these bad assets (Stiglitz, 2009). The Mortgage assets held by Lehman Brothers and their involvement in sub-prime mortgage lending, along with the belief that they could earn high returns on investment with the continuous rise in house prices, took a turn-about when the prices fell and they were highly leverage d. In an attempt to move assets off its balance sheet, Lehman brothers before its collapse transferred assets worth 5 billion dollars (Merced and Sorkin, 2010 p.1). Never the less, no one was able to come to its rescue, mainly because institutions didnt trust each other anymore. Another risk which was misunderstood was the default risk. The diversification of the risks were held under the notion that because they were being spread out, the risk of one defaulting would not affect the others, but the diversification was not going as planned in the sub-prime mortgage sector, and since these asset backed securities (ABS) were somewhat grouped together even though spread around, a default in one simultaneously led to a default in the other. SIVs were believed to be safe, but the Institutions did not take into consideration that since SIVs were completely off the rules of the regulators, the central banks were in no position to bail them out in the event of a crisis which eventually ar ose when SIVs were no longer able to sell their commercial notes. The leverage of Financial Institutions and the dependence on ABS, particularly mortgage backed securities caused so much havoc which pushed some of them on the verge of bankruptcy, For example; Bear Stearns the company was involved in mortgage backed securities, paid for by debts with short maturities and these mortgage backed securities were difficult for them to sell at a fast pace (Tett 2009, pp. 203- 236). Roles of Regulators There have been several debates as to whether the bank regulators could have contributed more in terms of monitoring the banks, supervising and scrutinizing these financial institutions in order to detect any illegal devices. Epstein (2008) commented on the fact that supervisors should have gone the extra mile in monitoring the risk of banks. He further went on to point that majority of the problems associated with the financial crisis originated from not paying full attention to the operational risk. The lackadaisical attitude in the financial system arose as a result of how the system regained balance after the Internet bubble and the collapse of Enron and Amaranth in 2006. By 2007, the dominant creed at the Washington Federal and US Treasury was that credit risk had been so widely dispersed via credit derivatives and CDOs, that any blows would be absorbed (Tett, 2009, p. 179). Again the regulators relied solely on the risk assessment techniques of the financial institution s which were not exactly error free. The banks on the other hand, felt they were doing a good job at managing their risks through rating agencies, diversification and many more, so also, risk assessment models and these mathematical models approved to be safe were indeed not because they failed to look at all other underlying factors associated with risk and could not clearly see the implications of excessive leverage, default risk on the part of the customers, the risk of sub-prime mortgage loans, the general misguided opinion of a constant rise in the house prices and the greed to earn higher returns on investment.