US housing market
One of the greatest risk posers are the government-sponsored enterprises (GSEs). The size of the government-sponsored enterprises (GSEs) investment portfolios creates regulation gaps that then catapult to lack of systemic risk regulation, exposing the economy to possible failure. Due to lack of universal market discipline between the GSEs and other mortgage investors, the government-sponsored enterprises (GSEs), create a gap of non-conformity to investment regulatory policies.
GSEs are allowed to operate with lower capital than other mortgage investors making them more vulnerable to liquidity failures. Due to the interconnectivity of the government-sponsored enterprises (GSEs) activities, failure among the GSEs investment channels would spark a failure in the investment portfolios trickling down to major investors. Speculations made in 2006 about the US housing market did not materialize. This caused the chain of financial failures around the globe and the effects of the credit crunch did not do the system any good.
“Even intelligent, well-informed people – who certainly knew that there had been bubbles throughout history and could even recite examples – typically did not comprehend that an epidemic of irrational public enthusiasm for housing investments was the core of the problem” (Shiller, 2008). With the increasing house prices, lender banked on the increase and lent our huge amount of money with the notion that if the borrowers default the collateral they had given would be liquidated to recover the loans.
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However, most of the loans lent out were lost when the housing market deteriorated and liquidation of collateral was invaluable as there was not market for the houses that had been used as collateral. Besides banks in the US, banks in other countries were lured by the notion that wholesale lending would create great returns. From the regulators’ perspective, the greater the lending by the financial institutions the greater the risk that would be incurred. With risk increasing resulting failure would lead to an economic collapse both for the firm and the system.
Though there may be a recovery in the finances of many firms, it may not be to the original levels. The excessive optimism from investors about the market prices and the underlying risk covered their foresight into the financial system interconnectivity and risk of failure. Drawn into the housing financing vacuum was the Northern Rock that borrowed heavily to invest in the mortgages that it assumed would pick up value in the future. This was however, not the case and the collapse of the US housing market spilled over to the UK causing major losses in Northern Rock.
Another example is the UBS case. As Citi and other firms sought securitization by growing their fixed income through investment banking, UBS sought to follow the trend by hiring a consultant to define the strategy. As risk managers left the company and were replaces by sales oriented personalities, risk assessment was inadequate and not well managed. Instead of focusing on the market and system risks, UBS’s main focus was on defeating its competitors and attaining leadership in the market. Growth and rapid growth in this case, was the main focus areas for the sales oriented team.
Poor performance coupled with cases of financial failure has seen new market entrants why aware in the face of probable loss. This on the other had reduces the hedge funds capital assets in their control creating a fresh risk of system failure. Some of the main causes of the current crisis that can be openly noted are: Failure by lending firms to scrutinize the borrowers intent and loan repayment capability Failure of network economies such as Asia and Russia that contributed to the failure of a chain of economies around the world.
Failure by system risk regulators to tighten policies that would prevent past crises scenarios from reoccurring Financial firms focus on competitive growth rather than risk management Increasing reliance of risk assessment models has created a vacuum in strategic management essential for the analysis of economic status and market stability Value of assets held by hedge funds is going down as the funds try to sell them off to regain solvency. This then creates a vacuum of equity capital help by the hedge funds making the highly vulnerable to failure.
Investors flight to quality trends are increasing. When one firms’ returns rates go down due to looming failure, the investors rush to withdraw their investments to try and deposit them in high interest returns hampering a turnaround for the financially challenged firm and fueling its rapid failure The intertwined complexity of financial market facts. Its believed that the higher the risk the higher the returns, therefore if one regulator says that the only way to eliminate systemic failure is be eliminating risk, then the regulator would be eliminating returns.
This turmoil has led to the confusion on what would be the best policies that would both lower risk and generate high returns. Regulators increasing dependency on past analysis results rather than generating forward based simulation to show risks that may be encountered in the future and applying relevant preventative measures. After one crisis happens the only measures put in places to counter reoccurrence are based on past gaps. This means that as technological advances increase, it would be difficult to prevent future reoccurrence of a crisis since policies implemented are based on old and outdates technology
Thought capital at hand would shield firms against total failure when systems collapse and debt. With capital debts owed to depositors can be covered by the capital held however, capital can be expensive and some bankers are always looking for ways to reduce these expenses leading to a reduction in the capital held. In the case of a financial failure, the bank may not have adequate capital to reimburse depositors hence a vacuum of debt is created that would spillover to other interconnected banks unless there is a buyout of the bank in crisis by a Federal Reserve or Central bank.