From the above discussions it is true that subprime crisis really affected the U. S and European markets and economy. In the final analysis, various insights can be provided with regards to the best way in which financial markets can be protected. As demonstrated in this article, it is important to recognize the fact that many causes of the subprime crisis are capable of being categorized into conflict, complexity as well as complacency. Conflicts are the easiest to identify and manage.
For instance, with regards to subprime crisis, this article illustrates that the demerits of originate and distribute model is capable of being managed by streamlining the interests of the lenders of mortgage with those of the investors. In this respect, the mortgage lenders are expected to have shouldered the risks of loss. However, it must be noted that it would be cumbersome to manage some conflicts more so, those concerning agencies. The subprime crisis greatly affected the investors in the North America, Australia, Asia as well as Europe.
It led to the halting of the asset backed commercial paper. At the same time, it has led to banks experiencing problems of liquidity. Generally the crisis has affected the overall economy. An attempt to trace the history of the subprime crisis reveals that the rates of interest were relatively down during the beginning parts of the decade. The low rates of interest led to rapid increment in the financing of mortgages as well as a significant rise in the prices of houses.
The end result of this was the investors seeking instruments which enhanced yields such as pension funds, hedge funds as well as investment banks among others. Given that subprime mortgages offered higher yields as opposed to standard mortgages, it has been being demanded as a security, which allows one to transform assets which are below investment grade into investment grade liabilities. With regards to complacency, the study establishes that it is little to track owing to the fact that complacent behaviour needs human behaviour change, a task which is impossible to achieve.
Usually after a crisis, like the subprime one, individuals usually focus on instituting measures aimed at evading a similar crisis in the future. The subprime mortgage crisis seems to have rendered credit less at least one type of complacency, the investor’s widespread obsession with securities which do not have stable markets and, are on the contrary, being valued by being model-marked. What needs to be noted here is that, other modes of complacency are rational meaning that they are only capable of being looked into by way of structural changes.
For instance, investors are certainly likely to rely heavily on rating agency in as much as the cost of making individual credit investigations is still high. This has the implication that if rating agencies continue to come up with unreliable findings, probably investors should reconsider if collective-action approaches of innovation like the collective credit determinations could offer reliable results. This however does not man that collective approaches do not have their share of demerits, they may not be trusted.
The category of complexity is the least possible to trace. For instance, complexity was highly responsible for the issue of failed disclosure as discussed in subprime crisis. This has the implication that over and above disclosure, the issue of complexity is more of a metaphor used in contemporary financial system and its high likelihood for failure, which is further demonstrated by the tight coupling which is the main driver of markets towards crises.
The above categories do not capture certain failures like systemic risks, whose uniqueness results from some kind of tragedy of the commons. Owing to the fact that benefits of if the exploitation of finite capital resources accrue to individuals participating in the market, while participants in the market do not have sufficient capacities for internalizing the externalities they have. That notwithstanding, it has to be noted here that the government has the capacity of purchasing securities which are collapsing like the subprime case.
This the government does at profitable discount rates with intentions of reducing moral hazards in a bid to prevent instability of markets which are a potential cause of systemic collapse. Finally, it is important to verify if occasional instabilities of financial markets have long-run negative effects on the economy. Instabilities in the financial market are generally considered as acceptable in a case where their scope is generally limited. The rationale here is that such instabilities could act as critical valves of safety.
However there is need to address some concerns. First, on a level of distribution, market instabilities affect people and the subprime crisis; many of the affected people were the low income earners. More fundamentally, it is not granted that the subsequent crises wouldn’t spread and transform into a big one affecting the financial system as a whole. The study equally recognizes one fundamental way in which the subprime crisis could have been avoided is by managing risks more as the liquidity as well as the credit and market risks.
What is meant here is that having undergone a long period of financial market liquidity, the sharp decline in the value of subprime mortgages as well as related mortgage securities coupled with the erosion of investor appetite during the period translated top a deep distress of the market during the summer of 2007. With respect to risk, the study established that one way by which organizations tended to manage risk was by effective corporate-wide risk identification and analysis.
In this regard, organizations which tended to share both qualitative as well as quantitative information among their senior managers eventually emerged more effective. Regarding liquidity risk management, it important to recall that as the interest of some investors to purchase certain types of assets declined, the willingness of firms to offer credit as well as liquidity to others tended to soften owing to their willingness to maintain some level of liquidity for their own needs.
It therefore implies that the level of reserves of contingent liquidity which are held by any firm tends to vary with various factors like business models, geographic dispersion, as well as degree of centralization among others. For instance, security organizations may offer to hold more excess liquidity more than banks owing to the fact that they may be lacking the stable sources of funding of retail deposits. In addition to managing the difficulties of liquidity risks, it is equally important to manage credit and market risks.
In this regard one most vital point that needs to be looked into was valuation. The concept of valuation is very important when dealing with risk management. Valuation in this case is used to refer to the process by which organizations assign certain prices to the holdings it has. The motive for price valuation is to establish the price at which the organization could either sell or transfer an instrument in ordinary market transactions of today. Therefore during the subprime crisis, organizations which had active approaches of valuation looked for ways by which they could accurately value their assets.
This implies that the issue of valuation was a challenge during the subprime crisis. It is equally very important to also recognize that the process of mortgage originators selling and offering security to loans was the reason there was a sharp change in the supply of mortgage credit during the period of 2001-2005. This increased expansion had effect on the customers of subprime who were initially marginal borrowers not capable of accessing the mortgage market.
This means that the change in mortgage supply eventually led to increased profile of those who wanted to borrow as well as an increase in supply-induced house price as well as growth in mortgage credit. The result of these changes was the increased rates of default which spiked off the rates of default eventually depressing the mortgage market leading to the subprime crisis. As earlier stated, the subprime crisis greatly affected the U. S and European markets and economy.
This is evident in the way credit risks highly persisted in the U. S. in other words, the quality of credit of the most recent mortgage vintages continue to be worse. At the same time, charge-offs in the U. S are currently on the rise from a generally poor base, cutting across all main categories of credit. The result has been increased concerns regarding potential future losses in some big commercial banks in the U. S which could greatly influence the economy. Presently, it is quite difficult to project a bottom for the housing market.
Equally, the price of houses in other economies lime Spain, United Kingdom and Ireland are beginning to soften thereby resulting to concerns about the imminent future losses in the mortgage, commercial as well as construction industries.
Ashcraft, Adam and Schuermann, Till. Understanding the Securitization of sub prime Credit. 2008. Federal Reserve bank of New York Staff Reports. Aguesse, Is Rating an Efficient Response to the Challenges of the Structured Finance Markets? Risk and Trend Mapping No. 2, Autorite des Marches Financiers 2007. http://ssrn.com/abstract=1113888