The Causes of the 2007-8 Economic Crisis in Britan

The economic crises in Britain were as a result of problems that occurred in the financial system of the United States. The spread of the downturn has been too rapid and has greatly affected the business sector (Guardian News 5 Mar. 2009). There were changes in the regulations as well as laxity in adherence to the normal process of lending and low interest rates. Equity markets collapsed and the crises spread all over world economies through the credit crunch leading to a recession and solvency in the banking system (BBC News Wed. 21 Nov. 2007). Asymmetric information usually affects transactions that take place in the fiscal market whereby information is not a significant factor to consider in the transactions. It is usually the customers who are aware of the risks and benefits associated with their intended venture. (Wendell Cox 2008 pp. 37-41). These problems may occur in the form of adverse selection or moral hazard.

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Adverse Selection

Adverse selection is the problems that are experienced before the deal between the lender and the customer is completed. It is usually exhibited by the lender giving credit to the wrong people, or the people whose risks in their intended investments are usually higher that the possible benefits. In the current financial crisis, adverse selection played a major role whereby credit was given to customers without proper analysis of their credit worth. On the other hand, the alternative would have been for the lenders to shun from giving any credit due to lack of the ability to assess the credit worth of their customers. This led to failure of firms of high quality to offer their securities since the undervaluation was evident (Frederic Mishkin 1997 pp. 67-71).

Rationing of credit was experienced due to the problem of adverse selection. This made it impossible for borrowers who were capable of borrowing to miss a loan while others who were unable to repay got it. Earlier on, the lenders were employing stringent measures for one to qualify for a loan. During this time, people who were until that time not qualified for a loan were allowed to apply. To qualify for a loan, a person was supposed to have minimum monthly earnings of $5,000 that satisfied the underwriting procedures. Many mortgage lenders contributed to the crisis. They would give loans regardless of whether the customers could afford to secure. Most of the loaned people were unable to pay for their mortgage which led to a rise in the number of defaulters creating a situation whereby the lenders could not afford to cover in their provisions. Many lending firms failed because of this occurrence (Guardian News 5 Mar. 2009).

Moral Hazard

Moral hazard usually occurs after the agreement has been reached between the lender and the borrower. The lender extends the loan to the borrower on the realization that there is a possibility of him engaging in ventures that are not desirable to the lender. He views this as a potential cause of default. As in the case of adverse selection, he usually has minimal information about the borrower and therefore it is hard for him to predict whether a borrower may engage in such activities. In the credit crisis, it was caused by the inability of the borrowers to repay the loans. There was no collateral that could help in lessening the impact of moral hazards. These could have been used to cover the losses incurred due to loan defaulters. During this time, promises made by the customers to the lenders were never realized, with the customers opting to live elsewhere, far away from their houses.

Insurance companies plunged in to high debt levels amounting to billions of dollars. There is no guarantee that shareholders will get the anticipated payments for their bonds and no more bonds are being offered by banks in the market since there is no one to buy them for fear of never getting paid for the ones they buy. There was reckless buying and selling of loans. Since the lending principles were predetermined in the loan policy and system manuals, they were assumed to be the same all through the mortgage industry. Buying and selling of mortgages by lenders was done with the assumption that the regular underwriting procedures had been completed from the initial lender. These negligent lending actions has caused commercial banks, mortgage companies, investment banks and insurance companies to incur heavy losses that rose to the tune of billions of shillings because of negligence of underwriting principles

The un-regulated Credit Default Swaps were providing uncertain mortgage bonds with insurance. This promoted irresponsible behavior during the time when mortgage was being offered by banks (Jorge Costales, Fox, pars. 6-7, 2008). Without the CDS readily available to offer insurance on these uncertain mortgages, companies could not have risked insuring such property; hence the mortgages could have been stopped before it had gone too far. There were no existing leverage control on savings banks and hedge funds and therefore they were operating at a considerably soaring economic leverage proportion. Leverage control could have assisted in ensuring that they do not lend to an extent of risky levels or fall in to the prevailing financial crisis that was caused by a general and considerable undervaluation of the imminent jeopardy.

Conflicts of Interest for credit-rating agencies help perpetuate the crisis

The process of applying for mortgage was characterized by a lot of dishonesty amongst mortgage brokers and the customers. Deceitful information was largely offered to the mortgage brokers by fervent customers in order to acquire mortgages. The mortgage brokers would gain in return after the customers got the loans. This led to a distorted representation of the customers by the mortgage brokers to banks which most of the time never took trouble to authenticate the information provided to them. This was a problem that was initiated by the banks which aimed at lending as much as possible to willing borrowers in order to acquire maximum interest. The banks viewed this as a golden opportunity to expand their markets. This was counteracted by unnecessary and fraudulent borrowing.

Policy Responses

The response of the government is significant in determining the success of solving the economic crises. The response of the Federal Reserve in the United States is the most significant. The monetary policy was eased by the Federal Open Market Committee in September 2007 which helped to reduce the Federal Funds rate target by 50%. The response of the committee has been constantly focused on the Federal Funds Rate, with a continuous reduction of the targets in regard to the proliferation of the economic decline. Through its policy, the government has been able to uphold employment and sustainable income. The Federal Reserve uses policy communication as an essential tool towards approaching issues concerning the financial crisis. Informing the public about the intentions of the fiscal policy has helped in building a positive attitude through raising high expectations about the outcome (Denis Bider 2008 pp. 46-51).

The Federal Reserve has set measures to ensure that short term credit is available for the financial institutions. It has also set up credit auctioning facilities and making borrowing easy for banks and primary securities through the window of the Federal account. The spread between the Federal Funds rates has been reduced by 75 percent, leading to an increase in the period for discount loans to 3 months. The Federal’s portfolio has long term securities that have been made available through the support of credit markets. These policies have also led to a drop in the in the rate of mortgage. These have been set in order to uphold the housing sector through reduced mortgage. Long term treasury securities are also being considered for purchase. These are expected to bring some improvements in the private credit market.

In a bid to revitalize the economy, the Bank of England has settled on cutting interest rates which will lead to a rise in the money supply. However, this might lead to a decrease in profits for the banks which in turn could lead to an increase in the impact of the credit crunch. This could be a major drawback in the efforts for economic recovery (BBC News 5 Mar. 2009). The Financial Times (5 May. 2009) reported that the Bank of England is planning to make the first-time shift of policy to buy off company debts though it is not clear how this will help in rejuvenating Britain’s deteriorating output. Printing more money and injecting it in to the economy is also another strategy by the Bank of England ease the impact of the downturn. If this process of quantitative easing succeeds, the economy may be revived (Telegraph Media 6 Jun. 2009).

Bibliography

  1. BBC News, 21 Nov. 2007. The Downturn in Facts and Figures, viewed on 5 Mar. 2009 at, <http://news.bbc.co.uk/1/hi/business/7073131.stm>
  2. BBC News, 5 March 2009. UK Interest Rates to Fall Further, viewed on 5 Mar. 2009 at, <http://news.bbc.co.uk/1/hi/business/7924234.stm>
  3. Denis B. 2008. Financial Crisis Attributed to Mortgage. New York: Knopf.
  4. Financial Times 2009. Bank Expected to Unveil Measures to Boost Money Supply, viewed on 4 Mar. 2009 at, <http://www.ft.com/home/uk>
  5. Frederic M. 1997. The Economics of Money, Banking and Financial Institutions, 8th edition, Princeton University.
  6. Guardian News 2009. Recession Britain: its Official, viewed on 4 Mar. 2009 at, <http://www.guardian.co.uk/business/economics>
  7. Jorge C. 2008. Deregulation vs. a Lack of Regulation. 2com, 28 Feb. 2008 at, <http://www.2thinkgood.com/2008/10/deregulation-vs-lack-of-regulation.html>
  8. Telegraph Media 6 Jun. 2009. Woolwich Increases Mortgage Costs Ahead of Interest Rate Decision, viewed on 4 Mar. 2009 at, <http://www.telegraph.co.uk/money>
  9. Wendell, C. 2008. Root Causes of the Financial Crisis. Primer Magazine.
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