The the costs of moral hazard. The banking

The financial crisis of 2007/8 reviewed the most
serious crisis of financial industry, different factors had contributed and one
of the factors is financial innovation and subprime mortgage markets. The
function of financial innovation is creating new financial instruments,
technologies, organization, and markets. The outcome of financial innovations
is mortgage-backed securities products and implemented collateralized debt
obligations (CDOs) during the period of financial crisis. Collateralized Debt
Obligations (CDOs) is a complex financial product, its special purpose vehicle
(SPV) had created securities from those purchased assets and then sell it to
investors. “CDO portfolios generally combine a variety of assets (e.g., bonds,
mortgages, other asset-backed securities (ABS), swaps), and the associated
credit risk is subdivided into different risk classes or “tranches.””( Pernell-Gallagher, Kim. 2015., Learning from Performance: Banks,
Collateralized Debt Obligations, and the Credit Crisis.) Many subprime mortgage
bundle together sold could lucrative for banks and the bank dependent on US
federal government support and guarantees. “The total value of USA subprime
mortgages has been estimated to have peaked at USD 1.3 trillion in March 2007. “(Buckley, Adrian. 2011., Financial Crisis.
online. Financial Times/ Prentice Hall.) It had led to a moral hazard to
happen when one party behave inappropriately after the financial transaction
has engaged while another party needs to suffer for the costs of moral hazard.
The banking crisis is another main factor that led to the financial crisis. For
instance, bank runs occur is when the customers withdraw their deposits as soon
as possible because they worry the bank might fail and it could affect the
banking activity. Besides that, banking crisis includes banking panics and systemic
banking crisis, which could lead increasing defaults in a country and all the
banks. Numerous of the financial institution and the government gave their assistance
during the crisis to avoid the financial system collapse. On September 2008,
Lehman Brother filed for bankruptcy, Merrill Lynch had sold to Bank of America
at low prices and AIG had lost billion. In addition, one of the factors
contributed to the financial crisis is agency problems and asymmetric
information. Agency problems happened when mortgage originators did not hold
the actual mortgage but they sold the notes on the secondary market to get the
commissions from the loans.
During 2007 to 2008, originators had got
information that many of borrowers from these loans about to default but they
still sold these loans to banks. Asymmetric
information occurs when the parties engage in a transaction, there do not have the
same information in between the different parties and it could exist between
investors and companies or investment corporate. Because when investors are evaluating
companies, companies may have good or bad information while investors or stock
analyst is lack of the information lead the risk exists between investment
firms and investors. For instance, the investment firm may advice their
customer to buy a company’s stock while they knew the stock’s price is decreasing.
Banks have to estimate the exact of riskiness with intelligence that precise in
order to do a rational decision.

Financial innovation and subprime mortgage markets factor
had led to financial crisis while financial innovation is ongoing development
on financial products to achieve specific customer objectives and offset specific
risk exposure (For example default of borrower) to assist obtain financing. The
bundling of subprime mortgages through securitization into collateralized debt
obligations (CDO) sale to investors. Borrowers which less than credit worthy
able to purchase a house through subprime lending because they taking advantage of collateralized debt
obligations (CDO). Northern Rock was a local mutual building society at 1850
and the company merger the Northern Counties and Rock Building Societies in
1965. At 1997, the company was demutualization and became prominent exponent of
mortgage lending. Northern Rock lending and offer cheap rates to the customer
had made them became the UK’s fifth-largest mortgage lender. By the way, housing
bubbles had occurred when housing prices increased in early 2006, but it
started to decline in 2006 and 2007. After the collapse of the housing bubble
had led to mortgage delinquencies and foreclosures increase, which is bank has
right to take possession of the mortgaged property when the mortgagor fails to
make payment and led the housing-related securities price decreased.  Besides that, Northern Rock faced the financial
crisis because of fell the standard of underwriting to increase approved on the mortgage had caused people intended
to buy houses that they could not afford led housing prices keep increasing. Increased
of house value led a large number of house owner to borrow against their house
to earn a lot of profit. But after the people not able to repay the mortgage
incur high delinquency rate and the value of these assets decreased at rapid
speed. Banks that were invested in these assets had started faced the lack of liquidity
and deteriorating balance sheets. Deteriorating balance sheets lead financial
institutions into insolvency and these lead to a bank panic. All depositors to
withdraw all funds immediately because they are worry and no idea which bank is
insolvent. Northern Rock started faced problems in raising funds in the money
market to replace maturing money market borrowings. The agency problem and
asymmetric problems arose when credit rating agencies gave asymmetric
information to investors while they consulted with firms to structure a fake
product to achieve the highest rating. Investors have taken on additional risk
when they relied on the asymmetric information. Borrowers get easier to qualify
for prime loans and make subprime to purchase the house that they not
affordable.  Banks had reduced the importance
of proof on income and assets. Besides that, they had lower the mortgage
underwriting standard, loans moved from full documentation to low documentation
and to no documentation. This action had made Northern Rock accumulated a large
number of mortgages and when delinquencies rate increase made they faced the liquidity
crisis. The reason that Northern Rock had nationalisation is when the subprime
housing problems rose up, banks stopped lending to each other because of the
fear towards exposure to bad debts. Northern Rock became unable to repay
loans from the money market because they lack fund raised after the subprime mortgage crisis began and the global
demand from investors for securitised mortgage was declined. Northern Rock’s
source of funding is completely dried up led to liquidity problem and forced to
approach the Bank of England, as lender of last resort for an emergency
financial assistance. When run on the bank occurred, many customers queued
outside branches to withdraw their savings and led to liquidity crisis out of
control. The bank was taken into state ownership as result of two unsuccessful
bids to take over the bank and announced was to be nationalised.

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Nationalisation means by government
take control of private assets or corporations into public assets or public ownership,
normally is purchase the assets from current legal owners. The opposite of
nationalisation is privatization, mean a public enterprise is give up of
control by government and disposal of shares and equity of the enterprise. “In August
2008, the company reported losses of £585 million for the six months to June
2008, £314 million higher than the base case forecast and worse than the
recession case used in the March 2008 business plan.”(House of Commons Public
Accounts Committee, 2009, The Nationalisation of Northern Rock, Thirty-first
Report of Session 2008-09). Northern Rock’s £25bn Bank of England loan into
bonds and guaranteed by government. The company need to repay £9.4bn loan to
reduce amount owed to £17.5bn from the Bank of England. In February 2009, the
nationalisation of Northern Rock bring forward legislation. The government
announced to support lending for Northern Rock to begin writing new mortgages. The
bank was split into two parts, Northern Rock Plc, which represents the “superior”
bank included new mortgages and savings while the “spoiled” bank of Northern
Rock was merged with state-owned rival Bradford & Bingley, designed to cut
costs and expected to generate greater returns. On 17 November 2011, the
government announced had sold Northern Rock to Virgin Money for £747m. Virgin
Money will have to pay the government an additional £50m to £80m if they
successful sells or lists the combined business on the stock exchange in the
next five years. Virgin Money had combined the two businesses together because
Virgin Money has credit cards, insurances, and investments but lack of
mortgages, savings, and current accounts while Northern Rock fulfilled their
requirements. Taxpayers had injected £1.4bn into Northern Rock plc, while the
spoiled part of Northern Rock is still owed Treasury £21bn and uncertain about
the potential losses contained. The net impact for nationalisation has been
positive because through the nationalisation government had saved the bank from
bankruptcy and tried to keep reducing the job losses. One of the advantages of
nationalisation is if Northern Rock loses more money from mortgage defaults,
the taxpayer will take responsibility for the losses. However, the government
could benefit from the profits of banks if the bank does well. During
nationalisation process, the government helped to enhance the company’s
financial conditions purpose to sell the company at a better price after a few
years later. The main reason led to this financial crisis is financial
innovation in mortgage and poor management of the bank, in fact,
nationalisation had helped avoided the collapse of economic or getting worse
circumstances. Through this financial crisis, we able to aware of the
disadvantage of deregulation, agency problems, and how serious the damage could
bring to the market if we don’t take seriously on the factors of financial

One of the reason led to the
financial crisis because most of the commercial and investment banks had been
deregulated started in 1980. The Glass-Steagall Act was repealed in 1999 for split
up the powers of commercial and investment banking to ensure that banks cannot
take the risk with the deposit money. In 1994, a credit default swap (CDS)
which is a financial swap agreement was invented by Blythe Masters from JP
Morgan. It designed to transfer the credit exposure of fixed income products
between two or more parties and it was increased in use in the early 2000s.
In the past, borrowers were able borrowed
mortgage to purchase a home that they may not affordable. Many banks had put
these mortgages from housing market together into packages of securities, created
credit default swap (CDS) and known as synthetic collateralized debt
obligations (CDOs). In 2000, the Commodity Futures Modernization Act had exempt
credit default swaps from regulation was passed. Besides that, the U.S.
Securities and Exchange Commission (SEC) and the Commodity Futures Trading
Commission (CFTC) largely exempt credit default swaps from regulation. By the
end of 2007, the amount of outstanding (CDS) was $62.2 trillion and was $25.5
trillion in early 2012. The lack of transparency in credit defaults swaps
market became a concern to regulators. In March 2010, the Depository Trust and
Clearing Corporation (DTCC), an American post-trade financial services company
which provide clearing and settlement services to financial markets announced
gave regulators greater access to its credit default swaps database. Credit rating
agencies (CRAs) is a firm paid by the banks who employ them to rate debt
instruments/securities according to the ability of the debtor to make
repayment. These agencies failed to remain committed to its own credit-rating
standards led to the financial crisis occurred. The agencies had given their
highest ratings to over three trillion dollars of loans to homebuyers with no
income proved by documents and bad credit record. Over half a trillion dollar
was losses and hundreds of billions of dollars’ worth of triple-A securities
were downgraded five levels to a speculative grade. On January 2017, one of the
rating agency “Moody’s Investors Service agreed to pay nearly $864m to settle
with US federal and state authorities over its ratings of risky mortgage
securities during 2008 financial crisis. In addition, EU regulator fines
Moody’s €1.24m for breaching credit rating rules and European Securities and
Markets Authority (ESMA) carried out its role to independent oversee of credit
rating agencies within the European Union. ESMA published its market share
calculation for EU registered credit rating agencies (CRAs). It is designed to
increase awareness of the different types of credit ratings offered by each
registered CRAs and helped issuers and related third parties to appoint smaller
CRAs. In an addition, The Basel Committee on Banking Supervision had published
Basel ? (Third Basel Accord) to avoid repetition of the financial crisis.  The main purpose of Basel ? is to enhance
international regulation, risk management and supervision of banks. It required
banks to maintain proper leverage ratios and minimum capital requirements to
avoid the liquidity risk of banks may out of control.

My opinion toward the factor which triggered the 2007 / 2008 crisis hasn’t
been addressed even after published Basel ? had strengthened
the banking supervisor and regulations. One of the reason is the mortgage
sector forced to shut down after the financial crisis in 2007 / 2008, currently
more and more lenders willing lend to people who were bankruptcy. But in June 2017, emerge new retail bank Masthaven
lend to people who suffered financial problems or who do not pay their mortgage
payments. The financial innovation led a great increase of the number of
default posted on credit files by mobile phone companies and more clemency on
defaults which have been registered by phone companies. There is an obligation
on brokers and lenders to check the borrower before making any borrowing to
ensure the borrowing is sensible and appropriate. Another factor which is
credit default swaps (CDS), a bundle of credit default swaps are tied to the
risk of corporate defaults and it has more than doubled in the first seven
months of 2017. Traders by over-the-counter market estimated have been issued
from $20bn to $30bn this year, compared to $15bn in the whole year of 2016 and
$10bn in the year of 2015. Bespoke tranches, type of collateralized debt
obligation (CDO) that a dealer creates for a specific group of investors are
created by allow the investor to pick a bundle of about 100 different
“single-name” of credit default swaps. Since the products are not graded by the
rating agencies, therefore, bespoke tranches possess large amount of credit
hedge funds and it exists a limited investor base. But after the market of pension
funds from the institutional investors in Canada and New Zealand have joined and
it might lead to the risk of defaults. For my opinion, the rescue of Northern
Rock is a good thing because after the rescue Northern Rock had split into “superior
bank”, containing deposits and quality mortgage assets while “spoiled bank”
containing the rest. The government forms UK Asset Resolution (UKAR) and lends
it £48.7bn to take on £68bn of loans from “spoiled” Northern Rock (NRAM
Limited) with the purpose to repay the state bailout. In 2011, Virgin Money
paid £1bn for “superior” Northern Rock, got £14bn of mortgages, and £16.6bn of
deposits. During 2013 to 2016, UKAR had sold NRAM’s unsecured loans and
mortgages to One Savings Bank, Marlin Financial Group, JPMorgan, and Cerberus. In
2017, UKAR had sold £9.7bn of NRAM mortgages and repaid £4.6bn of the
government loan and 93 percent of its borrowers are up to date with their
repayment. The rescued bank has performed well after they get bailout even
though the bank had faced the financial crisis at the beginning because of poor
management and subprime mortgage factor. After learnt from the lesson, UK banks
have raised more than £130bn in the additional capital since 2007 and the UK’s
largest four banks – HSBC, Lloyds, RBS, and Barclays, had launched rights
issues to boost their capital base in 2008 to 2009.



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