The Global Financial Crisis

Introduction

This report is based on the global financial crisis of 2008, in this report we look into what caused it, the effects of poor risk management, the subprime crisis and also how Australia has been affected by this matter. Although the GFC may not be the end of the world, it has had a catastrophic effect on the way we live and it doesn't look like it's going to end any time soon. The subprime crisis of 2008 kick started an event in which has had an effect across the whole world and many countries are still feeling the pressure of the GFC today.

The Cause

The Global Financial Crisis began in with the subprime crisis in the US which eventually developed into a financial crisis that engulfed the world. However, the subprime crisis may merely have been the catalyst to a crisis in a global financial system with questionable risk management practices. These practices included off-balance sheet financing and a pervasive use of leverage to finance presumably low risk assets on a rolling basis using short term funds. Many of these assets were exposed to the US mortgage market, hence the relevance of the subprime crisis. The period before the GFC was characterised by low interest rates, easy access to credit, a prolonged and a general increase in assets prices with low volatility. These conditions may have contributed to a generalised institutional complacency to risk management, with the usual relaxation of credit terms and requirements that come with affluent times. The consequence of such loosening of credit standards over such an extended period resulted in large and recurring assets write downs, a loss of confidence in the banking system and the insolvency of numerous banks, both large and small. According to the Bank for International Settlements (BIS), the GFC was not a one-event phenomenon but instead consisted of 5 stages, each containing a confluence of events that moved the crisis from one stage to another. The first stage involved large asset write downs, a deterioration of funding liquidity, culminating in large losses for the banking system. The

BIS puts a time frame on the second stage of the crisis, it highlights the period between June 2007 and March 2008 where the hither to funding problems gave rise to concerns about solvency and the increased risk of bank failures. The third stage was precipitated by the failure of Lehman Brothers, which at the time was the largest bankruptcy in US history. The failure of Lehman Brothers lead to a global loss of confidence which required government intervention on a massive scale. However, this broad government intervention had perhaps the unintended consequence of bringing about uncertainty about the global economic outlook with the markets having a gloomy disposition and adjusting accordingly. The BIS notes this as stage four and observes it occurring from October 2008 to March 2009. Stage five consists of market optimism despite continuing negative macroeconomic and financial news the BIS laments that the end of the crisis may still be some time away.

Risk Management

The underlying theme of the GFC and its phases is that of risk, more specifically the management there of, the failure of risk management brought about the GFC and continual failure to manage risk may lead to another GFC. The role of risk manager then becomes of paramount importance as institutions try to tackle the challenges that an uncertain future brings. Institutions however, will need to recognise the importance of this role and work to support and promote the significance of the risk manager in the fortunes of the institution. In their article 'Risk Management Lessons Worth Remembering From the Credit Crisis of 2007-2009 Golub and Crum refer to some practices at Washington Mutual Inc (WaMu) whereby the protestations by risk managers regarding the company's lending practices fell on deaf ears and that risk managers were treated unfairly and may have even been dismissed. These accounts may be apocryphal but if true it demonstrates the lengths that WaMu was prepared to go to avoid diligent risk management. Golub and Crum also go on to recognise that the role of risk manager whilst mandated by authorities was considered nonessential when it came to making investment decisions. Such attitudes may have been the most egregious of sins perpetrated in the lead up to the GFC. On 25 September 2008 the Office of Thrift Supervision (OTS) closed Washington Mutual and appointed the Federal Deposit Insurance Corporation (FDIC) as receiver, the company was subsequently purchased by JP Morgan for $1.9 billion. WaMu suffered losses in three consecutive quarters totalling $6.1billion due to the housing market down turn. With risk management being marginalised financial engineering could proceed relatively unchecked, particularly in the area of mortgage securitisation. Home loans were bundled together and resold in secondary markets with the intention of shifting the risk from the banks to the end investor. On the lending side mortgage products were customised to meet specific needs of some borrowers, there was an all out effort to provide as many homes loans to as many people as the many types of mortgage products would allow. As a consequence mortgages became more complex, mortgage underwriting standards fell and borrowers started borrowing beyond their means. Simultaneously, the types of mortgage backed products available to investors became more complicated but the high ratings provided by the credit ratings agencies for some of these products meant that investors ignored due diligence and began speculating.

This easy financing for borrowers and speculation by investors provided the back drop to an emerging domestic asset bubble in the U.S., with European and other overseas investors snapping up esoteric financial instruments in search of higher rates of return. Foreign investment in U.S. assets in 2007 exceeded $3trillion, a large portion of this investment was in the so called asset backed securities. With such a large investment in U.S. asset backed securities foreign investors were exposed when the subprime crisis developed domestically in the U.S. In Europe this considerable exposure first became apparent when BNP Paribus froze redemptions for three of its investment funds due to its inability to correctly value structured products. This in turn increased the counterparty risk between banks resulting in an increase in the rates that banks charge each other for short term funds.

Effects of the subprime crisis

The elements of the subprime