Main Factors That Contributed to the Global Financial Crises of 2007-2008

Assignment No. 3

By: Sandhya Kumari Chandwani

Reg # 1366113

Marks: 5

MBA D II A and B

Last Date of Submission: May 6’ 2014

Via email: masdmasd@gmail.com

Subject Line in email: Assignment 3 (Name and Registration no)

1. Identify and explain the main factors that contributed to the global financial crises of 2007-2008. (Word limit: 400-500)

Answer:

The major factor that contributed to the global financial crises were various attempts made by US administration to make credit available for home loans to all the levels of income, social groups and geographical locations. Banks and many depository institutions in US started to grant mortgages to those people as well who presented a very high risk of default. These mortgages are called sub-prime mortgages. These subsequently results in sub-prime crisis. In order to lay off risk associated with these mortgages, banks were then involved in the process of securitization by creating special purpose vehicle. In this way, bank converted its loans into cash so that it can lend again and result in expanding cycle of credit formation by issuing asset backed securities to refinance the further sub-prime mortgages in growing property markets. These SPV purchased these loans for cash which came from the issue of bonds which were backed by the income stream flowing from the mortgage holder. CDOs (Collateralized debt obligation) were then issued which repackaged the risk of a large number of risky assets such as sub-prime mortgages. Risks were then distributed into layers or tranches. Those investors who wanted more return went for higher risk. When payments are received from borrowers in the form of loan repayments and interest payments, these tranches were paid sequentially. CDOs could only be traded between banks and other financial institutions under US Securities and Exchange Commission rules. As property values started to decline and with rising unemployment caused number of defaults to occur and liquidity dried up that the CDOs required to satisfy their investors. All the tranches then became unfunded. Another problem that was faced by bank was how to value CDOs. There was no effective market against which these CDOs could be marked but they had to be marked to model in the bank’s balance sheet. Banks till the time became highly geared up and drastic asset value decline was faced by the banks. Because of this risk, banks started unloading their asset backed securities on to the market. But the sellers could not able to find the buyers for such assets in this restricted market. These sub-prime debt issued in US had become distributed across global markets and smaller sub-prime problems began to occur in other countries to refinance further sub-prime mortgages. In this way, credit worthiness of other banks were affected and banks became reluctant to lend on the interbank market. As result LIBOR started to rise which threaten the liquidity operations of banking system and credit began to dry up. At the end, homebuyers cannot raise mortgage which caused property prices to fall which further accelerated the crisis. More people defaulted on their loans and consumer confidence deteriorate and economy began to slow down.

1. Identify and explain the purposes, tools and limitations of fiscal policy. (Word limit : 250-300 )

Answer:

Purpose:

The main purpose of fiscal policy is to control the economy by fiscal policy tools. This policy refers to government policy that influence the direction and pattern of economic activity through government expenditure, taxation and borrowing. Changes are constantly occurring affecting both aggregate demand and aggregates supply causing changes in the economy. One of the function of fiscal policy is to determine how much funds are need to be allocated and distributed throughout each segment of the economy.

Tools:

There are two fiscal policy tools, one is taxes (revenue tool) and the other one is government spending/expenditure tool. Government collect taxes in various forms like direct and indirect taxes. Direct taxes are levied on individuals and firms whereas indirect taxes are levied on goods and services which includes sales tax, excise duty and value added tax.

        Spending tools include increasing or decreasing the government expenditure. The spending can be in the form of capital spending, current payments and transfer payments. This tools helps in building infrastructure that provides growth.