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Causes of banking crisis 2008

Banking Crisis

Just before 2008, it was the mortgage and other loans which threw the economy in the miserable situation of economic and financial crisis. There was an overinvestment in the US land and property which unduly inflated the price of the property and the bubble was completely burst in the November 2008 which affected the whole world’s economy. This was all because of the foolish banking policies for issuing credit to the customers discussed as under:

 

 

a)     BANKS WERE LESS RISK AVERSE:

Government policies and the competitive pressure were forcing the banking institutions to adopt the higher risk policies for lending not only against the mortgage loans but also the unsecured personal loans. As the economy was in boom and there was continues hiking property prices encouraged the borrowing customers to borrow loans blindly. There were artificial price hiking and financial bubbles all around. Banks made a stream of financial innovations in the lending policies which also attracted too many customers to lend and invests in the property and other innovative business opportunities created because of the artificial bubbles in the economy and people were spending more and saving the lesser amount of money.

There were certain factors which were mishandled by the banking system including weak underwriting standards, weak risk management practices, complex financial products and resulting excessive leverage combined to construct a vulnerable banking  system. Throughout the whole world policy-makers, supervisors and regulators did not concentrated to risks building up in the world financial markets. There were not only the bubbles created in the banking debt but also in the local government borrowing, hedge funds, leveraged buyouts, commercial and industrial loans, commodities, corporate bonds  and few other bubbles were ignored by the Bankers which busted of and it was the start of long term financial crisis.

There were some foolish policies made by the banks. One of them was Ninja loans were given to the people having No Income, no Assets and No Job. In another case the debt holder was allowed to pay just the interest during the initial payment but interest not paid was added to the latter payments with principal. In another example allowed the loan holder was allowed to pay the variable installments but any interest not paid was added to the principal amount. Short payback periods also made difficult to loan holders to payback which almost doubled a normal installment payment.

Credit rating agencies also played their part of being for economical crisis when they gave high ratings to the highly risky securities which encouraged the investors to pledging take excess of debts when they were knew that rating process was faulty. According to some reports few email from Standard & Poor insisted the Rating agencies to continue which created even bigger monster.

 

 

b)     LOANS ISSUED ON THE INCOMPLETE INFORMATION

 

Issuing loans on the high credit risk policies was not the only stupid work done by the banking system but they also made the mistakes of blindly issuing the loans on the incomplete information. A huge percentage of these loans went into the defaults. Firstly the processes for the loan issuing were not made to collect enough information and secondly the basic processes were not followed and there was a huge amount of misconducts made by the banking employees.

A sale for the banking products was on boom. Sales people were handled with an extreme pressure tactics and they were forced to bring more and more cases for the loans to the banks. There were also high incentives for bringing more cases for the mortgage and the consumer loans but the basic salary was just too short. Consequently sales person started to bring more cases with the dummy documentations. The documentation for the job, bank statement, and salary proves, business proves all were dummy. There were not enough measures to verify the information and confirmation departments were not doing the work required by them in the right direction.

 

This all was done just to increase the incentives and to meet the pressure exaggerated by the sales bosses. For example in year 2006 Bank Bosses took home bonuses totaling $23.9 billion. They were only planning for their bonuses at year end but not the long-term health of their banks. The whole system was developed to gain the short-term sales objectives but ignoring the long-term obligations. There was not a right amount of check and balance in the banking system. The consumer branches of the banks were working with the best of the efforts in the worst way.  

As mentioned before that the credit rating agencies were also not working in the best interest of economy but they many of them were receiving money from the investment bankers to keep the debt security rating high. High rating encouraged the investors to have heavier debts and invest in the mortgages. In Dec. SEC USA approved standard measure for the rating agencies to end the conflict of interest by the agencies. As most of the loans were the mortgage loans and invested in real estate sector. The real estate in boom as form 1997 to 2006, the price of a typical house in American increased almost by 125%. During the twenty years ending in 2001, an American median home price ranged from 2.9 to 3.1 times of a median household yearly income. This ratio reached to 4.0 in 2004 and 4.6 in 2006. Almost 70% of the people invested in real estate for reselling rather making a permanent home.

 

 

c)      US GOVERNMENT DEFICIT PROVIDED AND RISK FREE INVESTMENT OPPORTUNITY

Both the USA governmental actions and inactions played a big role the crisis. President George W. Bush stated in his speech September 2008 that as soon as the crisis would be resolved, we must update our financial structures for regulation. He said that global economy in 21st century is being regulated largely by outdated 20th century rule and laws. Where as The Securities and Exchange Commission of USA has conceded a research according to its report self-regulation of investment banks has contributed a lot to the current financial crisis.

In start of financial crisis from 2005 USA suffered from a high and rising current account deficit. These deficits required the USA government to borrow a big amount from abroad. These trade deficits bring a big a large amount of funds to the US. A nation can not spend more than its earnings unless it sells it’s assets to foreign, or foreigners lend amount to it. So, resultantly a flood of funds arrived to USA and its financial markets financial markets. The countries supplied funds and purchased US Treasury bonds and avoided the direct impact of USA crisis. Many of the financial institutions invested these foreign funds in the mortgage-backed securities and the county’s housing and financial assets radically fell down in value when the housing bubble burst.

 

 

d)     CENTRAL BANKS AS LENDER OF LAST RESORT FACILITIES

A state bank plays its role as lender of last resort when there is no option left to intervene to protect the institutions. In 2008 the US crisis reached to its peak when almost all the banks of the country were in the position of default and a big fish Lehman Brothers Bank group defaulted. There were some serious threats for the defaulting of the four major Banks and many other financial institutions or even the whole financial system. The Central bank of America interfered by providing them help with the bailout plan and nationalized some of the financial institutions.

In the recent financial crisis Central bank of almost every country had provided the facilities of lender of   last resort when refinancing became extremely difficult and house prices had a dramatically decline in many states of the USA. The borrowers who could not pay the higher monthly payments by even after refinancing started to default. This action by the central bank provided liquidity to the commercial banks and some other financial institutions. It eliminated, settled and stopped the risky projects and department of the banks like person loans, cash line credit cards. It also provided compensation for the defaults against the mortgage and other loans like personal and auto loans. Central Bank was the last as final option to the commercial banks as a lender of the last resort.

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